Transfer Provisions in LLC Agreements
Members of most limited liability companies (LLCs) enter into LLC agreements—also referred to as operating agreements—to document private agreements among themselves and to supplement or alter the default rules set out in the applicable LLC laws. LLC agreements often include transfer provisions, which can:
- Restrict the ability of a member to sell or otherwise transfer all or any portion of its LLC interest without either:
- Receiving the LLC's consent
- Giving the LLC or the other members an opportunity to buy the transferring member's LLC interests
- Require or permit members to sell their LLC interests to a third party
- Require members to buy or sell their LLC interests to or from each other
This article discusses the different types of transfer provisions commonly found in LLC agreements, including transfer restrictions, rights of first refusal (ROFR), rights of first offer (ROFO), drag-along rights, tag-along rights, and buy-sell provisions.
Most LLC agreements have a rule that members cannot sell or otherwise transfer their LLC interests unless approved in advance (typically by the manager or some percentage of the members) or allowed under another provision of the transfer section, such as an ROFR or ROFO.
LLC agreements with a general prohibition typically permit certain transfers to closely related people, such as immediate family members, affiliates, and controlled entities (such as family trusts). Transfers made in connection with an initial public offering of the LLC's securities are also usually permitted.
Despite any permitted transfer or other provision of the LLC agreement, if the LLC is treated as a partnership for US federal income tax purposes, any transfer—or withdrawal—that would cause the LLC to be treated as a corporation for US federal income tax purposes is generally prohibited.
Right of first refusal
The ROFR requires a member that has received a bona fide third-party offer for a sale of its LLC interests to first offer those interests to the other members before completing the sale to the third party. In some agreements, the offer is also made to the LLC, which offer can be simultaneous with the offer to the members, or the company can have a right of first refusal before the other members can exercise their rights.
Any offer to the company, the members, or both must typically be made on substantially the same terms offered by the third party. Interested members can then buy the offered interests pro rata in proportion to their current holdings. The agreement can include provisions that allocate all the offered interests among the members so that if any member declines to exercise its ROFR, the remaining members can acquire the declined interests.
Right of first offer
Similar to the ROFR, the ROFO requires a member to offer its LLC interests to the other members or the LLC before offering to sell to third parties. However, with an ROFO, the selling member does not need to identify a third-party buyer before offering its LLC interests to the other members or the LLC.
If an LLC agreement includes an ROFO, the LLC agreement should not also include an ROFR. Although there are no legal constraints against including both provisions, the procedures that must be followed in both cases can be lengthy and ultimately achieve the same goal, making it impractical to include both provisions.
Drag-along rights protect the majority member of the LLC by allowing it to require the minority members to sell their stakes in the company if doing so will aid in the sale of all or a significant portion of the company to a third party. Drag-along provisions are generally included in LLC agreements where one of the members owns a majority of the company's LLC interests (such as a sponsor in a buyout transaction).
They are also sometimes included in minority investments with multiple rounds of financing when no investor holds a majority on its own. When the members own an equal percentage of LLC interests—as in a 50/50 joint venture—the members do not typically have a drag-along right.
Tag-along rights are the flip side of drag-along rights and protect the minority members of the LLC. These rights typically provide that if the controlling members sell all or some portion of their LLC interests, they must allow the other members to participate in the sale and sell their interests on a pro rata basis on the same terms and conditions as the controlling member.
Buy-sell provisions describe the events and related procedures for when members are permitted or are required to buy or sell LLC interests from each other. These provisions are often used to plan for certain situations, such as:
- A member dying, becoming incapacitated, divorcing, going bankrupt, or undergoing a change of control (in the case of a member that is an entity).
- A disagreement among the members over the operation of the business they cannot resolve.
- A member that is an employee of the LLC resigning or being terminated.
- A member withdrawing from the LLC (if permitted, though this is rare).
Valuing the transferred LLC interests is a critical part of any buy-sell provision. It is important to include a clear procedure for valuing the transferred LLC interests when the parties first enter into the LLC agreement (or buy-sell agreement, if separate) because the parties' interests are more likely to be aligned at that time.
If the valuation procedures are ambiguous (or the agreement is silent on the matter), the parties will need to negotiate the valuation of the LLC interests at a time when they may have opposing interests. This can lead to time-consuming and costly negotiations.