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Arizona Law Arizona LLC Library Arizona LLC Operating Agreement with Buy-Sell provisionsWhy Multi-Member LLCs Must Adopt an Operating Agreement with Buy-Sell Provisions
An Operating Agreement with Buy-Sell Provisions is the Members' Exit Strategy. Don't Go Into Business With Unrelated Parties Without an Exit Strategy
by Richard Keyt, Arizona LLC and business lawyer
Bottom Line & Number 1 Reason Multi-Member LLCs Need an Operating Agreement with Buy-Sell provisions: Members of a multi-member LLC who DO not sign an Operating Agreement with Buy-Sell provisions are stuck with each other FOREVER unless they can agree on how to split the LLC pie when they cannot agree on anything else.
Although Arizona LLC law does not require that members of an Arizona LLC enter into an Operating Agreement with Buy-Sell provisions, I recommend that the members of every multi-member Arizona LLC (other than a husband and wife owned company) sign an Operating Agreement with Buy-Sell provisions. The purpose of an Operating Agreement with Buy-Sell provisions is to create a mechanism for the orderly acquisition of the membership interest of a member of the LLC on the happening of a specified triggering event. Without a written agreement that contains an exit plan, the members of an Arizona LLC are stuck with each other in sickness and in health and even after death because Arizona LLC law does not provide for the mandatory acquisition of members' interests in an AZ LLC.
I have formed 2,400+ Arizona LLCs. As a business lawyer who began practicing in Arizona in 1980, I have seen the unfortunate results of too many companies (corporations and LLCs) where over time the owners became at odds and desperately needed a "company divorce," but were forced to "cohabitate" indefinitely together in the business because they never signed an Operating Agreement with Buy-Sell provisions that contained a mechanism for a mandatory buy-out of an owner.
An Actual KEYTLaw Client Bad Example
In 1994 I formed an LLC for a small group of people to operate a business that became very profitable. I gave the members my comprehensive Operating Agreement that included buy-sell provisions, but the members never signed the Operating Agreement. In 2002 after an extended period of disagreement and infighting among the members, the company's built-in hair-triggered IED (improvised explosive device) exploded. After years of failing to document transactions such as the assignment of membership interests, the owners could not agree on who the members were or the membership percentage of each member. Result: A very expensive, time-consuming and worrisome Superior Court lawsuit where the parties sought to have the court determine who owned what and what to do with a group of owners who could not agree on anything. The litigation lawyers (not me because I don't litigate and I could not ethically represent any of the parties because I had represented the LLC) made a bundle of money. The lawsuit could have been avoided if the members had entered into an Operating Agreement with Buy-Sell provisions when they first formed the company. DO NOT LET THIS HAPPEN TO YOU AND YOUR LLC.
Prudent people who go into business together plan for a company divorce and hope it never happens. The statistics, however, show that eventually most multi-owner companies will reach a point where at least one owner will want to eliminate another owner or have the owner's interest acquired by the company or another owner. If your multi-member LLC does not have an Operating Agreement with Buy-Sell provisions, the members will not have any way to go their separate ways if they cannot agree on the terms and conditions of their split up.
An Operating Agreement with Buy-Sell provisions is like an insurance policy. It is a cost of doing business that you hope you never need, but when you need it, you are really glad you purchased it. A good Operating Agreement with Buy-Sell provisions is an important part of your business plan. No prudent business person would invest in a new business with unrelated co-owners without first creating an EXIT PLAN. Not only does an Operating Agreement with Buy-Sell provisions create binding legal obligations to buy and sell an interest in the company, it also sets the purchase price and the terms and conditions of the purchase.
