Dead Wood: 4 Things to Help LLC Owners Avoid Unproductive Members

When LLC business owners later decide to take on partner or partners, they can easily lose sight of what can happen if the partnership doesn’t live up to expectations.

Recently, a situation that came to our Phoenix business law firm illustrates the importance of thinking through the planned partnership and what can go wrong when you don’t consider the possibility of the partner to-be under performing expectations (or not performing at all).

LLC owner decides to add partners

A few years ago, our business owner (we’ll call him “A”) started LLC (the “Company”) to operate her service business.  A built out the business into a highly profitable one and was eventually approached by outsiders B and C to become part owners in the Company.  Partner C owned a successful business of his own that necessarily required the company’s services.  It was generally understood by A, B, and C that all of the C business’ needs in this area would be would fulfilled by the Company.

On paper, it seemed like an opportune “win-win” scenario– the Company would get a huge jump in business from C’s business, the C business would have its ongoing need for the Company’s services met, and C would share in it by virtue of his new ownership interest in the Company.  As part of the deal, A agreed to reduce her ownership interest to 1/3, with B and C each receiving a 1/3 interest in the Company.  The Company’s records were updated and a prominent law firm hired to amend the Company’s operating agreement to reflect the new ownership.

New LLC partner fails to live up to expectations

However, a year or so later, unbeknownst to A, C ended up selling his business (yes, that business) to an acquirer who already had their own vendor and was not interested in doing business with the Company.  The result?  Not only did A no longer have the anticipated revenue to from C’s business but, worse yet, she now had a 33.3% partner that was still entitled to share in the profits of the Company despite no longer contributing.  To both A and B, partner C had effectively become dead wood.

LLC partner “free rider” problem

Partner C was approached by owner A and partner B about selling C’s interest, however let’s just say that partner C was not receptive to the idea. Why should he be?  Under the current situation, C not only received a windfall from the sale of his former business, but he could now “free ride” off of the efforts of A and B until he decided to leave, which didn’t seem likely.

LLC operating agreement leaves no “outs” for its founder

The problem lay in the LLC’s amended operating agreement, which was actually a solid one covering 95% of the (important) bases.  However, it failed to address the one problem owner A and his partner B were now facing–how to force a “buy-out” of a non-performing or just plain bad member.  Keep in mind that I am not trying to blame the law firm that drew up the operating agreement; it is entirely possible that they did not know the specific circumstances surrounding the new partnership.

We reviewed the amended operating agreement and providing A with both his legal options, as well as more practical options, and the pros and cons of each alternative.  As you might expect, none of them were great.

Takeaways for LLC founders planning to add a partner (or more than one):

For those business owners considering taking on new partners in the business, the story of our friend owner A does offer some valuable lessons:

  1. Understand your reasons for the partnership.   As the business owner, know why you are doing it, and definitely let your attorney know, too.  An experienced business lawyer will help cut through the hype and emotion of the deal and run through the different scenarios with you to guide you on how best to reduce your and the company’s risk.
  2. Document those reasons.  In other words, make it clear what is expected of the new partner and new business relationship and what, if anything, will happen if such expectations or projections are not met.  If they are important to you or your new partner(s), they should be made a part of the LLC’s amended operating agreement (in this case, unfortunately, they weren’t).
  3. Consider restrictions on Member ownership interests.  To the furthest extent possible, resist or delay giving all of the new partners’ membership interests up front.  Discuss allowing the membership interest to be phased in over time or even tied to performance or some other event that is the reason for the partnership.  While not exactly the same situation, another possibility we often see with our startup company clients is a vesting schedule that reduces the ownership interest of a partner if certain negative events occur (in this case, for example, the sale of C’s business or sales from it falling below a certain benchmark over a defined period of time). If your new partner can really deliver, they should be receptive and not have a problem with this. If they balk, that might be a major red flag.
  4. Option to Force Buy-Out.  Even if you’ve taken care of all of the above, it is still a good idea to have a “nuclear option” to go to, one that enables you as the company’s founder to be able to trigger an involuntary buy-out of your new partners under certain, clearly stated and understood circumstances, either by supermajority or even a plain majority of the membership interest.  The operating agreement itself should spell out with clarity the procedures for purchasing the non-performing member’s interest, including a formula or mechanism for arriving at a value for the company and the member’s ownership interest, preferably in highly transparent manner fair to the partner being forced out and your fellow non-selling members.

The more you as the original LLC owner can express in an operating agreement what your expectations of your new partners (and their expectations of you) will be, the parameters of those expectations, as well as what will happen if those expectations are not met, the better your chances of forging a solid and fruitful new partnership, while at the same time cutting down on the risk of nasty legal challenges from your new partners should they fail to meet expectations and are not willing to be bought out voluntarily.

Ben Bhandhusavee is the Managing Attorney for BhandLaw, PLLC, a Phoenix business and technology law firm working with start-up companies, creative intellectual property, Internet and digital media matters, and complex corporate M&A and technology transactions.  Ben can be reached at (602) 222-5542 or by e-mail at bbhand@bhandlaw.com