What is a Transfer of Membership Interests?
A membership interest transfer agreement is a contract entered into by the existing members of a company and the company’s potential new owner under which the existing members transfer their membership interests to the new owner . The primary purpose of such an agreement is to transfer current members’ interests to the incoming member. Because of the importance of determining business transactions – namely, who owns what – it is vital that a membership interest transfer agreement is as clear and precise as possible about the terms of the transfer.
What Does a Transfer of Member Interests Involve?
Parties Involved: The agreement will identify the two parties entering into the agreement as the transferor (the member selling/assigning its membership interest) and the transferee (the buyer of the membership interest). The transferor will own a membership interest in a limited liability company by virtue of its membership and such ownership will be documented in the operating agreement. When an owner of a membership interest wishes to sell or assign its membership interest, the transferor will enter into a membership interest transfer agreement with the transferee.
Identification of Membership Interest: The membership interest will be identified in the agreement as a percentage membership interest or a number of units in the limited liability company.
Transfer Date: The membership interest assignment will include a transfer date. The closing of the transfer of the membership interest will occur with the payment of the purchase price.
Sale Price: The membership interest transfer agreement will include the sale price of the membership interest.
Assumption of Liabilities: A membership interest transfer agreement may include an assumption of liabilities. The parties can agree that the transferee will assume the obligations, liabilities and expenses of the transferor relating to the membership interest. If the transferee is purchasing all of the membership interests and the entire limited liability company, then the transferee would want to assume the liabilities.
Representations, Warranties and Indemnification: The membership interest transfer agreement can list the representations and warranties of the parties. The parties can also provide indemnities for breaches of the representations contained in the agreement through an indemnification provision. The parties can negotiate what representations will survive and for what period of time post-closing they will survive.
Statutory Formalities and Other Legal Requirements
When drafting a membership interest transfer agreement, it is essential to consider a number of relevant legal factors. Depending on the nature of the membership interest being transferred, the interests may be subject to various state and federal laws concerning registration, taxation, and the rights of transferees and transferors. In addition, any corporate documents, such as Articles of Organization, Operating Agreements and corporate bylaws, should be taken into consideration, as these may contain transfer restrictions as well as provisions regarding assumptions of liability and other obligations. A careful review of all applicable federal and state law and regulations, as well as the membership interest being transferred, will help ensure that the transfer process is in full compliance with relevant rules. This will help protect both the transferring member and the transferee from exposure to civil and/or criminal penalties, as well as future lawsuits. Another important legal consideration is tax implication. The transfer of any interest will likely involve numerous tax implications, not just for the transferor of the interest, but the receiver as well. Generally speaking, any time an interest is sold or transferred, it is considered taxable income. However, there are exemptions, such as if the property is being transferred between family members, which allow for certain exceptions. It is essential to consult an accountant prior to transferring any interest so that all tax implications can be examined, and so that the proper steps may be taken to ensure compliance with the IRS and to avoid unnecessary taxes.
Steps to Implement a Corporate Member Interest Transfer
The parties should begin by determining if an Extension Period is available. Next, the parties should negotiate the terms of the MIPA; which eventually will include the contractual and disclosure documents; including the Operating Agreement or a Third Party Transfer Agreement, and the purchase price. Parties should begin the due diligence process at this point. After the parties have negotiated and initialed the appropriate documents; the Seller should prepare the Corporate Resolution and obtain consents from the Board or Managers or Members; thereafter the parties should execute the Closing Documents.
Common Pitfalls
Navigating the world of membership interest transfer agreements can be challenging, and it’s easy to make mistakes that could have significant consequences down the road. Here are some of the most common pitfalls when crafting these crucial legal documents, and ways to avoid them.
Omitting Key Provisions
While membership interest transfer agreements may seem straightforward, there are certain key provisions that are necessary to include in order to avoid confusion or disputes later on. Be sure to include clauses that address the terms of the transfer (including any restrictions or requirements), details regarding post-transfer responsibilities, and any additional provisions related to taxes, indemnification, or confidentiality, among others.
