As an owner of a limited liability company (LLC), you likely work closely with other owners (called "members") to operate and manage your business—each with a vital role. For example, you might handle the finances, another owner might make the client connections, and the other owner might head the marketing and advertising. Or if you haven't opened your doors yet, you might've already had discussions with your co-owners about divvying up responsibilities.
While this arrangement might seem long-lasting, you need to prepare for the day when one of the LLC owners is no longer a member. Many LLC owners neglect to create a buyout agreement, but these agreements are critical when you co-own an LLC with other members. A buyout—also called a "buy-sell"—agreement says what'll happen when one member wants to leave the company, or worse, dies, goes bankrupt, or gets divorced.
This article discusses buyout agreements for LLCs. For a more detailed discussion, see our article on buy-sell agreements for small businesses.
Contrary to popular belief, buy-sell agreements aren't about buying and selling companies. Instead, they're binding contracts among co-owners of a business that govern what'll happen when an owner wants to leave or a new owner wants to join. Because of this confusion over terminology, we will use the term "buyout agreement" from here on.
Different business structures have different buyout agreements but they all address the same core concepts. For instance, corporations have shareholder buyout agreements and partnerships have partnership buyout agreements.
For an LLC, a buyout agreement controls the following business decisions:
A buyout agreement can be its own document or it can be included as a provision in the LLC operating agreement.
It's a huge mistake to ignore the fact that sooner or later your circumstances will change. If you don't have a buyout agreement, then you'll be forced to follow your state's default rules for LLCs. And there's a good chance you might not agree with them. To avoid having your state's laws decide the fate of your company, you need to create a buyout agreement.
Here's how an LLC owner buyout agreement can help when an owner wants to leave or a new owner wants to join.
A member leaves. The odds are good that a member will want to leave the company before the other members are ready to sell or close the business down. Without a buyout agreement, the LLC might be automatically dissolved when one member leaves, forcing the assets to be sold and divided among the LLC members. If the other members wish to continue the business, the absence of an agreement means there are no rules determining in advance whether and how departing members will be bought out, or for how much. This omission can lead to serious personal and business conflict—perhaps even court battles and the loss of the business.
A new member wants to join. A buyout agreement also places controls on who can buy a membership interest in the company and how new members can join your ranks. Without this provision, another member could sell their share to someone you'd rather not be in business with.
In addition to avoiding potential problems in the future, writing a buyout agreement has a very real immediate benefit: It'll force you and the other members of your ownership team to talk about your hopes and expectations for the business. This type of honest, open communication will put your LLC on the right track from the very start.
Typically, the events that trigger the buyout of a member's interest under a buyout agreement are:
Typically, these events will trigger an automatic buyout. In other words, a member filing for bankruptcy or retiring will be required to sell their share.
If a member wants out and the buyout agreement allows for it, typically you can't stop them from leaving. But you can control who that member sells their share to. Usually, the choice of who to sell the membership interest to is between an insider or an outsider—a member or non-member.
In your buyout agreement, you should specify to who the departing member can sell their membership interest.
Many LLC owners use the "right of first refusal" (ROFR), meaning that the departing member has to first offer their share to the other LLC members or the LLC itself before they can sell it to a non-member.
For example, suppose Anya, Chantay, and Sav are members of an LLC together. Sav wants to retire and leave his membership share to his sister, Alli. But the LLC buyout agreement has a ROFR clause requiring any member who leaves the LLC to first offer their membership interest to the other members. So Sav has to first offer his share to Anya and Chantay.
This ROFR option is a popular choice for LLC owners because LLCs are usually small and designed so that members have direct control over how the company is managed. So, LLC members typically want to have power over who they let into the company to prevent an outsider who they don't know from gaining access to a company they worked hard to build.
If you require the departing member to sell their share back to the other members or to the LLC, then you'll also need to decide whether the other members or the LLC are obliged to buy the share. For the departing member, this requirement means an automatic buyer.
In an LLC with only two members, requiring the remaining owner to buy the interest might make sense. After all, control of half the company is significant, and it might be burdensome for the departing owner to find an outside willing buyer. But if there are more than two members, many LLC owners decide that they're better off skipping this mandate.
Because it can be hard (if not impossible) to predict when a member will leave the company, it might be tricky to put a dollar amount on any membership interest. For example, your business's value will likely be significantly different at the start of year one than at the start of year six.
To account for this unpredictability, you should probably choose a valuation method that can give you an accurate picture of your business's worth at the time the member leaves—instead of trying to put a number on a member's share now. Once the business's value is determined, it should be relatively simple to calculate how much a member's share is worth based on their ownership interest.
For example, suppose you decide that the method you want to use to price your company is the value of your business if liquidated (the assets sold off and debts paid). Under this equation, your business's value is determined to be $1.5 million. Now suppose, the departing member owns 25% of the business. So, the member's interest would be worth $375,000 (25% of $1.5 million).
Paying a lump sum vs. installment payments. Sometimes a member's interest in the LLC can be worth more than what the other LLC members can currently pay. To prepare for this common reality, you should allow for payment installments in your buyout agreement. For instance, you can detail in your agreement that the departing member is entitled to a 20% down payment for their interest and the rest of their share will be paid out in quarterly installments over a five-year period.
Tax implications of a member buyout. If a departing member sells their share, then you and the other members will need to make the appropriate tax adjustments. You should include a clause in your buyout agreement that says who's responsible for filing the appropriate tax forms and notifying the required tax authorities. For more tax guidance, read how LLC members are taxed. You should also consider talking to an accountant or tax lawyer. They can help you understand your obligations and how your buyout terms affect your personal and business taxes.
As mentioned earlier, a buyout agreement can consist of several provisions in your written operating agreement or it can be a separate agreement that stands on its own. To create one, you can either use a self-help resource or see a lawyer—or both.
If you already have some experience with business contracts and you and the other LLC members are on the same page, you can likely create a buyout agreement yourself. If you'd like to try to write one on your own but are looking for a little help, one good tool to use is Business Buyout Agreements: Plan Now for All Types of Business Transactions, by Anthony Mancuso and Bethany K. Laurence (Nolo). This book contains an agreement with fill-in-the-blank buyout clauses and instructions on how to incorporate them into your operating agreement.
If you and your co-owners can't agree or the buyout terms you want are complex, consider consulting a business lawyer. An attorney can help you negotiate with the other owners, advise you on the best terms for your business, and draft a buyout agreement for you.