LLC Formation Basics Series
This blog post walks through some of basic considerations and essential questions and considerations founding teams must address in order to build a strong foundation for a new multi-member limited liability company. It is not exhaustive, so be sure to discuss your particular situation with a Fourscore attorney in order to understand how to best tailor your company to your needs.
Table of Contents:
Part I: The Basic Organizational DocumentsPart II: OwnershipPart III: Members’ Capital ContributionsPart IV: ManagementPart V: Allocations and DistributionsPart VI: Member WithdrawalPart VII: Dissolution and Liquidation
Part I: The Basic Organizational Documents
In most states, forming a limited liability company requires four documents: the Articles of Organization (or, in some states, the “Certificate of Organization” or “Certificate of Formation”), the Written Consent of the Organizer(s), the Joint Consent of the Members and Managers, and the Operating Agreement.The Articles of Organization make your limited liability company official. This document is filed with the Secretary of State’s office in whichever state you chose to form. The Secretary of State’s office will review this document, and upon approval, will establish you as a limited liability company. The Articles are a publicly-accessible document. In many states, anyone can search the Secretary of State’s website and view a company’s Articles. The Articles include only very basic information, including the company’s official name, registered agent, and registered agent’s address. The registered agent is a person or service provider with a physical address (not a P.O. Box). You are required to have a registered agent so that, among other things, the state can deliver tax documents to you and a third party can deliver a lawsuit to you if they decide to sue your company. If you live in the state where you are organizing your company, you can serve as your own registered agent. Otherwise, you can engage a third-party provider to serve in this role for you.A licensed attorney at Fourscore may serve as the official “organizer” of your company. The organizer will file the Articles on your behalf but will have no other authority over the company. In the Written Consent of the Organizer, the Fourscore attorney will (1) certify that he or she has filed and approved the Articles, (2) appoint the founders as the members of the Company, and (3) resign from all direct involvement with the company. This gives the members the authority to control the company’s structure moving forward.The Joint Consent of the Members and Managers is the first consent you execute governing the company’s operations. Throughout the lifetime of your company, the members and managers will execute consents whenever they are required to approve the company’s activities. It’s worth noting the differences between a member and a manager. Members are the individuals who own a piece of the company. Although the members have certain voting rights over the company and ultimately select the managers, the members give the managers broad authority to run the company’s day to day operations. As we’ll see in the Operating Agreement, the members decide which issues they want to retain authority to decide. The rest of the decisions are up to the managers. A member can also (but is not required to) be a manager--and vice versa. The members can generally terminate and replace a manager as they see fit.In the initial consent, the members (who were appointed by the organizer) (1) appoint the managers of the company and grant them authority to act on behalf of the company, (2) approve the Articles, (3) approve and adopt the Operating Agreement (more on that below), and (4) direct the company to file all necessary documents to make the company official, including any actions necessary to establish a bank account for the company.The Operating Agreement governs how your company operates, including delineating the rights, responsibilities, and obligations of the members and the managers. Most of the organizational considerations are addressed in the Operating Agreement, such that different sections of the Operating Agreement are worth highlighting in their own posts. As you work through these sections, keep in mind that the goal is to (1) tailor your Operating Agreement to the company you would like to build and (2) make sure you understand how to properly run your company.
