At the outset of any relationship, be it professional or personal, the parties to the relationship are not interested in discussing how it will end. For various reasons, many investors in limited liability companies (LLCs) seek to exit those companies by seeking judicial dissolution of the LLC. Based on recent case law in Delaware, however, members of an LLC should not take comfort in, or rely upon, the statutory provisions of the Delaware Limited Liability Company Act (DLLCA) as an “exit mechanism.” Although Section 18-802 of the DLLCA provides a possible exit mechanism for members of an LLC, recent case law has shown that the Delaware courts are loath to dissolve an LLC merely because of changed circumstances, including bad economic conditions or a failure by the LLC to perform as anticipated. (Although the focus of this article is Delaware limited liability companies, the discussion with respect to exit mechanisms is applicable to LLCs formed in other jurisdictions as well.)
The DLLCA (Section 18-1101(b) of the Delaware Limited Liability Company Act) and relevant case law (Ross Holding & Mgmt. Co. v. Advance Realty Group LLC, 2010 WL 3448227, at *5 (Del. Ch. Sept. 2, 2010)) make clear that LLCs are creatures of contract and provide the members with substantial flexibility to tailor a business relationship in a manner that best suits their needs. Given the contractual flexibility provided by the DLLCA, members of an LLC and counsel drafting the limited liability company agreement (LLC Agreement) should be careful to include terms in the LLC Agreement that will provide the parties with an exit mechanism that meets the goals and objectives of the members. Depending on the purpose for which the LLC is being formed and the tenor of the negotiations between the parties to the LLC Agreement, it may be desirable for the members to rely on the statutory exit mechanism provided by the DLLCA. In the event the parties will rely on the statutory exit mechanism, the nature of this statutory exit mechanism should be explained to the members prior to entering into the LLC Agreement to ensure they understand the limits of the exit mechanism provided by the DLLCA. This article highlights the importance of addressing the issue of exit mechanisms in an LLC Agreement and provides a brief description of possible exit mechanisms that could be included in an LLC Agreement.
The DLLCA Default Provisions
In the event an LLC Agreement does not contain an exit mechanism, the members’ ability to exit the LLC will be governed by the default provisions of the DLLCA. Under Section 18-603 of the DLLCA, a member of an LLC does not have the right to withdraw from an LLC unless the LLC Agreement specifically provides such right. Therefore, unless a member has the right to resign under the LLC Agreement, a member cannot resign or withdraw from the LLC until it has been dissolved and wound up pursuant to its LLC Agreement or the DLLCA. Under Section 18-801 of the DLLCA, an LLC shall be dissolved (1) as provided in its LLC Agreement, (2) upon the requisite vote of members of the LLC, (3) at any time the LLC has no members, unless the LLC is continued as provided in the DLLCA or (4) upon an entry of a decree of judicial dissolution under Section 18-802 of the DLLCA.
The typical multi-member LLC Agreement is drafted in such a way that the LLC is dissolved solely upon a vote of the members (which vote often requires the consent of multiple members) or upon a judicial dissolution pursuant to Section 18-802 of the DLLCA. Thus, a typical multi-member LLC Agreement will not allow a member to unilaterally withdraw or cause the dissolution of the LLC. Therefore, if a member of an LLC governed by such an LLC Agreement determines, for any number of reasons, that it wants to exit the LLC, neither the LLC Agreement nor the DLLCA would provide the member with attractive options to exit the LLC. Such member may either (1) negotiate with the other members of the LLC for an exit acceptable to such member or (2) petition the Court of Chancery of the State of Delaware for the judicial dissolution of the LLC. The foregoing options may not be appealing to the member desiring to withdraw because none of the options can be taken unilaterally by such member.
With respect to the first option, negotiating an exit with the other members, the member that desires to withdraw will need to persuade the other members, or the LLC, to purchase its interest (which may not be a viable option for the LLC or the other members); or, such member will need to persuade the other members to dissolve the LLC. Presumably, the other members will only agree to either of the foregoing options if it makes business sense for them to do so at that time. Therefore, the member that desires to withdraw will have little influence over its power to withdraw. In the event that such member is unable to persuade the other members to purchase its interest or dissolve the LLC, such member may seek judicial dissolution of the LLC pursuant to Section 18-802 of the DLLCA.
Under Section 18-802 of the DLLCA, “on application by or for a member or manager the Delaware Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” At first blush, the statutory exit mechanism provided in Section 18-802 of the DLLCA may appear to be a reasonable option for parties to rely upon instead of having the difficult discussion at the formation of the LLC about how members may exit the LLC. But the case law applying and interpreting Section 18-802 of the DLLCA makes clear that such reliance may not be justified. The Delaware Court of Chancery has made clear that the remedy of judicial dissolution is an extreme remedy that should be used sparingly, and even if a petitioner is successful in proving the requisite elements under Section 18-802 of the DLLCA, as described by the court, it is still within the court’s discretion to grant judicial dissolution. In re Arrow Inv. Advisors, LLC, 2009 WL 1101682, at *2 (Del. Ch. Apr. 23, 2009).
