For purposes of this article, a minority member is a member who does not have voting control or the power to exercise voting control over the limited liability company that the minority member is joining or has joined. This article identifies those provisions that may be important to a minority member and may be subject to negotiation.
Even though a client is a minority member, the client may still have significant leverage to negotiate the terms of the limited liability company agreement (the operating agreement). For example, a real estate developer who has control over an opportunity to acquire or develop a property but needs a money partner controls the opportunity and can (hopefully) pick the money partner. Although the money partner may have voting control, the minority partner may retain control over day-to-day operations, and the minority partner may also retain the ability to find funding from another source. Similarly, an owner of a business who is selling control, but is retaining a minority ownership share, controls the opportunity and may be able to find a buyer offering friendly terms in the operating agreement. In addition, minority owners who have little leverage by themselves may be able to team up with other minority owners and gain leverage through their teamwork. However, in a situation where the client is an investor who simply is providing funding and the organizers can find replacement investors, the client is likely to have little negotiating leverage.
The purpose clause is a statement of the scope of the LLC’s authority to conduct business; management may not cause the LLC to enter into agreements or conduct business outside the scope of this purpose. From the standpoint of the minority investor, a purpose clause permitting “any business” or “any purpose,” or a clause permitting broad types of activity, may allow a manager or majority members to engage, without the approval of the other members, in businesses that were not contemplated at the venture’s outset.
The ability of a minority member to negotiate a limited purpose often depends on the type of LLC and custom within the industry. The purpose of an LLC organized for investment purposes is often broad, and a minority investor may not be able to negotiate any limitations. If the LLC is investing in a single piece of real estate, mortgage lenders frequently require that the purpose of the LLC may be limited to dealing with the particular real estate.
However, if the LLC is organized to undertake a particular type of business, such as a law or dental practice, a plumbing business, or operation of a dealership or other specific business, a minority member should expect and require that the purpose clause be limited to the intended business and related activities, and a minority investor would want the LLC’s purpose clause to reflect a limited scope of authority.
Additional Capital Contributions
An LLC that needs additional capital may attempt to seek that capital through capital calls. If the minority member is an investor, notice and the opportunity to elect to invest additional funds may be all that the minority member is willing to commit. Minority members in businesses formed for a particular venture may be obligated to commit additional capital in the future, but may negotiate a cap on their future contribution obligations. If a minority member cannot control the making of a capital call or obtain a cap, the minority member may be able to require that there be a demonstrated “need” for additional funds, or to include a provision that requires management to attempt to borrow funds to meet the need before a call is made.
Failure to Fund a Capital Call
A minority member’s failure to fund a capital call may drastically affect the minority member’s interest. Operating agreements that provide for dilution of the defaulting member’s interest as a remedy (a reduction in the defaulting member’s interest in the LLC) often base dilution on relative capital accounts or contributed capital. If the value of the venture has appreciated, dilution on either basis will not take into account the defaulting member’s share in the “equity” of the venture.
A common alternative for the minority member to consider is a provision that permits other members to elect to fund the defaulting member’s capital call and to make a “deemed loan” to the defaulting member, repayable from future distributions. Unless these “deemed loans” are convertible into equity at the option of the funding member, provisions of this type should not result in dilution. However, if future distributions are not sufficient to repay the “deemed loan,” the defaulting member may wind up with personal liability for the unpaid contribution. Other possible penalties for a defaulting member include loss of voting rights or the triggering of a buyout (generally at an unfavorable price).
From a minority member’s standpoint, an operating agreement that mandates quarterly distributions of all or a specified percentage of cash flow (after objectively determined reserves) best protects the minority member. However, in many cases, a minority member will not be able to negotiate for mandatory distributions. Moreover, even if distributions are mandatory, if the manager or managing member has the discretionary power to determine the amount of reserves, the manager or managing member might conservatively establish reserves and thus keep distributions artificially low.
Minority members (of LLCs with taxable income) also should seek assurance in the operating agreement that mandatory tax distributions (an amount sufficient to pay income taxes, assuming maximum marginal tax rates are applicable, on income allocated to members) are made quarterly so that members will be able to make estimated payments. If the members of the LLC work for the LLC (for example, lawyers, dentists, or plumbers) and are the drivers of the LLC’s business on a full-time basis, those members will expect to receive regular distributions. “Guaranteed payments” may be negotiated for service members, which may be in a fixed amount or may be determined by a formula or by agreement. A service member may be required to treat regular payments as a draw against projected cash-flow distributions. However, minority members who provide services typically would not want to lose the right to receive past payments even if cash flow does not meet projections.
Voting and Control
By definition, a minority member does not have voting control. However, any minority member should have the right to consent to amendments to the operating agreement that, among other things, disproportionally affect the minority member’s limited liability, economic interest, or voting interest. In that regard, the minority member’s share of income and loss and other fundamental rights should be protected. If the LLC is formed to operate a specific business, and the LLC’s purpose clause is limited (or if each member’s consent is not required to amend the purpose clause), a minority member may have a veto over the LLC’s entrance into a different line of business.
Minority members may seek the right to require a certain level of consent in order for “major decisions” to be made, and if the venture has more than one minority member, that consent will frequently require only a majority of the minority members. Major decisions often include amendments to the operating agreement, sale of the business/mergers, etc., changes in long-term business plan/type of business conducted, dissolution, bankruptcy of the LLC, issuing equity beyond initial capital commitments (i.e., dilution), related party transactions/management compensation, initiation or settlement of major litigation, transfers of manager’s interest/management rights, material tax elections, borrowings in excess of a defined leverage limit, and removal/election of a manager of the LLC.
Although attractive at the outset, minority approval rights over more operational matters can be costly to the LLC, particularly if there are numerous minority members. For example, if entering into a significant lease is a major decision, delay in obtaining approval may result in the loss of the tenant. As a result, in most cases, minority members have few rights to consent to day-to-day operational matters. Service-provider members of an LLC engaged in a service business often have approval rights over more types of operational decisions, such as the annual budget or major personnel changes. Even so, only the manager or managing member is usually authorized to propose a “major decision.”
Prospective members should review a list of possible major decisions with a view toward understanding the effect on the LLC’s business if a major decision is delayed or not approved at all. The simplest resolution is that if there is no approval, then the LLC will maintain the status quo. Frequently, however, if a dispute persists, members may initiate a buy-sell process, which often favors a member who has the resources to execute a purchase. When representing a member who must find funding in order to be the buyer, the buy-sell process should be negotiated to provide for enough time before closing for the member to obtain and close on funding. If a member fails to close on the purchase, the quid pro quo may be that the member loses voting rights for future major decisions or loses other rights.