Issues for LLC Owners with Minority Interests
A limited liability company is one of the most popular business entity types, both for North Carolina LLCs and nationally. It allows for flexibility, pass-through taxation, and fewer formalities than an S-corporation or C-corporation. This is both good and bad. If you are a minority member of an LLC (that is, you own less than a 50% interest in the LLC), this flexibility can also lead to overreach by the majority member or members. There are ways to plan ahead, however.
In particular, though there are many issues minority members should be mindful of, there are three important ones that our firm recommends entrepreneurs prepare for: capital calls, distributions, and dispute resolution. These are explained below.
1. Plan for Capital Calls
A capital call, also called a draw down, is when the LLC requires additional money for business purposes. Most LLC operating agreements permit the company to issue a capital call to members when reasonably necessary. The decision to make a capital call is usually done by the majority.
If a minority owner is unable to contribute the amount required under a capital call, he or she could face consequences as a result. The penalty is often to dilute the minority owner’s share, take away voting rights, withhold distributions, or even force a sale of their interest.
Because capital calls are common, a minority owner or their attorney should require that any operating agreement place limits on capital calls. One option may be a cap on the contribution amount. Another option is to lessen the penalties for failing to contribute. Each LLC is unique, so possibilities abound.
2. Distributions to the LLC’s Interest Owners
A distribution is when profits of the LLC are paid to the members. As with capital calls, the amount and timing of distributions is usually determined by the majority. Distributions are sometimes paid as a salary, or monthly, or quarterly, or any other time permitted by law or by the operating agreement. Many operating agreements also provide for what is called a reserve. A reserve is an amount the majority or the manager may hold back to cover expected expenses.
If you are a minority member of an LLC, you should consider the timing and amount of the distributions that you will require. If you need your distribution paid at certain intervals (for instance, if distributions are your primary source of income), you should ensure this is clearly written in the operating agreement. Additionally, if the majority would be entitled to withhold excessive funds for the reserve -- thereby decreasing your distribution -- the circumstances under which this may occur should be spelled out. The purpose of an operating agreement, just like any contract, is so that the parties know what they should expect.
3. Resolving Disputes Between the LLC’s Owners
Disputes of one type or another are inevitable in life, and LLCs are no exception. Whether about the LLC’s management, ownership, distributions, or virtually any other aspect, one thing any entrepreneur should expect is that not everyone will always see eye to eye.
Even if the disagreement is a surprise, the means of resolving it should not be. The LLC’s operating agreement provides the answer for how any dispute is decided. If there is a question about decisions made by the manager or majority, it is best to provide for a quick, efficient, and inexpensive means for resolving disputes. One of the best ways is to include mandatory mediation and/or arbitration for any disputes. Taking a lawsuit through the legal system is often unnecessarily time-consuming and expensive.
Trying to salvage the parties’ relationships is important, so our firm suggests a two-step process, non-binding mediation so that each side can explain its interests, and then, if that fails, mandatory arbitration with an accepted neutral like JAMS or the American Arbitration Association.
Owning an LLC can be immensely rewarding. To maximize your ability to grow and profit from your business, and to minimize the potential for distracting disputes, LLC members should plan ahead. This means utilizing legal counsel who will help you plan for common issues like capital calls, distributions, and dispute resolution.
We can help. DYE CULIK PC is a Charlotte, North Carolina business law firm that serves entrepreneurs, small businesses, and franchisees. If you have an issue involving your business, give us a call at 980-999-3557 for guidance.