Transfer restrictions in LLC and Partnership Agreements
Common Transfer Restrictions In LLC And Partnership Agreements
People enter into written limited liability company (LLC) and partnership agreements so that there is a clear understanding among the business’ owners regarding duties and responsibilities. These legal agreements often include transfer provisions that may restrict the ability of owners to sell or transfer their ownership interest in the business or giving directions regarding how they can specifically transfer their ownership.
What Are Transfer Restrictions in LLC and Partnership Agreements?
Transfer restrictions create parameters around the sale or transfer of a business’ ownership interest. They may require that the manager or a percentage of members must consent before the transfer can occur. Other transfer restrictions require that the owner give notice and an opportunity for other owners to buy out their share before the transfer. Additionally, transfer restrictions commonly prohibit any transfers that would cause the LLC to be treated as a corporation for tax purposes to occur.
Why Transfer Restrictions in LLC and Partnership Agreements Are Necessary?
Business owners work closely with each other. Without transfer provisions, there is no clear plan about what will happen if one of the business owners passes away, becomes incapacitated, gets divorced, or goes bankrupt. Transfer provisions state whether the partners can buy the owner out, take on new partners, or take other action to preserve the business.
Transfer restrictions help business owners address these potential challenges. These provisions are typically made at the time the business is founded before any conflict arises between business partners. If there are no transfer restrictions in place, default corporate rules apply. However, the American Bar Association reports that the Uniform Commercial Code overrides anti-assignment provisions that do not apply to LLC or partnership interests. The clearest way to ensure the business continues the way the owners intend is to have clear transfer restriction provisions. Without transfer restriction provisions, an owner can freely sell, pledge, use as collateral, give away, bequeath, or otherwise transfer their ownership interests to anyone else. Additionally, there would be no restrictions regarding the price for a transfer. They also would not have to provide notification to the other owners so they could take protective action.
Involuntary Transfer of Ownership Interest
There may come a time when the business needs to make an involuntary transfer of ownership. For example, an owner may become disabled or file bankruptcy. Typically, these transfers are completed by a forced sale, removing voting rights, or transferring the interest through a will or divorce decree.
Common Transfer Restrictions in LLC and Partnership Agreements
Some of the common transfer restrictions in LLC and partnership agreements, include:
Right of First Refusal
A right of first refusal requires a member that has received an offer to buy their share in the business to first offer the share to the other members of the business. This gives the existing business owners the right to buy out the member’s share before they sell their share to a third party.
The offer to the company or the members must generally be made with the same terms that the third party offered. Interested members can buy the departing member’s share in proportion to their current interest.
This type of provision gives the members a limited amount of time to exercise the right. Additionally, it may include stipulations that if one or more members decline to make an offer, the remaining members will have the right to obtain the declined shares. If the other members refuse to buy the shares, the member can sell the shares with terms no better than the ones they offered the other members. This provision ensures that an owner can sell their share at fair market value.
Right of First Offer
The right of first offer is similar to the right of first refusal. With this provision, a member who wants to sell their interest must first offer their interest to the other owners. However, with a right of first refusal, the selling owner already has an offer from a third party. With a right of first offer, the selling member first notifies the other owners of their wish to sell and gives them the opportunity to make an offer for their ownership interest. Then, the selling owner cannot sell their shares to a third party with terms that are worse than the offering member or members made.
The LLC or partnership agreement may include a general prohibition against selling ownership interests at all. This is more common when a company is in its early stages. This prohibition might include exceptions for involuntary transfers or transfers to closely-related people or when an initial public offering is made of the business.
Mandatory Purchase of Stock by the Company
Another restriction that may be imposed is a mandatory purchase of stock by the company or shareholders. With this provision, if the agreement requires a sale of stock to a third party be approved by the company and the company denies the sale, shareholders must purchase the stock at a set price. This is sometimes a reduced price that is a percentage off the actual value of the stock. This arrangement is more common when the business wants to give an exit strategy to an owner so they can retire after they have been at the company for a certain amount of time.
Buy-sell provisions may also dictate how and when a transfer may be made. For example, it might state that company stock can be sold when:
- An owner is dying or becoming incapacitated
- An owner is going through divorce
- An owner is in the process of filing bankruptcy
- An entity with an ownership interest has a change of control
- Members disagree about how to operate the business and cannot resolve the dispute
- A member employee is quitting or has gotten fired
- Buy-sell provisions may also include specific details about how to value the ownership interest