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In Part I of our series on The Pitfalls of Limited Liability Companies, we talked about a success story – how one smart business owner avoided being stuck in an LLC with another member after their relationship turned sour. This time, we’ll share the opposite, a case where a lack of foresight trapped a business owner in an LLC with an abusive member. We’ll also share some ideas for breaking deadlocks among members.
This business owner, after a couple of years of growth, decided to bring a friend into his limited liability company as an investor. They downloaded a free operating agreement and made changes – all without help from an attorney. Worst of all, even though the business owner retained a majority interest in the LLC, the operating agreement required unanimous consent of the members for just about any decision. These two were friends and surely they would never disagree, right?
Wrong. A few months into the new relationship, the new member became a problem. After a few attempts to resolve their differences, the business owner tried to rely on various provisions that seemed to automatically remove the problem member, who – you guessed it – did not agree. Litigation ensued, and the business was essentially paralyzed because the members could not agree on anything. Ironically, the problem member would not even agree that there was a deadlock.
Deadlock can arise when the members fail to reach a required majority vote (other than 51 percent), when a member with approval rights fails to give approval, or when unanimity is required.
Under the Florida Limited Liability Company Act, deadlock among members is grounds for judicial dissolution of the LLC. Of course, this requires litigation and the attendant expenses and loss of time. However, the Act also allows the courts to provide alternative remedies, including equitable remedies.
The important lesson here? Don’t agree to an allocation of voting or management rights that allows for the possibility of deadlock. If you absolutely must be 50-50 partners, include a mechanism in your operating agreement to break a deadlock. Remember that operating agreements for LLCs are just contracts, and you can agree to just about anything, including making decisions by flipping a coin (which we don’t advise).
Here are some other possibilities:
These provisions contemplate one or more members dissociating from the LLC and thus rebalancing the voting rights. The operating agreement can designate a member who will be bought out at fair market value or a predetermined amount. So-called shotgun provisions allow one member to make an offer to another member for the offeree’s membership interest. The offeree must either accept or turn the offer around: The offeree becomes the offeror and vice versa, but the terms proposed by the initial offeror remain the same. The offeror-turned-offeree must accept the offer, hopefully having made a fair offer to begin with.
An operating agreement can provide that members take turns casting the deciding vote. The possibilities of manipulation and gamesmanship should be obvious, and this is not a popular option.
The operating agreement can appoint a third party to make decisions when the members cannot. Ideally, the third party is someone familiar with the LLC’s business and the situation requiring the decision, but the problem of having an outsider make potentially significant decisions is likely too much for most business owners to accept. This option can also be in the form of a mediation or arbitration provision.
Put Options/Call Options
A more intricate option is to designate specific events or situations that trigger rights in specific members. For example, one member’s failure to make a capital call can trigger another member’s right to purchase the first member’s membership interest. These kinds of provisions should be carefully drafted.
Partition of the Company
Depending on the nature of the LLC’s business, partition of the company and its assets may be an option. Valuation of assets should be done at the front end. As with some of the other options, there is the potential for gamesmanship and manipulation by those members who stand to benefit the most from a partition.
Clearly, all of these possibilities have disadvantages, chief among them the loss of control over the process and the company. If you are embarking on a new business venture or want to formalize your business relationship, contact us at Iurillo Law Group, so we can help you plan for the future, including the possibility of deadlock.
If you are already deadlocked, we can help you try to salvage your company or, at a minimum, protect your interests. That’s what the business owner discussed above did, and we were able to extricate him from the business in a reasonable settlement that let him walk away him from a toxic relationship with his former friend and allowed him to move on to new ventures.