In today's Freedom Friday blog and email newsletter, I want to talk about a topic that doesn't come up very often. Most prospective clients believe an LLC is the best business entity for their small business, and that's usually correct, in most instances. However, even the best business entity possible still has the possibility of traps. Why is that true? Well, think about how many business disputes exist, and of course, the business entity involved is an LLC. Just because you choose an LLC doesn't mean you won't have problems. In today's Freedom Friday blog, I want to talk about common pitfalls (or traps) in an LLC.
First of all, an LLC in and of itself is not the issue, here. LLCs are probably the best business entity because they provide the owner(s) with the maximum flexibility they could have in structuring their small business. However, the owner(s), which are called “member(s)” of an LLC need to make a key decision, especially if it is a multi-member LLC. Before I talk about that key decision, if an LLC is a single-member LLC, a lot of this specific issue won't apply. But if an LLC has more than one member (or owner), then the members, collectively, need to decide whether they will manage the LLC, or if they will appoint a manager to their LLC. An LLC can be member-managed, which is very common in a single-member LLC, or can be manager-managed, which is very common in a multi-member LLC, especially in a multi-member LLC with three (3) or more members (owners). In the case of a two-member LLC, especially if it's a husband-and-wife team, it's still very common to stay member-managed, and not appoint a manager. But the more members in an LLC, the more common a manager is or should be appointed to manage the daily affairs of the business. Once a manager is appointed (usually in the operating agreement), then the members usually only vote on the “big” decisions, e.g., changing the operating agreement, changing the articles of organization, accepting a new member, or other major, structural changes in the LLC.
So, in a manager-managed LLC, there can be problems. If a member or members disagree with the business decisions that the manager is making (or the board of managers if there is more than one manager), the member(s) may need to get together to fire and/or replace a manager, AND, the member(s) may need to file a derivative suit against the manager(s) who caused the issue to begin with, and that kind of litigation can be very expensive, especially in a small business.
If an LLC is a member-managed LLC, that means that all the member(s) of the LLC vote to make a business decision. Typically, the votes are weighted, e.g., if you own a third of the LLC, then your vote is weighted accordingly. Many multi-member LLCs have three members, and they each own a third of the company. So, it takes two to make a decision, if the LLC members (owners) haven't appointed a manager to run the business. In Oklahoma, the default option with LLCs is that the members are responsible to run the daily affairs of the business, unless a manager is appointed in the operating agreement for the LLC. In this context, if you have a lot of different members in an LLC (and maybe some have a very small percentage of ownership like 5% or 10%), when it's time to make a big decision, there can be a lot of discord among the members. This discord can be avoided by carefully drafting the operating agreement for the LLC to include rules regarding voting and decision-making, and making sure the LLC members agree on these issues in advance.
Regardless of whether or not an LLC is member-managed or manager-managed, the best way to avoid these pitfalls is to clearly define the roles of members in the LLC's operating agreement when the LLC is created. Each LLC has unique needs, and the operating agreement needs to be drafted in a way to meet those needs. In general, I do recommend a manager being appointed for an LLC with more than three (3) members, especially if several of the members have a very small ownership interest, e.g., 5% or 10%. However, if it's just one or two members, an LLC can be member-managed so long as the operating agreement has other safeguards in those circumstances.
Thinking about starting a small business? Or maybe your business is having issues with contracts, leases, business partners, collection issues, or experiencing other barriers to growth? Please contact me at [email protected] to schedule a FREE strategy session.
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