LLC Operating Agreements – Failure to Contribute, Part II

By: Tamara B. Pow, Esq.

What do you do if your LLC needs capital and a Member fails to contribute their share?

The question of “What if the Company needs more money?” was addressed in Part I of this blog . If it is at all possible that the LLC will need additional funds in the future, the operating agreement should provide both for the right to borrow on prescribed terms from insiders, and the right to require members to contribute their share of the additional capital needed. This Part II addresses potential provisions to include in your LLC operating agreement to deal with the situation where the members are required to contribute additional capital and a member defaults in this obligation. The operating agreement can provide that either the managers or the non-defaulting members may elect one or more of the following remedies:

Advance the Funds for the Defaulting Member

The non-defaulting members may advance funds to the Company to cover those amounts which the defaulting member failed to contribute and then treat that sum as a loan to the defaulting member at a high interest rate (such as 10% per annum). The terms of the advance could include a mechanism for all cash distributions from the LLC that would normally go to the defaulting member to be paid to the advancing member instead until the advance, including interest, is paid in full. It is a good idea to include a form of promissory note as an attachment to your operating agreement if you plan to include this remedy. You may also want to provide that the defaulting member automatically grants a security interest in his or her membership interest to secure the promissory note.

Adjust Percentage Interests

Another alternative may be to simply adjust the percentage interests of the members after the additional capital contributions are made so that the defaulting member is diluted by the additional capital contributions of the other members. If you plan to use this remedy, your operating agreement should provide a formula or other methodology for adjusting the percentage interests so that an appraisal is not required.

Dissolve the Company

This may be considered the nuclear option. If a member does not contribute additional capital when required, the other members may simply not want to continue doing business with the defaulting member and can choose to dissolve the Company. This could be decided by a majority of the non-defaulting Members (or a supermajority, but not less than a majority of the LLC members), or by all of the non-defaulting Members. The method for dissolution should be set forth in the operating agreement.

Buy Out the Defaulting Member

The operating agreement can provide a right in favor of either the Company or the non-defaulting members to buy out the defaulting member’s membership interest. Terms and conditions should be set forth in the agreement. Because this is supposed to be a penalty for the defaulting member’s failure to contribute funds when needed, the purchase price could be less than fair market value as long as the discount is agreed to in advance (by inclusion in the operating agreement).

Preferred Distributions to Non-Defaulting Members

The operating agreement could include a provision giving non-defaulting members preferential distributions in the amount of their additional capital contributions plus a preferred return thereon so that the non-defaulting members get all of their additional contributions back plus more before the defaulting member gets any distribution.

Loss of Rights

A defaulting member could lose her voting and approval rights, either permanently or until the default is cured. A defaulting member could also lose her ability to participate in management or operations, as applicable, either permanently or until the default is cured.

There could be many other potential remedies depending on the type of business of the LLC. For instance, if the additional contribution required is actually for certain property or services by the member, the Company could choose to require the defaulting member to contribute cash equal to the fair market value of the property or services not contributed. Or the Company could simply require specific performance.

Regardless of which remedies are right for a particular LLC, it is critical that the options for enforcement be included in the operating agreement so that each member acknowledges and agrees that the remedies are fair and reasonable at the time the operating agreement is signed, well in advance of any default.

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.