The fundamentals of an LLC operating agreement

Kristin S. Coffey, The Daily Record Newswire

Regardless of the purpose of the valuation, a review and analysis of the limited liability company operating agreement is essential. In his article “Anatomy of an LLC Operating Agreement: The Fundamentals for Valuation Analysts” (The Value Examiner September/October 2012, National Association of Certified Valuators and Analysts, Salt Lake City), L. Paul Hood Jr. discusses important LLC provisions and their implications to business valuations.

First and foremost, as Hood notes, you need to know whether the LLC is taxed as a partnership, a C corporation or as an S corporation. If the operating agreement does not state how the LLC is treated for tax purposes, that information can be found on the LLC tax return. A Form 1065 is filed if the LLC is taxed as a partnership; a Form 1120 if it is taxed as a C corporation or an 1120S if taxed as an S corporation.

LLC operating agreements can vary significantly. Some agreements are comprehensive, providing for many reasonable contingencies. Others are more boilerplate and omit some material provisions and terms. Any terms not covered in the operating agreement are covered by state default rules available online.

An LLC agreement can be ambiguous or conflict on material points. The valuation analyst may require guidance from the client’s attorney, who may or may not have drafted the document. If you are unable to clarify an ambiguous provision, Hood recommends making an assumption about its meaning and disclose that assumption in the valuation report.

Provisions which have particular relevance to valuation engagements include:

1) Term: The LLC may have a stated finite term or it may expressly provide for perpetual life. Hood points out that, for federal estate tax purposes, LLC for families typically have a finite term because of IRC Sec. 2704, which requires that the rule set forth in the operating agreement not be more onerous than the default under applicable state law.
If the LLC has a perpetual life and the members are not permitted to withdraw prior to the termination of the LLC, the valuation analyst could conclude that a hypothetical buyer would not purchase such an interest, regardless of the discounts applied, because of inability to “cash in” on the interest.

2) Management and voting: The LLC is either member-run or managed by one or more members. This provision typically articulates what the members have the right to vote on and what percentage of total votes is required to authorize action. Different classes of members and how actions of the LLC may be authorized, i.e. by written consent in lieu of a meeting are stated in this section. A member’s right to vote and participate in the management of the LLC impacts the applicable discount for lack of control.

3) Distributions: Is the manager required to make cash distributions? Are the distributions at the manager’s discretion, as well as when the distributions are to be made? The agreement provision on distributions answers these questions and other related questions. From a valuation perspective, if the interest is entitled to periodic distributions of available cash, than it is likely more marketable (reducing the discount for lack of marketability) and the entity can be valued using a cash flow approach.

4) Transfer or withdrawal: The LLC sets forth in this provision whether membership interests are assignable, the rights of the assignee and, if there is one, a right of first refusal. Whether members are permitted to withdraw prior to dissolution and possible reasons or events permitting withdrawal are discussed in this section.

If an LLC has significant obstacles to the transferability of an interest, absent the consent of the other members which can never be assured, and no right to withdraw prior to the termination, the discount for lack of control will likely be higher. Conversely, if the interest is freely assignable, even if the assignee lacks certain membership rights, it will likely have a lower discount for lack of marketability.
Other LLC agreement provisions have implications on business valuations and should be reviewed including:

• Access to information

• Capital contributions

• Capital accounts

• Dissolution

• Governing law

• Waiver of partition

• Number of members

• Rights of creditors

The operating agreement together with state LLC law will assist in the valuation of a limited liability company by setting forth the members’ rights as they relate to the prerogatives of control. With the assistance from the client’s attorney and state LLC law, ambiguities and conflicts in provisions can be resolved.

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Kristin Coffey is the senior manager of Business Valuation Services with Mengel, Metzger, Barr & Co. LLP. She may be reached at kcoffey@mmb-co.com.

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