A new business venture is exciting. Your limited liability company (LLC) may appear solid now, but no one can predict what will happen in the future. Ownership changes within your company due to retirement, death, finances, or other circumstances can throw your LLC into disarray. Drafting an LLC buyout agreement when you form your company may help avoid conflict and litigation down the road when circumstances change.
What Is an LLC Buyout Agreement?
On the surface, the term “buyout agreement” would appear to be limited to cases where a member sells their interest in an LLC. The reality is that an LLC buyout agreement serves a much wider use.
An LLC buyout agreement is a binding agreement that addresses what happens if a member is voluntarily or involuntarily leaving. The agreement may be a separate contract, or the LLC may include the terms within the company’s operating agreement.
While the buyout agreement covers situations where a member wants to sell their interest, the contract often touches on problems when a member leaves for personal or financial reasons. Whether your LLC has just one owner or multiple members, a buyout agreement provides much-needed clarity when company ownership changes.
Why Should You Have a Buyout Agreement in Place?
While an operating agreement defines how the LLC conducts its business, the buyout agreement sets the stage for what happens after a member leaves. In some cases, the LLC may dissolve upon a member’s departure. Other times, the buyout agreement outlines the terms to buy out the member’s interest.
A buyout agreement is a valuable tool for members to discuss different “what if” scenarios if a member decides to leave. By agreeing to these expectations in the buyout agreement before the company starts, an LLC might avoid future conflict and legal costs when a member chooses to leave. Although it can’t guarantee a complete lack of conflict, the agreement provides structure to minimize it.
What Events Can Trigger a Change in LLC Ownership?
One of the only constants is change, especially when dealing with a business. Events that may trigger a change in ownership interest in an LLC include:
- Retirement or resignation
- Personal bankruptcy
- Death, illness, or disability of a member
- Acquisition of a member’s interest by a spouse in a divorce settlement
- Foreclosure of a debt secured by the member’s interest.
- Fraud or illegal activity
- Contract violations
- Offer to buy the member’s interest from a third party
What Are the Key Elements Included in an LLC Buyout Agreement?
While the provisions in an LLC buyout agreement can be tailored based on what the members wish to include, you will find most contracts address these key elements:
- The triggers for LLC ownership changes
- Determining the value of a departing member’s interest
- Who can buy a member’s interest in the LLC?
- Acceptable payment terms when buying out a member
Members may include additional provisions in the LLC’s buyout agreements. For example, the agreement may outline the process for resolving member disputes or it may prohibit members from using their interest as collateral to secure loans.
You can draft a buyout agreement on your own. Yet, if your LLC has multiple members or complex operations, you might seek legal help to prepare the buyout arrangement.
Regardless of the size of your LLC, seeking the help of experts may help avoid costly litigation and possible challenges that you may not be aware of.
How Is the Value of an Owner’s Interest Determined in a Buyout Agreement?
A critical element of a buyout agreement is determining the value of a member’s interest. Valuation can be a complicated process, and there are many ways to determine how much an LLC is worth.
Some of the most common ways to value an LLC include:
- Hiring an independent business appraiser
- Reviewing the market value of similar companies recently sold
- Using the LLC’s book value approach, the company’s value is determined by subtracting what the LLC owes from the value of its assets.
Membership interest is typically valued based on the percentage each member owns of the LLC. However, the buyout agreement may lay out different parameters for calculating the value of the member’s ownership.
How the LLC determines its value affects the purchase price of the member’s interest. So, it is essential to agree on the LLC’s valuation method from the start. When such details are vague or not addressed in writing, it could lead to conflict and litigation.
Who Is Eligible to Purchase a Departing Member’s Interest?
Determining who is eligible to purchase a departing member’s interest is a pivotal decision to make when forming your LLC. Often, LLC members want a say in who can become their business partners, so the buyout provisions will likely follow these wishes.
For example, some buyout agreements give existing members preferential treatment to purchase the departing owner’s interest before a third party. Or the LLC may enter into a purchase agreement to buy the departing member’s interest. Other buyout agreements may allow sale to a third party if the remaining members approve.
What Happens if an Owner Cannot Afford to Buy Out Another Owner’s Interest?
The buyout agreement should clearly outline the procedures to follow even if an owner cannot afford to buy out the departing member’s interest. The owner can seek financing, sell to the LLC itself, or sell to a third-party buyer.
What Are the Tax Considerations Related to LLC Buyout Agreements?
Selling your interest in an LLC is usually a taxable event. You could realize a gain upon the sale. However, the tax effect on the departing member can vary based on their financial situation.
There may be tax implications for the members who remain. When one or more of the remaining members purchase the outgoing owner’s interest, their percentage ownership of the LLC rises. Owning a higher percentage has a taxable effect as more income or loss flows through to the remaining members.
Protect Your LLC with a Buyout Agreement
You are starting a new business venture, so why talk about an exit strategy before your company has even begun? Yet, taking the time to agree on the terms of an LLC buyout agreement helps avoid conflict among the members and grants clarity over the process when members choose to leave.
Consider consulting an experienced professional to draft your LLC’s buyout agreement. While you can complete the agreement on your own, an experienced professional can help prepare the appropriate terms for your contract.
Proper recordkeeping is critical for reporting and tax filings. Keeping your books and records in good order can be helpful should a member choose to leave. But when you get caught up in the daily operations of your company, it is easy to fall behind on the LLC’s books and records.
doola Books is an easy-to-use bookkeeping software that helps you keep your finances up to date. Just link your bank and credit card accounts to doola Books and get all your financial transactions in one place instantly.
Can a buyout agreement be customized to suit the needs of our LLC?
Yes, the members of an LLC may customize their buyout agreement to meet the unique needs of their company. Drafting a buyout agreement gives members the opportunity to discuss and agree upon the terms surrounding ownership changes within the LLC.
Can an LLC owner buyout agreement be changed or amended?
Yes, a buyout agreement can be changed or amended. When the contract is already in effect, the LLC should follow the terms of the LLC operating agreement and relevant state law when amending the buyout agreement.
Do all states require an LLC owner buyout agreement?
No, all states don’t require an LLC to have an owner buyout agreement. An LLC owner buyout agreement gives clarity upon a member’s exit. So, even if your LLC resides in a state that doesn’t require a buyout agreement, the members should draft one anyway.
Can an LLC owner buyout agreement be enforced in court if necessary?
An owner buyout agreement is a legally binding document when properly drafted. Therefore, the contract claim could be enforced in court if necessary.
Can a buyout agreement be used for a single-member LLC?
Yes, a single-member LLC may use a buyout agreement. For a single-member LLC, the buyout agreement can help transfer ownership in the event of the owner’s death, retirement, or illness.