Under Section 18-802 of the DLLCA, the case law shows that the Delaware Court of Chancery will grant judicial dissolution if either (1) the purpose for which the LLC was created no longer exists or can no longer be achieved (i.e., “frustration of purpose”) or (2) a deadlock exists. With respect to a petition for judicial dissolution due to “frustration of purpose,” the petitioner will need to show that it is not reasonably practicable for the LLC to carry on its business in conformity with its LLC Agreement because the defined purpose of the LLC can no longer be fulfilled. With respect to a judicial dissolution due to a deadlock, the Delaware Court of Chancery has found that the following factors are relevant (although no one factor is dispositive): (1) is there a deadlock?, (2) does the governing document provide a means of navigating around the deadlock?, and (3) whether due to the LLC’s financial position, is there still a business to operate? See Fisk Ventures v. Segal, 2009 WL 73957 (Del. Ch. January 13, 2009). Thus, due to the difficulty of obtaining a decree of judicial dissolution, Section 18-802 of the DLLCA may offer cold comfort to a member that wants to exit an LLC. The expense of a full trial litigating judicial dissolution will not be attractive to a member, particularly when the outcome – even if the member is successful in proving the “requisite elements” required under Section 18-802 of the DLLCA – is within the Court of Chancery’s broad discretion. Thus, this article recommends that counsel and his or her client consider including an appropriate exit mechanism in a multi-member LLC Agreement. A well drafted exit mechanism will save the parties money and time, should one of the parties wish to withdraw from the LLC.
Section 18-1101(b) of the DLLCA states that “[i]t is the policy of the [DLLCA] to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Further, the Delaware Court of Chancery has stated that LLC Agreements are creatures of contract; therefore the options available to members of an LLC in crafting exit mechanisms are vast. In drafting the exit mechanism provisions, counsel should understand the goals and objectives of the client and try to identify the circumstances that might cause the client to want to withdraw from the LLC. The reasons for wanting to withdraw from an LLC are limitless, but some of the reasons that typically crop up are listed below:
- Purpose. A member may want to withdraw from an LLC because the defined purpose of the LLC can no longer be fulfilled. For example, the defined purpose of an LLC may be frustrated if the company was formed to develop and market technology that has since become obsolete. However, if the purpose clause is broad and the client does not have authority to veto a decision to cause the LLC to enter into a different area of business, such member may find itself stuck in an undesirable line of business.
- Member Breach. A member may want to withdraw from an LLC because of a breach of the LLC Agreement by another member. Or, even if the other member has not technically breached the LLC Agreement, a member may want to withdraw because the other member has failed to perform as expected and has not lived up to the benefit of the bargain made by the members.
- Disagreement on Strategy. A member may want to withdraw from an LLC because the parties cannot agree on the LLC’s strategy. Often when this occurs, a deadlock will result if management is split equally and decisions require the consent of the other members.
- Lock in Gains. A member may want to withdraw because the LLC has been successful and it wants to lock in and realize the gain on its investment.
Understanding the reasons why a member would want to withdraw from an LLC will enable counsel to draft appropriate exit mechanism provisions. Further, this exercise will help align the exit triggers with the exit mechanisms. Certain exit mechanisms may not match an exit trigger. For example, the parties to an LLC Agreement may not want to provide a breaching party with a “put” right upon its breach of the LLC Agreement, which could have the effect of rewarding the breaching member for its misconduct.
One indirect way to address exit mechanisms is for counsel drafting the LLC Agreement to ensure that the defined purpose clause in the LLC Agreement accurately reflects the objectives and purposes for the LLC. Members entering into a multi-member LLC Agreement should consider whether a broad or narrow purpose clause should be included in the LLC Agreement. A broad purpose clause will typically state that the LLC is formed for the purpose of engaging in any lawful act or activity for which Delaware limited liability companies can be formed. A broad purpose clause like the one described in the preceding sentence will make it difficult for a petitioner to obtain a judicial dissolution of the LLC for “frustration of purpose.” Thus, if the purpose for which the LLC is being created is narrow and limited, the defined purpose clause in the LLC Agreement should also be narrow and limited. Further, provisions should be added to the LLC Agreement to prohibit the LLC from operating for a different purpose, or amending the purpose clause, without unanimous member consent.
