A common scenario I see: Two or more friends have a grand business idea and file their Articles of Organization for their LLC. They start taking clients and all goes well… for awhile. They start making money and are excited for growth. Then the honeymoon phase is over. The business partners realize one of their comrades is not putting in as much effort but still reaping all the benefits. Or one partner has ‘creative differences’ with the other partners and the partners are deadlocked in how to grow the company. Conflict ensues and they start to fight over who gets what or how things get done. Ouch.
Problems of Not Having an LLC Contract aka ‘Membership Agreement’
So what happens? Or could this have been avoided? Great questions. It is best practice to create a ‘membership agreement’ between LLC partners. Without the Membership Agreement, the Illinois Limited Liability Act will govern the rules. For example, if a member wants to leave the LLC, the LLC Act will dictate the terms. If, however, the members want to have different terms, they can put it in the Membership Agreement. For example, under the newer LLC Act, that became effective on July 1, 2017, the LLC no longer is required to be buy out a member who wants to leave the LLC. However, the LLC members can write up their own terms in their Membership Agreement such as requiring an LLC to purchase a member’s interest or other terms that would dictate a conflict. Because members wanting to leave an LLC is very common, this is very important to negotiate with fellow LLC partners.
Another problem with not having a Membership Agreement are the terms of how profits and losses are divided. As a default according the the LLC Act, profits and losses are allocated based on ownership ratio. So if John and Jane go into business together and John owns 35% of the LLC and Jane owns 65% of the LLC, the profits and losses are split the same way. But if John and Jane want to agree to a 50/50 split instead, they can do that if they write it out in the Membership Agreement. Some LLCs even failed to decide how much the members own and just assume it’s an equal split. Another huge failure that LLCs fall into is not clearly deciding what is an ‘contribution’ and what is a ‘loan.’ For example, Jane decides that she can give the LLC $10,000 but wants only $3,000 to be her contribution and the remainder she wants back. This is extremely important because if the LLC needs to close up or Jane wants to leave the LLC, whether she gets her money back really hinges on clearly communicating what part of that money is an investment and what is a loan.
What to Discuss With Your Business Partners When Making an LLC
With all of the above said, it’s good to have a list of topics to discuss when creating your LLC and get the agreement in writing. Your Membership Agreement does not have to be fancy, does not need witnesses, does not need fancy legal linkgo, and in Illinois does not need to be filed with the Secretary of State. Of course it’s always best to have a lawyer to ensure that all the terms are enforceable and make sense, but there are definitely some considerations that the LLC members need to consider:
- The terms spelling out what the LLC will do if a member wants to leave
- The terms spelling out what the LLC will do if the members want to ‘kick someone out.’
- Profit/loss division
- Which contributions are loans and which are investments
- If a loan, the terms of the loan (when and how to pay back)
- Which LLC members have authority to act on behalf of the LLC and which may be ‘silent members’
These conversations may be hard to have and people might think that no problems will arise. Sometimes members completely trust their business partners and no one thinks that a member may lie or steal. Unfortunately, these ‘being blindsided’ situations are extremely common. So even if you think all be well in your LLC, prepare for the unexpected and make sure you have a solid LLC Membership Agreement.