Limited liability companies are entities created by state statutes that have their rights and responsibilities governed by a contract – typically called an Operating Agreement – among the owners. This gives the owners/member of the LLC, great flexibility in creating the entity, but also allows for important provisions to be forgotten or not provided for at all. One provision I frequently see missing or incomplete in an Operating Agreements is a comprehensive description of ownership among the members – how much each member owns, any rights and preferences that differ for a member, and a provision to make the ownership divisible into units.
In contrast to corporations, LLCs don’t typically have shares, or units, that are issued to the owners to indicate ownership and percentage of ownership. A corporation has a fixed pool of shares which can be issued to shareholders. Statutes require corporations to keep a list of the shareholders and their ownership percentage and requires language on different rights and preferences of the stock to be described in a public filing. As a result, it is easy to determine what a shareholder owns and then the percentage ownership of such shareholder.
With LLCs, members own membership interests (sometimes called limited liability company interests) in the Company which are not naturally broken down into units of measure. You simply own a membership interest (singular!) in the Company and part of your agreement with the other members is to describe what and how much you own. Typically, an Operating Agreement will have a schedule that lists out the ownership percentages, but it could also be included in the text of the Agreement.
If desired, membership interests can be expressed as “units” or “shares” rather than just an “interest.” Members would include language in the Operating Agreement that the membership interests in the Company, including all of the Members’ rights in the Company, have been converted into “Units.” Then, each member would own a certain number of Units and all of the Units make up all of the membership interests. In this approach, the members could limit the total number of Units that are issued, and provide some protection against dilution.
Additionally, providing for Units can also make the LLC appear more like a corporation in its ownership. It is easier to prepare certificates for a set number of Units, rather than a certain percentage membership interest.
To make LLCs even more flexible, members can own different types of membership interests or Units. Like corporations, LLCs can have nonvoting interests, or preferred interests, or even nonvoting preferred interests. The rights and preferences of each type of interest must be described in the Operating Agreement along with ownership in such type. Providing for Units can make the issuance of different types of ownership interests easy to describe. For example, the Operating Agreement can provide that the initial Members or “Founders” own the Voting Units, but allow for the issuance of a limited number of non-Voting Units to employees or management.
Alternatively, the Operating Agreement could provide for different Units to track certain investments or property of the LLC. For example, in an LLC that invests in real property, you might have a situation where not every member agrees that a specific investment is a good idea. In that case, you could have Common Units that all the Members own and share in the profits, along with “Risky Strip Mall Units” that only certain Members have purchased which capital contribution was then used to purchase a “Risky Strip Mall.” Ownership of the “Risky Units” would qualify the “Risky Unit Members” – and only those Members – to the profits generated on the risky asset the Company bought.
It is impossible to describe in this blog all the options available for ownership in a limited liability company. Because of their incredibly flexible nature, LLCs make the perfect entity for sophisticated business arrangements. Remember to describe the ownership properly – who are the owners and how much do they own – and be specific about any special rights or preferences that differentiate members. Neither the LLC statute nor a public filing (like corporations have), will provide guidance if you forget to include this information in your Operating Agreement. Finally, if LLC ownership is divisible into Units, you need to make that clear in the Operating Agreement if that is your intention.