Part II: Ownership
Owners of a limited liability company are referred to as “Members.” Members are those individuals entitled to receive distributions of cash, vote for managers and on certain enumerated issues, and receive other forms of payout. Members do not generally have broad management authority over the company’s operations (that role is reserved for Managers, who may or may not be Members). Additionally, as we’ll learn later, Members are generally required to pay their share of taxes on the company’s annual profits or losses.There are multiple ways to allocate ownership interests in the company to the Members. You might have read about the term “Percentage Interests,” which refers to the percent of a company that a Member owns relative to the total ownership of the company. While this is a common way to think about ownership interests early in a company’s development, in general, thinking about your ownership in the company as a percentage can lead to confusion and miscommunication. If your company brings in any other members in the future (e.g., if someone new decides to join your team or you receive some money from an investor), granting that new Member ownership will necessarily decrease the percentage ownership for all the existing Members in order to make room for that new investor. This is a process called dilution. To learn more about dilution, and to see some examples, we recommend reading this: How Does Dilution Work?To address this problem, we like to think about ownership of limited liability companies in terms of “Units.” Units are analogous to “shares” held by the owners of a corporation. Your company will authorize a certain set number of Units that will be available for issuance to current and future Members. You will not grant all of the authorized Units to the founders, because you want to have some available in the future for others. However, the percentage of the Company that you own will be determined only by those Units actually issued to Members at the time of calculation. The number of authorized Units can be increased in the future via amendment to the Operating Agreement and a written consent of the Members.Here’s an example. Let’s say you have three Members, each initially wants to own one-third of the company, and your company decides to authorize a total of 100,000 Units. We might then allocate to each initial Member 10,000 Units. This means that the company would issue a total of 30,000 Units, so each Member would own one-third of the issued Units. The remaining 70,000 Units would be reserved for a future grant to existing or new Members. If a new Member comes in, and the existing Members decide to grant the new Member 10,000 Units too, then the company would have 40,000 total issued Units, and each Member would then own 25% of the Company.The number of Units are arbitrary as long as they (1) achieve the initial ownership percentages you would like, (2) are high enough that future Unit issuances won’t require fractional Units, and (3) leave some room for future Unit issuances without the hassle of amending the Operating Agreement. As a rule of thumb, we generally recommend authorizing 100,000 - 500,000 Units up front.Take some time with your founding team to think about who should receive what number of Units in the company. Here are some factors to consider:
How much time, money, intellectual property, and other resources have each of you put into the company?
How much of these resources do each of you plan to put into the company in the future?
Will anyone be an employee of the company? Will they be paid a market rate or a reduced rate for their role?
Will any of you play a leadership role in the company? Will they be paid a market rate or a reduced rate for their role?
Do any of you prefer to play a passive role (invest but not be actively involved in the company day to day)?
Do you want the Company to retain a right to repurchase any of a Member’s ownership for a period of time? This is often referred to as “vesting.” If you’re unfamiliar with this concept, ask your Fourscore attorney for an overview. As a default, we do not subject LLC ownership interests to vesting and instead emphasize buy-sell provisions (discussed below). However, you can include both if it makes sense for your situation!
Part III: Members’ Capital Contributions
With limited liability companies, there is a mechanism to account for the capital a member contributes to the company. This is fittingly called a Member’s “capital contribution.” Capital contributions are often considered the most confusing part of an LLC. So, don’t worry if you get confused. We’re here to help!All capital contributions are initially tracked in a schedule of the Operating Agreement as the Members’ “capital accounts.” Once you get going, however, your accountant will usually keep track of these some other way. If the company is ever liquidated or sold, assuming there are remaining funds after the company pays its existing debts, Members receive payment for the capital contributions in their capital accounts before any additional distributions are made to the Members.A capital contribution is different from a loan, in that it’s tracked as part of the Member’s involvement with the company, Members are not entitled to interest on the amounts in their capital accounts, and the company will generally only repay a Member’s capital contribution if the company is liquidated or sold.Note that the capital account tracks amounts of money. It does not account for services or property contributions by Members. Although there are mechanisms to account for the monetary value of services or property that a Member might contribute to a company, doing so may trigger unfavorable tax implications for the contributing Member and/or the company. For example, if a Member makes “capital contribution” by providing services to the company, that Member must (1) get a market valuation for the value of the services to be provided and (2) pay taxes on the value of the shares equal to the value of the services the Member will provide. Property contributions also require a market valuation and can trigger numerous different tax liabilities.For these reasons, we generally recommend that you do not consider services or property contributions as part of any Member’s capital contributions to the Company. Instead, if a Member is making these types of contributions to the Company, consider granting that Member more Units in the company, compensating services with a salary in an employment agreement, and/or structuring an in-kind contribution as a loan to the Company.Members may (but are not required to) make initial capital contributions to the company. Initial capital contributions are necessary to ensure that the company can adequately cover its initial expenses. If your company does not have enough money to cover its expenses, and you start using your personal money to pay for those expenses, you risk blurring the distinction between you and your company, which can expose your personal property to collections and other liabilities related to the company.If your LLC is taxed as a partnership, then initial capital contributions do not need to be proportional to a Member’s number of Units. This is a major advantage of creating a limited liability company versus a corporation. Even if two members each own 50% of the company, one Member might contribute $10,000 while the other Member contributes $10. This might be appropriate where the first Member has more money, but the second Member created the business idea and/or will be doing a lot of the physical work required to grow the company.Each Member’s capital account balance will change during the life of the company. There’s a few ways this can happen.A Member’s capital account will increase if:
The Member makes an additional capital contribution to the company, which would increase any contributing Members’ capital account accordingly. For example, the managers of the company might make a capital call if or when they think the company needs more money. Members are not legally required to contribute any new money during the capital call (unless your Operating Agreement says so), but only other Members who do contribute will see an increase in their capital account.
