Keep your Delaware LLC from sinking prematurely as a result of member business divorce. Plan ahead for inevitable partnership disputes by drafting membership prenuptial provisions from the outset. In this article we teach you the vernacular of LLC member buyout options, such as “Baseball” versus “Shotgun”, “Tag-Along” versus “Drag-Along”, and “Rights of First Refusals” versus “Rights of First Offers”. These are ways to avoid the “whipsaw” of unfairly discounted valuations, minority rights problems, and keeping out unwanted third parties from owning membership interests. All of this helps keep the ship afloat, no matter who is aboard. These provisions can and should be considered no matter if your LLC is for holding real estate or for running an active business venture.
All good Delaware LLC Agreements include some language that outlines how new owners buy into the business and how existing owners sell their interests or are “bought out.” Some of these business owners are selling their interests to cut ties with the other LLC member with whom they no longer want to do business.
Shotgun – Your Option, I Will Buy You Out For $X or Turn the Tables and Buy Me Out for $X
This first example of a buyout clause in an LLC Agreement can go by a few different names—“Texas Shootout”, “Russian Roulette”, or “Shotgun”. We will refer to this as a “Shotgun” buyout clause. In a Shotgun buyout, Owner #1 offers to buy all of the interests of Owner #2 at a certain price. Owner #2 either accepts the offer to sell out to Owner #1, or Owner #2 can turn the tables, decline the offer and buyout Owner #1 at the offered price. Owner #2, under the rules of Shotgun, is forced to sell. This buyout clause is popular in LLCs with two equal 50/50 owners, a structure inherently prone to deadlock. The shotgun clause eliminates the negotiation period of other types of buyouts since it always results in a sale of one owner’s full share, regardless of whether the initial offer is accepted or denied. The shotgun clause is usually structured to spring to action when the business relationship between owners has deteriorated and a “professional divorce” is the desired outcome for both parties. The chief advantage of having a shotgun clause in your LLC Agreement is the speed and simplicity—it facilitates a quick transaction without a lengthy negotiation period. Although both parties are equally unhappy, because neither gets the business for a song, it nevertheless is fair and therefore desirable.
You can think of Shotgun buyouts as similar logic to “I cut, you choose”. This is how some fair-minded parents solve “ownership disputes” between their children. For example: who gets the last piece of cake? You tell one son that he must split the last piece with his brother and that first brother can divide the slice however he wishes. Your second son is tasked with choosing who gets which slice. The first son is incentivized to divide the slice as fairly as possible because he knows his brother will choose the bigger one if he makes an uneven cut. The variation on the theme is avoiding the business getting split in two. Instead the cake stays intact and one brother offers $2 to buy the piece of cake. The second brother either accepts the $2 or has to pay $2 to keep and eat the cake. This also forces the parties to go beyond market values and add other things like sentimental values into the price of the business to avoid losing it. The same incentives are in place for the owner who is making the offer in a Shotgun buyout; Owner #1 is inclined to offer the fairest price he can live-with if he were forced to accept it because he will be stuck with that amount of money if Owner #2 turns the tables.
Critics of the Shotgun clause in LLC Agreements have said that it gives an unfair advantage to cash-rich owners over the cash-strapped or illiquid owners. The cash-rich owners, with the knowledge that their business partners are cash-poor, make an offer that is low and undervalues the business, but is just high enough to be out of range for the other owner to purchase the shares. That can create an imbalance and forced sale at a less than fair price. Even in that situation, the poor owner can sometimes find a backer and the result is buying the business on the cheap.
Day and Night Baseball – Third Party Valuations
Another type of buyout is the “Baseball” method. These buyouts involve an arbitrator who is brought in to be the unbiased third party and is tasked to determine the fair market value of the business. In a Baseball buyout, both parties submit a sealed value for the business, not seen by the other party, and the arbitrator then appraises the business. The arbitrator decides who wins based on which bid is closer to his valuation and awards the sale to that bidder. A similar method is the “Night Baseball” clause. Night Baseball requires an arbitrator as well, but in this case, the arbitrator would make a valuation of the business before the owners submit their valuations. This blind appraisal can be viewed as more independent and not influenced by pre-view appraisals. Like the shotgun approach, both baseball options (day and night) incentivize the owners to make fair and accurate valuations of the business if they want to purchase it. The Delaware Court of Chancery is the most likely court to enforce agreements as written and so more sophisticated LLC agreements tend to be Delaware LLCs.
