What is an LLC Purchase Agreement?
A Limited Liability Company (LLC) purchase agreement is a legal contract that governs the sale, exchange, or transfer of company ownership. The purchase agreement for an LLC typically outlines the sale of a member’s interest in the company to another member or outside party. While the agreement can be simple or complex depending on the nature of the transaction, it normally contains a statement of purchase, a definition of terms, the sale price and payment details, the representations and warranties of both parties, the obligations of the buyer and seller, indemnification language, provisions for closing, governing law and jurisdiction, and other miscellaneous provisions. Sometimes called an LLC membership sale agreement or transfer agreement, it is used in both arms-length sales between unrelated parties as well as in intra-company transfers, such as to pay an owner spouse following a divorce. Its purpose is to define the reasons for, and terms of, the sale, and to otherwise protect the operations and reputation of the business. A purchase agreement is also useful in describing the distributions made to the seller, and it can contain a buy-sell provision, which is a preemptive option given to existing members that allows them to buy the member’s interest in the company before it can be sold to an outside party . In addition to the sale of membership interests, an LLC purchase agreement can also be used to document the purchase of an LLC’s assets by an outsider or by a related entity controlled by its owners. In that context, an LLC purchase agreement can serve as a bill of sale under the Uniform Commercial Code (UCC) to transfer the LLC’s assets and it will include the price for the assets and the means and timing of payment. In a stock sale agreement, for example, the purchase may pay the seller over time, such as for example, pursuant to a promissory note. The LLC purchase agreement may also serve the purpose of transferring a business entity’s goodwill, which is defined as the established reputation of the business. Often, the purchase agreement itself will include an explicit assignment of the goodwill, with language such as "the undersigned assigns to the purchaser(s) all of its right, title, and interest in and to the goodwill of the business." The agreement may also include language limiting the seller’s right to compete with the LLC following its sale.
Essential Elements of an LLC Purchase Agreement
The purchase of an LLC membership involves the negotiation and execution of a limited liability company membership purchase agreement ("purchase agreement") between a selling member (i.e., the selling minority member member) and a purchasing member (i.e., the purchasing majority member member), under which the purchasing member member agrees to purchase the membership interest of the selling member member. Certain key components of such a purchase agreement include:
(a) Payment terms: Under this component, the purchasing member sets forth the consideration that it is paying for the membership interest, taking into account the current assets and liabilities of the LLC, in addition to any restrictions the selling member may impose on the LLC’s subsequent sale of its assets. The purchase price can take the form of cash, deferred compensation or a combination thereof.
(b) Representations and warranties: Here, the purchasing and selling members provide each other with various representations (which attribute certain facts to those members and the LLC through the date of the purchase agreement), and thereby protect themselves from exposure to certain unknown and unexpected liabilities following the closing. These warranties can relate to several different areas, including the LLC’s incorporation, compliance with applicable laws, title of assets and pending litigation.
(c) Conditions: This component sets forth conditions that must be satisfied in order for the closing to occur. An example of a standard condition is the obtaining of any required third-party consents.
Process to Write an LLC Purchase Agreement
When looking to prepare a purchase agreement for a limited liability company, there are various steps you must take and certain things you must keep in mind. Detailed herein are the steps you should take in drafting a purchase agreement for a limited liability company:
- . Determine the Method of Purchase – Parties looking to draft a purchase agreement, should review relevant case law and statutory law so they understand what the method of purchase means. There are two major types of purchase methods; sale of member interest, and sale of business assets. It is imperative that you seek legal advice in order to understand the pros and cons of each method of purchase.
- Choose a Purchase Price – When looking to draft a purchase agreement for an LLC, it is crucial that the parties determine the value of the LLC. A useful method to determine the value of an LLC is the calculation of book value. Book value is simply the LLC’s total assets minus it’s liabilities. Book value can be skewed if the LLC has inventory, plants or equipment, or even real estate. The LLC’s assets must be evaluated accordingly. Furthermore, if the LLC has a substantial amount of retaining earnings, this should be taken into consideration when determining the purchase price. Book value is merely a starting point to determine the value of the LLC.
- Review the LLC’s Operations – Prior to preparing and drafting the purchase agreement it is essential that the purchasing party conduct thorough due diligence to understand the operations of the LLC. This involves looking at the LLC’s financial statements, real property deeds, employment contracts, lease agreements, etc. The purchasing party may also seek to interview the members/employees of the LLC.