The company allocates any profits to the Member at the end of a particular year. Note that, as we will discuss below, allocations are different from distributions.
The Member assumes any liabilities on behalf of the company.
A Member’s capital account will decrease if:
The company allocates any losses to the Member at the end of a particular year.
The company makes any distributions to the Member at the end of a particular year. Note that, as we will discuss below, distributions are different from allocations.
The company assumes any liabilities on behalf of the Member.
Part IV: Management
As we learned earlier, the management of your company will be governed by Managers. These managers can be anyone, and there can be any number of managers (as long as there is at least one!). Managers do not have to hold any ownership in the company, and not all owners need to be managers. Ultimately, who is a manager comes down to what your founding team decides is most appropriate. Here are some things to consider:
How involved do each of you want to be in the company? It is perfectly fine for someone to play a passive role in the company.
How much time, money, intellectual property, and other resources have each of you put into the company? How much of these resources do each of you plan to put into the company in the future?
Managers have broad authority to manage the business and affairs of the company unless a specific topic or issue is reserved for the members. We’ll make a list of these reserved issues in just a moment.
In general, Managers may be appointed or removed by a Majority in Interest of the members. However, you can set a higher threshold for appointment or removal. Company sometimes do so when the ownership percentages of the Members are such that a majority vote would give one Member a disproportionate amount of power over Manager appointment and removal and the other Members are unwilling to agree to that.
As noted above, the Operating Agreement can limit the broad scope of the Managers’ authority, such that only the Members may decide certain issues and topics. Often, these are substantial issues that would significantly affect the company’s existence or function or the Members’ ownership rights. This list can include any topic, however, the following are the most common issues to reserve for the Members’ vote and we generally recommend including all of these.
An action contrary to any term of the Operating Agreement
Purchasing or assigning any company property for a purpose unrelated to the company’s business
Merge the company with another company
Sell all or substantially all of the company’s assets
Have the company become an owner of another company
Purchase all or substantially all of another company’s assets
Admit a new Member to the Company
Authorize the transfer of a Member’s Units
Grant Units to someone who is not already a Member
Change the company’s business or its tax or accounting methods
Enter into a related-party transaction (a transaction involving one of the Members or an affiliate of a Member on terms that are more favorable to the Member or its affiliate than they would be to an unrelated third party)
Borrow money in excess of a predetermined aggregate amount.
A few other items to note about Managers:
In general, Members who are Managers do not receive compensation for serving as a Manager. However, companies generally reimburse Managers for expenses that Managers incur in their role as a Manager. If a Manager is not a Member, that Manager might request some form of compensation for serving as a Manager.
Managers are generally indemnified by the company for a Manager’s actions in a management role. This means that, if the Manager is sued because of something the Manager rightfully did on the company’s behalf, the company would cover any financial consequences of that lawsuit for the Manager. Companies virtually always indemnify their Managers for lawsuits related to the Manager’s role with the company and companies advance expenses for those lawsuits, since a Manager might not have the financial capacity to pay those expenses upfront and then get reimbursed later.
Part V: Allocations and Distributions
LLCs are generally taxed as a “partnership.” What this means is that each Member of the LLC is responsible for paying taxes on a percentage of the company’s profits and losses equal to that Member’s respective ownership interest in the company. The company itself is not responsible for paying taxes on its profits or losses.Your accountant will keep track of all Members’ respective ownership interests and if those ownership interests change or transfer throughout the year. At the end of the year, your company will provide each Member an IRS form detailing the Member’s portion of the profits and losses. It’s important to note that these tax allocations are not actual payments of money. Allocations simply function as an accounting mechanism to ensure all of the LLCs profits or losses have been appropriately accounted for.Tax allocations can create substantial personal tax bills for Members. Fortunately, most LLC Operating Agreements require the company to reimburse Members for their tax liability through certain mandatory distributions.Distributions are the ultimate monetary goal for Members of an LLC. To the extent a company has any available cash or property beyond that which the Managers deem necessary to maintain any reserves the company might need, the company must or may make distributions of such cash or property to the Members. There are two types of distributions: mandatory distributions (to cover a Member’s tax liability) and voluntary distributions (to share profits amongst the Members).Mandatory distributions help Members avoid paying out of their own pockets for their respective tax allocations (as discussed above). Because each Member is responsible for paying taxes on their respective portion of the company’s profits or losses for a particular year, Members could face a sizable personal tax bill if the LLC is very profitable each year. To avoid this, to the extent the company has available cash or property, the Managers must distribute to the Members at least enough money to cover these tax liabilities.Managers can also decide to transfer additional available cash or property to the Members based on their relative ownership in the company. This makes sense when the company does well and is very profitable. These distributions are made in accordance with each Member’s relative number of Units in the company.
