What's in the fine print? Make sure you know before you sign
Many business planners and lawyers have departed from the traditional form of corporation and employ limited liability companies. The popularity of this business form is based on the favorable pass-through treatments these companies enjoy under the tax laws of the United States. Consequently, deals involving limited liability companies become tax driven. Often, the drafting of documents involves complex tax analysis that may result in the documentation departing from the contemplated transactions.
Limited liability company transactions typically include the formation of a new LLC with an operating agreement between all of the members. The new company acquires assets from one member using cash contributed by another. An experienced transactional lawyer may understand the document, but fail to fully explain its nuances to the client and later find that failure to be basis for a malpractice claim.
Typically the members of a limited liability company expect to be partners in the venture with the rights of governance as expressed within the operating agreement and related deal documents. However, these same documents very often include traps or complex clauses that alter the relationship.
One example involves the typical financial member who will make commitments to meet the future funding requirements for operations. These funding requirements find their way into the agreement as capital contributions, and are credited to the member’s capital account. Conversely, there are guaranteed extra benefits (an increased share of the company) and preferences on profits or sales attached to these contributions, which may be buried in the documentation.
Similarly, the member who has contributed his or her business to the new company may not receive a credit for the full value that the parties had agreed upon for that business. Sometimes this contribution is treated as inferior to the cash provided. This is particularly true if such values are included within the former business owner’s capital account only upon achieving EBITA performance milestones, and then may be very low on the list of actual distributions. On occasion, a close reading of the documents will reveal that that promised payment for the business being contributed is so far down the distribution claim that it is unlikely be realized. In all events, the true payment price for the business must be based on what may actually be realized discounted back to the closing date.
When fresh money is put into the company there may be stringent “pay to play” requirements. Failure to contribute fresh money may result in significant dilution to an existing interest. Similarly, there are often preferences in favor of later cash relative to whether the company will ever pay the amount promised for the original business.
To understand what the client is truly getting, assuming you are involved in one of these transactions, a few basic questions should be asked. First, exactly how does the transaction work? What are the mechanics involved in receiving the credits or debits to a capital account? How much will the client actually be paid based upon formulas that have been agreed upon?
Unless careful attention is paid to each one of these questions, a seller or buyer may be very disappointed. Unfortunately, the format of most of these transactions involves language that your client will not understand. Your “translation” of the complex instruments will be essential to assuring that the client gets what is bargained for rather than being a plaintiff in a malpractice case against you. If the instrument does not provide for a precise and clear methodology for payment of profits or on sale, the seller may not get what the seller thinks he or she should be getting and this will lead to a major dispute decided in the courtroom.
By Andrew C. Hall
Hall, Lamb and Hall, P.A.
2665 S. Bayshore Drive, PH 1
Miami, FL 33133
South Florida Legal Guide 2013 Edition