- Describe the Terms of Sale – Once the parties have completed step "2)" and "3)", they then should move onto describing the terms of the sale. The purchase agreement should describe what the purchasing party is buying from the LLC (if any real property, employment contracts, lease agreements, etc. are being purchased it needs to be specified.) The parties should decide on the method of payment, whether the payments will be made at closing, in installments during a specific period of time, or a combination of both. Furthermore, a dispute resolution clause may be included in the purchase agreement, in the event either party breeches the terms of the agreement. The parties may elect to sue the non-complaining party, or go into arbitration or mediation.
- Finalize and Execute the Agreement – Once the purchase agreement has been drafted, and the terms have been agreed upon by both parties, the next step is to finalize and execute the purchase agreement. The parties should sign and date the document. Additionally, a notary public may be required to review the agreement, prior to the agreement being executed.
Throughout this entire process it is vital that you seek legal advice. A purchase agreement between a limited liability company is a nuanced, tedious, and complicated process that requires ample preparation and understanding of various areas of law.
Mistakes to Avoid
As with any other type of contract, the key to a contract for an LLC acquisition is ensuring that all important matters are addressed as clearly as possible. The specific items to watch out for in an LLC purchase agreement can be broken down into two categories, Buyer mistakes and Seller mistakes.
Buyer Mistakes
All too often, Buyers will get so eager to enter into a purchase contract that they will fail to include certain aspects into the purchase agreement that are of great importance to them. For example, a common mistake I see buyers make is that they are so eager to move forward with the acquisition that they fail to adequately address the purchase price with the Seller. I have seen situations where the Buyer and the Seller do not clearly agree to the purchase price, and instead just conclude that they will take care of the purchase price later. This is a huge mistake that can result in very costly litigation down the road if the Buyer and Seller do not agree on the price when the transaction closes. I have also noticed that Buyers do not address the issue of closing costs and who will be responsible for them in the purchase agreement. I have seen numerous situations where there is a disagreement between the parties as to who should be responsible for certain closing costs and it results in one party or the other being very displeased with the outcome of the transaction.
Another common mistake is limiting the scope of the representations and warranties in the purchase agreement. Sellers will often times include a laundry list of complete disclaimers in the purchase agreement attempting to protect themselves from any potential liability. For example, in a typical LLC, there are corporate formalities that must be followed such as holding annual meetings, preparing Operating Agreements, and filing certain documentation with the State Government. Some sellers have attempted to completely disclaim their liability for not following those corporate formalities. However, there are certain disclaimer limitations under Louisiana Law that prohibit those types of disclaimers. As such, it is crucial that you are aware of what disclaimers you may or may not use in order to avoid overlooking an important issue.
Seller Mistakes
One of the biggest mistakes I see Sellers make is trying to over proclaim the assets and liabilities being purchased. I’ve seen many agreements where the Seller will attempt to sell assets which they do not actually own, and attempt to sell those assets as part of the purchase agreement. Upon closing of the transaction, it becomes very clear that the Seller actually did not own the property. A common example of this can be purchasing real estate which the Seller does not actually own from the LLC, or attempting to sell any assets which belong to a third party. However, the most important mistakes by Sellers involve assumptions of liability. Most LLC members understand that the LLC should shield them from personal liability; however, it is important that you delineate exactly what liabilities you are assuming when purchasing the LLC. If the Seller has any outstanding debts owed to third parties, you may want to remove those debts as purchasable liabilities.
Importance of Due Diligence
Due diligence acts as a safeguard for the security and success of your business transaction. This investigation allows the purchasing LLC to examine a potential LLC before committing to buy. Diligence provides protection for potential contingencies that could hinder the purchase and make the agreement even more complicated. It generally occurs within a specific period of time after signing the agreement and the results are always available to both parties.
In order to properly research the financial status of the potential LLC, the purchasing party must properly assess what they want out of the deal. While some may want a clean slate, others may want specifics such as approved contracts or previously negotiated terms. Assessing these needs and desires provides an outline of the due diligence. Additionally, customizing what information is disclosed allows the seller to feel more comfortable with the level of privacy for their business affairs. All of this information is outlined in a letter of intent known as an integration clause. Prior to the integration clause, actual due diligence can include a thorough review of documents concerning the LLC’s operations and finances. This can include auditing the business’ actions and outlining any concerns in its operations, taxes, OSHA regulations, environmental issues, business permits and licenses, along with other corporate matters . All potential contingencies must be investigated and compensated for in the document, while also being evaluated by the purchaser. In most cases, the parties involved will agree to nondisclosure provisions. This ensures that all information disclosed during the purchasing process is kept private and anything learned will not be used for other means. Essentially, information that the prospective buyer has access to should not be used against the company during the negotiation. NDAs should also include a non-circumvention provision which secures the buyer against the possibility of a cheap bypass to the deal. This means that a buyer cannot seek other means of obtaining the company before the deal has been finalized. Limitations-based clauses differ depending on the specific and unique situation of the LLC transaction. All due diligence falls in line with the principles outlined in a letter of intent. This group of guidelines provides the framework for the deal and how it should be transacted, including its requirements, the processes involved and how to proceed should the deal fall through. With this integration in mind, both parties can comfortably enter into due diligence.
