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Case Study: Member Dispute and Buy-Sell Provisions

July 5, 2020

A client (we’ll call him “Max”) started a closely-held limited liability company (the “LLC”) to operate a small business. A few years back Max bought out his former co-member and brought in a new member (we’ll call him “Stan”) to help run the LLC. Stan did a bang up job and soon had the LLC humming along. NOTE: Max gave Stan his membership interest in the LLC at no charge. Basically it was a sweat equity for membership interest deal.

Then, as most things do, the honeymoon period ended. Stan decided that he was doing all the work so he should receive all the benefits. Stan conveniently forgot that he paid nothing for his membership interest and was, in fact, paid well for his time operating the LLC (which was a “side job” for Stan – and not his primary employment). As a result, Stan decided that Max needed to go.

Fortunately, Max engaged the firm to draft the LLC Agreement for the LLC before bringing in Stan. The LLC Agreement provided for just such a dispute. If there were any “deadlock” between the 50-50 owners, then either owner could make a buy-sell offer to the other member. In other words, either member could choose a price at which he would be willing to buy the other member’s interest or sell his interest to the other member.

In this case, Stan overestimated his bargaining power and tried to low-ball Max. Stan figured that even if Max bought him out he’d be able to start a competing company and bring the LLC’s biggest client with him because of Stan’s relationship with that client. Max called his bluff and offered to purchase the LLC. Then the situation got weird. Stan refused to comply with simple due diligence requests and took other actions that raised immediate red flags.

The firm advised Max to dig deeper into the LLC’s financials and records. And dig we did. Turns out Stan was getting an even better deal than suspected. The first year or two with Stan running things there was an approximately equal distribution of net funds to the two members. However, over the next two years Stan started funneling more and more funds to his personal benefit through the LLC. It appeared Stan was actually paying himself about 2-3 times the amount Max was receiving.

After being presented with these issues and using some external leverage, Max and Stan agreed that Stan would return his membership interest in the LLC to Max in exchange for a release from Max and the LLC of any future litigation. The takeaway? Having a good LLC Agreement with a reasonable “exit plan” is a good first start. But any member of a closely-held business needs to stay up to date on the business financials and be sure to trust your instincts when presented with questionable financial items. If you are unsure, hire counsel. A good business litigator sees these situations regularly and can help “sniff out” just the type of mismanagement Max found here.