Part VI: Member Withdrawal
This section outlines the process for how a Member might leave, or be forced to leave, a company. In general, a Member cannot leave an LLC without the consent of all the other Members.To avoid the need for negotiating a Member’s departure in every situation, an LLC Operating Agreement often outlines certain “buy-sell” events, events that might justify a Member separating from the Company.Some of these are unfortunate situations where something negative happens to or among the Members. For this reason, this area of an Operating Agreement is often ignored by founding teams, because it’s often difficult for team members to discuss and address the possibility of tension or conflict. However, a key sign of a successful company is the ability of its leaders to preemptively and actively address difficult situations. Creating safeguards to Member conflict is a key first step to doing so. For a more detailed discussion of buy-sell events, we recommend reviewing our other blog post on the topic.The list of buy-sell events can include any topic. However, the following are the most common to include.
The death or incompetence of a Member;
A Member becomes insolvent or goes bankrupt;
A Member tries to transfer any of the Member’s Units in a manner not authorized by the other Members.
A Member materially breaches the Operating Agreement and doesn’t fix the breach within 10 days
A Member gets divorced
A Member is charged or convicted of a legal offense that subjects the Member to public scandal, disrepute, widespread contempt, public ridicule, or which is widely deemed by members of the general public, to embarrass, offend, insult or denigrate individuals or groups, or that will tend to shock, insult or offend the community or public morals or decency or prejudice the company in general; and
The Member tries to leave the company in a way that is not authorized.
After a buy-sell event occurs, the company might be required or entitled to repurchase all of the applicable Member’s Units. If a Member dies, the Company is obligated to purchase that Member’s Units within ten days after it receives notice of the Member’s death. If any other buy-sell event happens (other than a Member’s death), the company may (but does not have to) purchase the Member’s Units within ten days after the company receives notice of the event.The purchase price for the Member’s Units is either determined by a third-party appraiser or the Members can all agree to a valuation of the company to be used for the purposes of a buy-sell event. However, for any buy-sell event other than the death of a Member, the purchase price is generally discounted.When the Company repurchases a Member’s Units, those Units goes back in the pool of authorized but unissued Units. The ownership percentages of the remaining members would all increase proportionally to reflect the new, lesser total.Note that everything related to buy-sell events is customizable. If you would like to alter the structure of these buy-sell events, please discuss this with a Fourscore attorney.
Part VII: Dissolution and Liquidation
A company might dissolve for positive, neutral, or negative reasons. Your company might become so successful and appealing to others that another company decides to purchase your assets. Or, the Members might simply decide that it’s time to move on to other opportunities. Upon dissolution, the company needs a formalized mechanism to sell, monetize (also known as “liquidate”), and distribute its remaining assets.Dissolution occurs if:
All or substantially all of the assets of the company are sold
All Members elect to dissolve the company
The company goes bankrupt
A court or the Secretary of State forces you to dissolve (generally because you haven’t paid taxes or fees).
Upon any of these events, the Managers (or, a third party “liquidator”, if the Manager chooses to appoint a liquidator) sells all of the assets of the company and then uses the proceeds of such sale to do the following (in the order listed):
Pay off any company debts (including if the company has any outstanding loans or debts to Members)
Create a “reserve” of funds to pay any debts that might arise that the Manager was not otherwise aware of
Bring all Members’ capital accounts to zero. If there is not enough money to do so, the Members with positive capital accounts receive the amount of available money equal to their capital account divided by the total capital account balance.
Distribute the remaining funds to the Members in accordance with their percentage ownership in the company at the time of dissolution.
Headquartered in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in the Triangle, throughout the Southeast and in Silicon Valley / San Francisco. We also represent venture capital funds and other investors who invest in companies throughout the U.S. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.