Coin Flip or Rochambeau LLC Dispute Resolution
Some Delaware LLCs reject all of these notions and just add the coin flip resolution. Each party proposes a solution and then one member of the LLC literally flips a coin. I have yet to see dispute resolutions by Rochambeau dispute resolution. If you are not familiar with this, it is the childhood game of “rock, paper, scissors.”
Tag-Along or Piggy-Back – Minority Member’s Option to Ride Coattails
Aside from deadlocks, there are also member issues with regard to majority versus minority owners. One method for insuring that you do not end up sharing ownership with someone you do not want to do business with is including a “Piggy-Back” clause in your LLC Agreement. The Piggy-Back clause is typically used to benefit a minority interest holder when a majority interest holder sells his interests in the business. The minority interest holder may be unable or unwilling to purchase the interests of the majority interest holder that are up for sale, but he does not wish to remain in business with the new majority interest holder. The Piggy-Back clause will force the new owners to purchase the minority owner’s interests too, letting the minority owner “piggy-back” on the purchase price set by the majority owner’s shares. This is also called a “Tag-Along” provision. This provision is more friendly to the minority because it gives the minority owner an option he would otherwise not have.
Drag-Along – Minority Members Forced to Ride Coattails
A Drag-Along clause is similar in concept to a Piggy-Back and can be thought of as a Piggy-Back in reverse. The main difference between the two is that a Drag-Along clause is added to an LLC Agreement primarily to benefit the majority interest holder. If the majority interest holder accepts a fair purchase offer to sell his shares, the Drag-Along clause requires the minority interest holder to sell his interests at the same price. This prevents any holdouts from occurring and sweeps clear the “little guys” who buyers often do not want in the company, allowing the buyer to own 100% of the company. This provision is friendlier to the majority owner because it gives him an option to clear out those pesky minority holders who can be a headache in many deals.
Right of First Refusal – Strangers Keep Out
How do you keep out unwanted outsiders or competitors from your LLC? Many Delaware LLC Agreements entitle the sitting members of an LLC the Right of First Refusal (ROFR) to prevent the transfer of an interest to an outsider. The ROFR permits the member who wants to sell his interest of a Delaware LLC to solicit offers from outside parties. The fun part comes next. First the Company itself has the option to scoop up that offer and buy the LLC interest out from under this potential third party buyer within a certain number of days. If the LLC itself does not exercise this right with the period of time, then next each sitting Member is given a right to purchase the interest in the company under the terms of the offer. If the individual members do not respond within the notice period allowed, then the selling member is permitted to accept the offer from the outside party. Even if the interest is sold, most Delaware LLC Agreements provide that the rights of the transferee is only that of a non-voting member, until admitted by the other members as a voting member. This is yet another protection to minimize the impact of an interest sale on the remaining LLC Members.
Right of First Offer – Give Me the First Whack
A similar concept is the Right of First Offer (ROFO), wherein the selling owner is required to field an offer from the existing owners before he is contractually permitted to negotiate with third parties. The ROFR should carry more weight in an LLC Agreement because it lays out the terms of which the sale of the business is transacted, whereas the ROFO is an agreement upon how the sale will be negotiated.
With this background in partner/member/shareholder rights, we hope you will gain an appreciation for a carefully crafted Delaware LLC Agreement. It is important to think of these issues in any business with more than one owner. The time to agree to a pre-nuptial agreement is before the marriage. Once the deal is signed or business is started, it’s too late; unless everyone can agree later. A well-crafted LLC Agreement can be the ounce of prevention to avoid a pound of cure in a lawsuit or an unfair, expensive and protracted lawsuit for judicial dissolution.
Before you set sail with your new Delaware LLC, remember it is better to be on land wishing you were at sea than to be at sea wishing you were on land. With careful contractual drafting, planning ahead should help you go over the horizon off into the sunset safely to your destination, ready for any sea. Is your LLC seaworthy? The answer depends more on the people than the ship. Have you included contractual provisions to prepare you for a mutiny?