Typical Triggering Events
Here are some of the common events that can trigger a buy-out of a member, all of which are optional and selected by the members:
Triggering Event | Purpose |
1. Any event the members desire | Each Operating Agreement with Buy-Sell provisions can include any all triggering events that are important to the members. For example, the members could agree that if the New York Yankees win the World Series, member 1 must sell to member 2 for $100. |
| 2. Death | The LLC or surviving member purchases the interest of a deceased member. Mandatory buy-outs after a death can be funded with life insurance on the lives of the members. |
| 3. Divorce | Prevents the wrong spouse from acquiring an interest in the LLC if two members own their interest as community property and they get divorced and the wrong spouse becomes the sole owner of all or a portion of the membership interest. |
| 4. Termination of employment | Especially important when the employee is a minority member and should only own an interest while employed. |
| 5. Default under the Operating Agreement | Allows the LLC or other members to purchase the interest of a member who defaults under the Operating Agreement. Especially important when a member fails to make a required contribution of money or property. Purchase price may be less than fair market value. |
| 6. Sale of majority of the company | "Drag Along" provision: Majority member has the option to require minority members to sell their interests in the LLC if the majority member sells. The sale of the minority members' interests are on the same terms and conditions as the sale of the majority member's interest. |
| 7. Sale of majority of the company
| "Tag Along" provision: Minority members have the option to require the majority member to include the sale of the minority members' interests in the LLC if the majority member intends to sell. The sale of the minority members' interests must be on the same terms and conditions as the sale of the majority member's interest. |
8. Transfer of membership interest without consent of the members | The LLC's Operating Agreement should provide that a member may not transfer or encumber all or any interest in the member's interest in the company without the approval of the members and compliance with the terms and conditions of the Operating Agreement. If a member violates the no transfer/encumbrance provisions, the LLC should have an option to acquire the interest of the defaulting member, perhaps at an amount less than the fair market value of the interest. |
| 9. Loss of professional license | Commonly used for LLC's that are owned by members who must be licensed in a particular area. For example, the Operating Agreement with Buy-Sell provisions of an LLC owned by physicians might give the LLC and other members an option to acquire the interest of a physician/member who loses his or her license to practice medicine. |
| 10. Conviction of a felony | Many LLC members do not want to have another member who has been convicted of a felony. |
| 11. Disability | Used to acquire the interest of a member who become permanently disabled and unable to provide needed services for the LLC. |
| 12. Retirement | Members sometimes want to retire, but without an Operating Agreement with Buy-Sell provisions that provides for a retirement purchase, it probably will not happen. |
| 13. Bankruptcy | If a member loses the member's interest in the LLC because of filing for bankruptcy, the company and other members should be able to buy the interest from the creditor who acquires it out of the bankruptcy. |
Fixing the Purchase Price
A very important task of the Operating Agreement with Buy-Sell provisions is to state how the purchase price will be calculated. The purchase price is a material term of the contract to purchase a membership interest. If the purchase price cannot be determined from the agreement, it will not be enforceable.
An Operating Agreement with Buy-Sell provisions may use one of the following three primary methods to determine the purchase price of a membership interest:
Stated Value Method. The members agree on the value of the LLC, they state the value in the Operating Agreement with Buy-Sell provisions. For example, if they agree the LLC has a value of $100,000 then the purchase price for the interest of a 40% member would be $40,000. Stated values also work well when the purchase involves the membership interest of a minority member who is an employee. If Jane purchased a 2% interest in the company for $2,000, the agreement might provide that the company will repurchase her interest for the same amount if she terminates her employment with the company. It is important that the members update the price regularly because the price always changes.
Formula Method. The members agree on a formula that computes the value of the company. For example, they might agree that the value of the company is: (i) the average of the net profits (defined in the agreement) of the LLC for its last three fiscal years multiplied by three, or (ii) two times book value.
- Appraisal Method. The selling member and the company mutually select an appraiser to value the LLC, but if they cannot agree, each party selects an appraiser (and pays the cost thereof) and the value of the LLC is the average of the two appraisals unless the difference between the two appraisals is more than 15%. If the difference is too great, the two appraisers select a third appraiser (the cost is split) and the value determined by the third appraiser is the value if it is between the first two appraisals.
In my experience as an Arizona business lawyer who has been preparing Operating Agreement with Buy-Sell provisions for my clients since 1980, it is very rare for owners of a company to be able to agree on the stated value method or the formula method. I estimate that over 95% of the Operating Agreement with Buy-Sell provisions I have prepared use the appraisal method to determine the value of the company.
Mandatory Versus Optional Triggering Events
After the members decide which triggering events are needed for their LLC, they must then decide which events result in mandatory acquisitions and which events merely give the company and other members an option to purchase. Some triggering events such as termination of employment are almost always mandatory purchases. An Operating Agreement with Buy-Sell provisions that provides for mandatory purchases of the interest of a deceased member usually require that the company buy and the estate of the deceased member sell the interest of a deceased member. An excellent way to fund the purchase of the interest of a deceased member is for each member to purchase a life insurance policy on the life of the other members.
Terms and Conditions of the Purchase
Once a member becomes obligated to sell and the company or other members become obligated to buy, the Operating Agreement with Buy-Sell provisions sets the terms and conditions applicable to the sale. I can draft any terms and conditions that the members desire, but a common scenario is that: (i) the closing of the sale will occur within 60 days of the date the buyer becomes obligated to buy, (ii) at closing the buyer will pay not less than the greater of 20% of the purchase price or the amount of insurance on the life of a deceased member (not to exceed the purchase price), (iii) the balance of the purchase price will be evidenced by a promissory note signed by the buyer that provides for equally monthly payments of principal and interest over five years with interest to accrue at Bank of America prime, (iv) the continuing members of the LLC and their spouses must guaranty payment of the promissory note, and (v) the guaranties of the members are secured by pledges of their membership interests.
