Buy-Sell and Valuation Provisions in LLCs
Most LLC operating agreements have provisions on transfers of interests by members. Without specific provisions in an operating agreement, statutory defaults apply. LLC statutes usually permit transfers of economic interests (the right to get allocations and distributions), but not governance rights (the right to vote and access to information). This split can tend to concentrate management authority in those who still possess governance rights, even though they represent only a minority of the economic interests in the LLC.
To address this, operating agreements often have “buy-sell” provisions to to ensure a reasonable level of match between owning economic interests in the LLC and its governance. Sometimes these provisions mimic an unrestricted market dynamic in which capital can be efficiently deployed and property rights easily alienated. More often than not, they have complex processes and ambiguous legal terms far removed from the goal of facilitating transfers at a price a willing buyer would pay a willing seller.
There are five key topics important when drafting buy-sell provisions:
Triggering Events. Triggering events vary greatly based on the nature of the business. Service partnerships where all members agree to devote substantially all of their time and attention typically list triggers that include death, disability, resignation, and retirement.
An LLC organized as a passive real estate holding company under third party management is likely to have a very limited set of triggering events. Where management authority is divided in a way that could result in deadlock, the parties may choose to include buy-sell provisions to break the deadlock.
Valuation of LLC Interests. The basis for valuing LLC
interests falls into three categories: the Market-Based approach, the Income-Based approach, and the Asset-Based approach.
Some agreements use a standard like “fair value,” “fair market value,” or “book value.” Some go the extra step of describing who is responsible to decide. Other agreements use a detailed formula based on a multiple of revenues, earnings, or both. Finally, some simply say the value as determined by an outside expert.
Among the issues often neglected are the impact of changed market conditions and company circumstances, extraordinary events, the applicability of valuation discounts, or the relationship of the valuation to the amount of available insurance.
Transaction Structure and Terms. Buy-sell transactions can be cross-purchase transactions between or among equity owners, entity purchase transactions, or a combination of the two. The structure of the transaction has important tax implications and can also significantly impact ownership ratios and governance of the LLC.
In certain circumstances, transactions can be funded with insurance. In others, a long-term payout may be required to ensure financial soundness. The agreement must consider release from debt obligations and other liabilities; and any cash waterfalls or profits interests. Members may want to address the possibility of a clawback in favor of the selling holder in the context of a change in control transaction within a defined window following the buy-sell transaction.
Dispute Resolution. Buy-sell transactions often generate disagreement – on value, on terms, on structure, and any issues. This is particularly true when the transaction is associated with alleged improper conduct. The success of a buy-sell agreement is highly dependent on the mutual perception of fairness and willingness to share information perceived relevant to value.
Hiring a competent neutral under well-defined conditions can help achieve a speedy end to these disputes – especially if the agreement specifies the requisite background and qualifications of the neutral. If parties agree to a good process up front, they can minimize long battles over selection of mediators, arbitrators, appraisers and other experts, access to information, and the allocation of costs of the process.
Tax Implications. A buy-sell transaction is a mini-acquisition. Like any other acquisition, the structure will dictate the tax consequences for both the buyer and seller. Tax consequences depend on both the transaction structure and the tax classification of the entity. It is possible for the parties to agree up front to standard deal terms. For entities taxed as partnerships, the agreement must also consider the impact of release from debt, Section 754 elections, the taxation of periodic payments and whether standard release language in buy-sell agreements operates to shift pre-closing tax risks of the seller to the buyer.