LLCs Were Not Designed For Today’s Technology
Written By Adam Yohanan
When Limited Liability Companies (“LLCs”) were invented in the late 1970s by the State of Wyoming and eventually adopted by all states throughout the 1980s and 1990s, it was not intended for the LLC to become the entity of choice for so many entrepreneurs as it has today.
Quite to the contrary: when the LLC was invented, the assumption was that parties using LLCs would be legally represented, commercially savvy, and able to customize their rights and obligations through contracts, specifically the LLC operating agreement. That is why so much of the relationship between LLC owners is left open-ended for the owners to negotiate. Unlike corporations, which came with extensive default rules and fiduciary protections built in, LLC statutes were skeletal, allowing private parties to negotiate nearly everything.
It wasn’t until the 2010s with the rise of online formation services like LegalZoom that the LLC became the default entity for the masses. As a result of this technology and pro-LLC social media content, the LLC has become the entity of choice for people who often don’t have lawyers, despite being built on the assumption that everyone involved would use a lawyer.
The irony is that people who don’t have lawyers might be better served by using corporations than LLCs, because corporations have guardrails in place, whereas the LLC approach is more laissez-faire.
So, if you are forming a multi-member LLC, here are some landmines to look out for:
Default Rule: One Member, One Vote. The default rule is that each owner has one vote, regardless of the percentage of ownership. This is shocking because people tend to think that LLC voting will be similar to that of a corporation, where owners who own more of a company cast more votes. But the default rule for LLCs is not one share one vote; it’s one person one vote, unless the operating agreement says otherwise.
Default Rule: Equal Allocation of Profits. The default rule for LLCs is that there will be an equal allocation of profits, even if there is unequal ownership. In corporations, the default rule is a pro rata distribution of profits, meaning a distribution in proportion to the ownership interest. LLCs don’t work like that. So even if Person A owns 90% of the LLC, that doesn’t mean Person A receives 90% of the profits. The only way to change the default rule is to agree to a different allocation in the operating agreement.
Default Rule: Unanimous Owner Consent for Major Decisions. The default rule for LLCs is that major decisions, such as mergers or fundraising, require the unanimous consent of all owners. In a corporation, by contrast, the board can usually approve major decisions by majority vote. But LLCs don’t follow that model. That means a single owner of an LLC can block a transaction, even if there are 25 owners, unless the operating agreement says otherwise.
Bottom Line:
If you are creating an LLC or signing into one, pay close attention to what is and is not included in the operating agreement. If there is no operating agreement in a multi-member LLC, that is a red flag. Don’t solely rely on your general knowledge of corporate law rules because they might not apply to the LLC.
Adam Yohanan is a transactional business lawyer with extensive experience representing companies, investors, and entrepreneurs in a wide range of high stakes business transactions.
Adam handles the small and large transactions in the life of a businesses, including mergers & acquisitions, entity formations, partnerships and joint ventures, investing and fundraising, commercial contracts, and dissolutions. His office can be reached at 212-859-5041.
Haley Kopp is a corporate lawyer focused on representing start-ups and small companies in formations, venture capital, angel investor financings, mergers and acquisitions, and general corporate matters.
Haley's diverse experience gives her a practical approach to solving complex business issues, whether guiding companies through financing rounds or corporate transactions. Her office can be reached at (619) 512-3652.
This guide is meant for educational and informational purposes only and should not be considered legal advice. It is essential to consult with an attorney or other advisors regarding all legal and other important matters.
