“Choice of entity” may be the most mercilessly beaten dead horse of all. There are many varieties of the presentation. All of them have merit. Criteria used vary widely. No matter which criteria folks emphasize, all agree that there is a choice to be made. No business entity is clearly superior in all cases or circumstances.
While different circumstances call for different entity choices, there is at least one constant in business. Business is conducted by human beings. Human beings have weaknesses, vulnerabilities, varying degrees of emotional management, and differing ethical codes. These human qualities (or failings) can produce disputes, sometimes ugly disputes.
Most business attorneys representing a closely-held business will attempt to anticipate these disputes. They’ll attempt to deal with these disputes by advising the business owners to establish a contractual business divorce process. In the corporate world, these provisions are contained in the shareholders agreement. In the partnership/LLC world, the provisions are in the partnership agreement or limited liability company agreement (an LLC agreement).
The business divorce provisions in a shareholders agreement will in many ways be a good template for similar provisions in a partnership agreement or LLC agreement. While a wise business law practitioner might begin to draft business divorce provisions for an LLC agreement using a shareholders agreement template, she will not simply cut and paste. Rather, she’ll modify the shareholder agreement provisions, sensitive to the business, economic, and tax differences between corporations and partnerships/LLCs.
One Delaware case highlights the perils of failing to clearly and unambiguously address these differences where a partner’s interest is “redeemed”. In Hampton v. Turner, C.A. No. 8369-VCN (Del Ch. April 29, 2015) the Delaware Chancery Court addressed a dispute between members of a tech company. One set of members were responsible for creating the intellectual property of the company. Let’s call these folks the IP Members. The other set was a group of members providing capital led by Mr. Turner. We’ll call these folks the Investor Members.
We don’t know what precipitated the dispute between the IP Members and Mr. Turner, but you can imagine what might have happened, based on the differing interests and backgrounds of the groups involved. In any case, the IP Members filed an action to have the LLC dissolved under judicial dissolution. That action triggered a provision in the LLC agreement granting the LLC the right to buy out the IP Members’ interests in the LLC (their units). The buyout provision in the LLC agreement stated that amount to be paid for their inits (in this case) is the fair market value of their units.
That provision begs the question: what is the fair market value of the units? The Investor Members argued that the LLC agreement provides that the fair market value of a person’s units is determined with reference to liquidating distribution provisions. In other words, for each unit, a departing member receives the net amount that person would receive as to that unit if the company sold all of its assets for fair market value in liquidation. Under this approach, the IP Members were entitled to about $197,000 each.
The IP Members argued that the fair market value of their units was the product of the enterprise gross value multiplied by their share of profits. Under this approach, the brainy folks were entitled to about $444,000 each.
Vice Chancellor Noble disagreed with the Investor Members, denying their motion for summary judgment. He correctly stated that if the Members wanted fair market value to be determined with respect the liquidating distribution waterfall, they could have said so. They did not.
Vice Chancellor Noble also said that a payment from the company to a person for units is not necessarily a distribution. And even if it were a distribution, it could be a distribution that is made differently than distributions under the LLC agreement’s liquidating distributions provisions.
Vice Chancellor Noble’s statements on distributions seem suspect to me. It seems to me that a payment from a partnership to a partner to liquidate a partnership interest must be treated as a distribution. And if it is a distribution, it seems that payment should be governed by distribution provisions in the partnership agreement.
Regardless of whether Vice Chancellor is correct about distributions, he is absolutely correct that the Members could have made that result inevitable had they drafted the agreement more precisely and clearly, in keeping with their business deal. Under the Chancery Court’s ruling, the business deal seems to have been undone, as the Investor Members’ capital will shift from them to the IP Members.
Or not. If the parties had accurately accounted for the value of the intellectual property contributed by the IP Members, the IP Members would have been entitled to book capital accounts equal to that value and perhaps a priority return of that value. In that case, perhaps the ruling gives the IP Members their due, or something close to it.
Regardless of whether the IP Members received true value for the interests, something more, or something less, the parties each took a chance. They signed an agreement with a buyout provision that was suitable for a corporate deal, but inadequate for a partnership deal. Partnerships, unlike corporations, are not distinct from its equity holders. The partnership is an aggregate of the equity holders. Their shares of that partnership are determined by their shares of equity as determined by the partnership agreement. Those shares are likely at odd with shares of units.
When drafting partnership buyout provisions, or partnership drag-along and tag-along provisions, bear in mind that each partner’s interest is not necessarily measured by shares of units. In other words, if you simply use a corporate model, you are taking a risk. If, however, you draft referencing interests as measured according to the partnership deal (usually distribution provisions or capital account balances), you will probably get the result that you probably intended.