As noted above, possible exit mechanisms in an LLC Agreement are limited only by the imagination of the drafter, but a few options are as follows: (1) a right to terminate the LLC upon the occurrence of a specified event, (2) a right to “put” interests to the LLC or the other members upon the occurrence of a specified event, (3) a right of a member or the LLC to “call” interests in the LLC upon the occurrence of a specified event, (4) a buy-sell provision which gives the parties the right to either be a buyer or seller of the LLC interests upon the occurrence of a specified event, or (5) a right to sell all of the LLC interests in the company (or just the exiting member’s interest) upon the occurrence of a specified event. As previously noted, care should be taken by the drafter to correctly match an exit mechanism with an exit trigger to ensure that the parties to the LLC Agreement are incentivized to maximize the value of the enterprise consistent with their duties and obligations under the LLC Agreement.
Under Sections 18-801(a)(i) and (a)(ii) of the DLLCA, an LLC is dissolved upon the time specified in its LLC Agreement or upon the happening of events specified in the LLC Agreement. Thus, the parties to an LLC Agreement may want to provide that the LLC terminates upon the occurrence and/or non-occurrence of certain events specified in the LLC Agreement. Such a provision, with clear and objective triggers, will be helpful if the parties to the LLC Agreement disagree upon the strategic direction of the LLC. The range of triggers that might cause a termination of the LLC are limitless, but whatever the trigger is, the drafter of the LLC Agreement should take care to ensure the trigger is clear and objective in order to avoid litigation as to whether the trigger event in fact has occurred.
Put or Call Rights
Members of an LLC may want to include put or call rights with respect to their LLC interests in the LLC Agreement. Again, care should be taken by the drafter to ensure that the put or call right is correctly aligned with the appropriate trigger to create incentives that are desirable to the LLC and its members. Pursuant to a put right, the holder of such right will have the ability to cause the LLC, or the other members, to purchase its LLC interest upon the occurrence of certain events. A put right enables a member to monetize its LLC interest and withdraw upon the occurrence of certain events. In drafting the put right, and certain other exit mechanisms described below, the drafter of the LLC Agreement should carefully consider how the LLC interests will be valued and how the purchase of such LLC interests will be financed.
Similar to the put right, a member or the LLC may be granted a call right, which would give a member or the LLC the right to purchase another members’ interest in the LLC upon the occurrence of certain events. This right may be attractive to a member that no longer wishes to be in business with the other member due to that member’s breach, or some other reason. A call right would enable the holder of the call right to purchase a member’s interest upon certain trigger event(s). The valuation issues described above should also be considered with respect to a call right.
Members of an LLC may want to include a buy-sell provision in the LLC Agreement. In using this type of exit mechanism, a member will set a price at which it would be willing to buy or sell its LLC interests. The other member then has the right to either buy or sell at the offering member’s suggested purchase price. This right will allow members to terminate their relationship, presumably at a fair price. The purchase price should be fair because the initiating member will presumably suggest a fair price because it will not know at the outset whether it will be a buyer or seller.
Another exit mechanism that the members may want to include in the LLC Agreement is the right to sell the LLC or the right of the exiting member to sell its interest in the LLC to a third party. Typically, a multi-member LLC Agreement will contain transfer restrictions that prohibit a member from transferring its interest in the LLC to a third party without the consent of the other members. But the parties to an LLC Agreement may want to consider adding a provision that allows a member to sell the LLC or its interest in the LLC to a third party. If the sale right provision will permit the exiting member to cause the sale of the LLC as a whole, then the LLC Agreement will also need to contain a drag-along provision to force the other members to sell their LLC interests in the LLC to the third party.
In addition to the foregoing exit mechanisms, the parties may also want to consider adding dispute resolution provisions to resolve any disputes among the members, including disputes over valuing the LLC interests in connection with any of the exit mechanisms described above. This would be particularly important in an LLC with two members in which management is split equally and decisions require the consent of the other member. The drafters of the LLC Agreement should specify whether the exit mechanisms set forth in the LLC Agreement are intended to trump the default provisions of the DLLCA or simply supplement those provisions. Thus, the parties should consider whether members should retain the right to seek judicial dissolution in spite of the negotiated exit mechanisms set forth in the LLC Agreement.
The foregoing discussion is not meant to suggest that an inordinate amount of energy, time, or expense should be devoted to drafting the exit mechanisms contained in an LLC Agreement. But rather, the purpose of this article is to suggest that as part of the process of negotiating and drafting an LLC Agreement, the members should consider how the parties will exit the LLC. In spite of the foregoing suggestion, the author recognizes that at times it may be preferable for members of an LLC to not address termination or exit provisions at the outset, because it would be better to address those issues at the time a member wishes to exit the LLC based on the circumstances as they exist at that time. Nevertheless, the parties to the LLC agreement should realize the consequences of that decision and the risk that the parties may not be able to agree as to acceptable exit terms; and furthermore, reliance on the judicial dissolution provision in the DLLCA may not be warranted, considering the lack of success that parties have had petitioning the Delaware Court of Chancery for judicial dissolution. Although counsel representing an investor in an LLC should not assume the failure of the LLC or future discord among members of the LLC, he or she should carefully educate the client as to the risks involved and the possible ways to resolve such risks.