How to Negotiate Terms
Negotiating the Terms of an LLC Purchase Agreement
When it comes to negotiation, one of the rules we discuss often with our clients is to "know your limits." Or, as some refer to it, "know your BATNA", which stands for "Best Alternative to a Negotiated Agreement". Simply put, determine beforehand what you need to occur from your negotiation so that you can get up from the table. If you’re familiar with business negotiation strategies, you’ve likely heard the saying: "no deal is better than a bad deal." With this in mind, you can determine what your threshold is for signing your LLC purchase agreement. For instance, if you know that your creditor is going to take a lien on your assets anyway, if they have no recourse, then you are likely not going to be able to protect your assets during the negotiation. In those cases, determine how you can either avoid litigation afterward or reduce your liability as much as possible. With regard to your key contract terms, again you are looking for ways to maximize your position and protection as much as possible. For instance, certain clauses used in asset purchase agreements can reduce your liability, including representations and warranties, as well as limitation of liability provisions. Make sure that representation and warranty clauses are specific, so the seller cannot avoid its responsibility by stating that the representations were "intended" by the parties when the agreement was entered into. Oftentimes, liberally negotiated clauses such as these get negotiated differently in every transaction, based on the level of risk inherent in the particular LLC being purchased. In other words, "well, if this asset (the risk of the minimum amount owed to the creditors) is property worth $200,000, but we know the creditor is going to take ownership of it regardless of who it belongs to, then it’s not really worth arguing about." This is opposed to a contract clause specific to a tangible asset with a limited known value. Further, recognize that LLC purchase agreements are often imprecise. In this sense, a neutral will be able to explain the versions of each party at the end of the negotiation. As such, it is best to take a "win-win" approach to the negotiation, one where each side has a bit more confidence that its version may be the closing version. This way, if you have to review each version in court, there is a reasonably good likelihood that you’ll land on your version. Further, it will likely allow everyone to be comfortable with the result of the agreement.
Legal Considerations and Regulatory Compliance
LLC purchase agreements need to be carefully crafted in accordance with federal and state laws as well as those of the home country of non-U.S. buyers. Statutory and regulatory requirements vary by state. Specific wording may be required in certain areas, such as inclusion of the words "limited liability company" or the abbreviation "LLC" in the name, otherwise known as the "certificate of organization" or "articles of organization." Others may also require filing of the purchase agreement with the appropriate Secretary of State or agency authority after the sale is completed.
Many states require that LLCs file an annual report along with payment of an annual fee, which keeps their good standing status in the eyes of that state. The results of failure to do so can bear unanticipated and costly burdens. All operating agreements and purchase agreements must be kept at the principal place of business for examination by members, or in the case of a purchasing member, their personal examination. Failure to maintain appropriate documentation can lead to issues for new LLC members with the IRS and in cases of potential bankruptcy filings by the LLC.
The agreement should make it clear that it is permitted by the state statutes (or an exception is provided by a state statute). Some states require LLC purchase agreements to adhere to requirements of the state’s Uniform Commercial Code (UCC) section on limited liability companies. Certain states have specific requirements for noting the transfer of membership interests, if not shown on the certificate itself, so as to be enforceable against third parties.
Foreign (non-U.S.) buyers need to understand tax treaties between the U.S. and their home country (to avoid double taxation) and potential state-specific tax requirements applicable to foreign persons and entities.
Execution and Completion
After extensive negotiations, due diligence activities and discussions among the parties, the LLC purchase agreement will need to be finalized and executed. While every state should have their own state-specific requirements for finalizing the LLC purchase agreement based on the type of LLC involved, the requirements for finalizing an LLC purchase agreement as follows will guide the drafting for the final agreements.
Some practical points regarding the signing of an LLC purchase agreement include: Each agreement relating to the purchase or sale of an LLC should be signed by all parties executing the agreement. Any party listed in the LLC purchase agreement should sign the document. If the parties are companies and are closing the transaction through a closing agent , it may be the case that at closing each company’s agent will sign in its own individual capacity. Regardless, if the agreement is being executed by one person on a company’s behalf, it should also indicate the authority of that person. As an example, John Smith, President of Widget Company, Inc. (an Indiana corporation), signs the document.