Operating Agreement with Buy-Sell provisions Preparation Service
I prepare Operating Agreements with Buy-Sell provisions custom drafted specifically to meet the desires of the members of Arizona LLCs. My Operating Agreement with Buy-Sell provisions is the end result of preparing this type of business agreement many times since I first started practicing law in Arizona in 1980. Here's the sequence of events when somebody hires me to prepare an Operating Agreement with Buy-Sell provisions for their LLC:
A member completes and signs my Arizona LLC Operating Agreement Preparation Service agreement and faxes or emails it to me. If you have questions about this agreement, call Richard Keyt at 602-906-4953, ext. 1.
LLC pays for the Operating Agreement with Buy-Sell provisions with a credit card in our secure online store or by calling my legal assistant Katie at 602-906-4953, ext. 7 and giving your credit card information over the phone. You may also send a check.
Richard Keyt prepares the Operating Agreement with Buy-Sell provisions and emails it to the LLC's contact person along with a 10 page letter of explanation. These documents are in digital (pdf) format for distribution to all members for their review and input.
Members review the Operating Agreement with Buy-Sell provisions and make notes of text to be changed, questions about provisions and additional issues to be covered.
We meet with the members in our office or via a conference call to discuss the Operating Agreement with Buy-Sell provisions, answer members' questions and decide on changes to be made to the agreement.
We revise the Operating Agreement with Buy-Sell provisions and send it to the contact person to forward to all the members for their review.
We make any additional changes requested by the members (via email, phone or in person) and send the final agreement to the contact person.
- Members sign the agreement.
Our Fee to Prepare an Operating Agreement with Buy-Sell provisions
Our fee to prepare a custom Operating Agreement with Buy-Sell provisions is:
 | $500 if we are forming the LLC simultaneously with preparing the Operating Agreement, or |
| $897 if we did not form your LLC. |
Note: There is a $387 discount when we form the LLC.
I constantly tell members of multi-member LLCs that the most important company document is the company's Operating Agreement with Buy-Sell provisions because it is the only way to plan for the orderly future "divorce" of a member. Without an Operating Agreement with Buy-Sell provisions, the members are stuck with each other forever unless they are fortunate to agree on who will go, who will stay and how much, if any, the remaining members will pay the selling member.
Our Fee Includes Attorney Consultation & Revision Time
The fee includes one hour of attorney time conferring with members, modifying the agreement and drafting custom provisions. Few of our LLCs exceed the allotted attorney time to finalize their Operating Agreement with Buy-Sell provisions. We want the final agreement to contain all of the provisions desired by the members of each LLC. Some LLCs need more custom drafting of provisions for the Operating Agreement or need more conference time with members to discuss the agreement and make changes. We bill the LLC for any excess attorney time at $250 per hour.
How to Hire KEYTLaw to Prepare an Operating Agreement with Buy-Sell provisions
If You Want Richard Keyt to Form Your New LLC
| If you want Richard Keyt to form your new Arizona LLC and you also want an Operating Agreement with Buy-Sell provisions, complete the online Arizona LLC Formation Agreement and check the second box on page 2. |
If You Have an Existing AZ LLC or You Do Not
Want Richard Keyt to Form Your New LLC
| Complete our Arizona LLC Operating Agreement Preparation Service agreement and fax or email it to Richard Keyt. If you have questions about this agreement, call Richard Keyt at 602-906-4953, ext. 1. |
| Click on this link to go to the KEYTLaw online store and purchase the agreement. |
About the Author
Richard Keyt, J.D., LL.M. (income taxation New York University Law School) is a business, real estate, transactions, contracts and estate planning attorney licensed to practice law in Arizona. He has formed over 2,300+ Arizona limited liability companies in the last few years because his low cost high quality LLC package is second to none and it only costs $599 for everything. Rick has practiced law in Arizona since 1980. Rick can be reached by telephone at 602-906-4953, ext. 3. Email at rickkeyt@keytlaw.com and fax at 602-297-6890. Rick's web site located at www.keytlaw.com had over 3,000,000 visitors in 2006 - 2008. To follow Rick on Twitter go to www.keytlaw.com/twitter. Rick does not accept matters involving landlord / tenant disputes or litigation of any kind (other than tax lien foreclosures). Communicating with Richard Keyt via email or otherwise does not cause you to become a client or cause your communications to be confidential or subject to the attorney client privilege.
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This page was last modified on May 23, 2010.
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