Don’t get caught with an underfunded LLC. Plan ahead in your LLC Operating Agreement.
The question of “What if the Company needs more money?” is often not addressed by an LLC until it is too late, the LLC is in need of cash, and has no ability to borrow and no way to force the members to contribute additional funds. This issue could arise in an operational business limited liability company of any type due to cash flow needs. It can also arise in real estate limited liability companies where the members fund the company initially to provide capital to purchase the real estate, and then additional funds are needed later for capital improvements, repairs, or even operating cash if the tenants leave or are not paying their rent. If the members of an LLC unfortunately used some standard form of LLC agreement found online or copied from a friend, the agreement is probably silent on this matter.
Although investors generally do not want to enter into an agreement whereby they can be forced to contribute additional funds, LLC managers do not want to have their hands tied when a cash flow situation arises. Providing for members to make additional capital contributions is especially common in closely held and family entities, where the intent is not to allow for additional outside investors. Here are some ideas to consider when drafting your LLC operating agreement, to make sure you have a plan to deal with cash flow crunches.
The Right to Borrow from Insiders:
The biggest problem arises when the Company cannot force the members to contribute additional cash and also cannot obtain financing from a third party or institution. In this case, it is incredibly helpful to have a provision in your operating agreement providing for the managers to act on behalf of the Company to authorize a loan from a manager or member to the Company on reasonable pre-agreed terms. In particular, this provision should spell out what interest rate is considered acceptable, and that interest rate should be high enough to entice the manager or member to loan to the cash-strapped LLC. The operating agreement should also set forth the rules for paying back the loan, and whether it must be paid in full before any distributions may be made to members. Keep in mind that members are taxed on profits of the LLC, not distributions they receive, so you may want to provide for minimum tax distributions for the members while the loan is being paid down.
If no manager or member wants to loan funds to the Company, and the LLC operating agreement provides that members must make additional capital contributions in certain circumstances (usually either by the majority vote of the members, or a decision by the managers), then the operating agreement should clearly state that a failure to contribute such funds is a default by that member. Usually the agreement provides for the managers to give written notice to the defaulting members, with a period of time during which the member can cure the default by making the required capital contribution. However, the agreement must also provide options for the managers or the Company to take action once it is clear the member is in default.
Several options for dealing with a member default for failure to contribute capital are covered in part II of this blog.
Tamara B. Pow is a founding partner of Strategy Law, LLP in downtown San Jose, California where she practices business and real estate law including limited liability company and other business entity formations, operations, transfers, conversions and dissolutions. Her tax background, including time as a tax consultant at Price Waterhouse, LLP, as well as her MBA and real estate brokers license help her spot issues like these when advising owners of LLCs and other business entities.
The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.