Not Understanding the LLC’s Operating Agreement
When transferring ownership interests in an LLC, it is crucial to familiarize yourself with the operating agreement of that LLC. While some LLCs may not have substitute member provisions, many do, and they often set forth framework for the company’s membership interest transfers. Familiarize yourself with the terms of the operating agreement so that you can include all necessary language in your membership interest transfer agreement prior to finalizing these transactions.
Failure to Address Changes in Membership Interests
Any time a membership interest is transferred , the percentage of ownership in the LLC may change. This can affect a number of things, including tax liabilities, distributions, and management. Be sure to properly address how membership interest changes will affect the operations of the business, and provide contingencies to account for unanticipated changes to the membership structure.
Using Boilerplate Agreements
Using boilerplate legal agreements can be tempting as a way to cut down on costs. However, these agreements are often not tailored to your specific situation, or may not even address your needs at all. It’s important to take the time to create a membership interest transfer agreement that is specific to your situation, rather than relying on a generic form.
Not Considering Contingencies
A membership interest transfer is not always a permanent decision. Sometimes, business owners transfer their interest to another party temporarily before reclaiming ownership. Address potential contingencies in your agreement to account for this possibility, so that both parties know exactly what to expect when the membership interest is no longer held by you.
Dispute Resolution and Remedies Available
As with many contracts, it is always a good idea to include a dispute resolution section in a membership interest transfer agreement. If the parties cannot settle their disputes amicably, there are a few avenues that they could possibly pursue to resolve them, and consequently post-close disputes for claims against the seller. It also details the remedies available upon a breach of the agreement.
Parties usually specify the applicable law and venue to govern the entire agreement. Usually parties require the laws of the state in which the company is organized to control, regardless of where the interests are to be transferred. A governing law clause is important in order to avoid forum shopping, lessen possibility of claims and to dictate any statutory period that govern filing of a claim for breach of contract.
Parties may insert a provision requiring any disputes or unresolved issues arising out of this Agreement or related to the Agreement, to first be submitted for mediation or other non-binding dispute resolution procedures. Mediation sessions can be facilitated by a licensed professional mediator. If mediation does not resolve the dispute, then the parties may submit to arbitration, but with the caveat to allow a party to file an action in court where appropriate.
Sometimes parties may enter into a binding arbitration or a special master agreement as the exclusive remedy for disputes arising out of the interpretation of this Agreement. This is advisable because it allows settlement of the dispute without a formal lawsuit or discovery process, and further eliminates possibility of appeal. At the same time, parties may have option to opt out of arbitration or special master provision (e.g., if any adverse ruling could likely exceed the applicable limits of insurance).
Typical remedies include;
(i) Specific performance to compel the transferor to transfer the membership interest to the buyer
(ii) Liquidated damages provision where the parties may mutually agree on an amount of liquidated damages in event a remedy is sought.
(iii) Damages in addition to specific performance including consequential and punitive damages.
Examples of a Transfer of Member Interests
To illustrate the importance of membership interest transfer agreements, we present the following examples of when they were part of the structuring of the transaction.
Case Study 1: Purchase of a Retail Store
A closely held family corporation owns and operates several clothing retail stores in a shopping center. The parents (the sole shareholders of the corporation) decide to sell one of the stores prior to their retirement in a few years. Unfortunately, they don’t believe that there would be sufficient business income generated from three stores to support their retirement, so they decide to sell one of the stores and keep the other three.
Whilst the corporate shareholders agree in principle, the store manager and the parents’ son (and a shareholder of the corporation) does not support the plan, as he wants to manage the store himself and use the income from it (together with his salary) to fund his children’s college education. He refuses to sell his interest in the corporation and even refuses to negotiate purchase price on the sale of the store, as he believes there will be no purchase price, as there is no store to be sold. The parents and the corporation have now been forced to employ someone to run the store, which is underperforming and could become unprofitable quickly. The parents call for a meeting to discuss the matter. At the meeting, the good news is that the son is willing to talk with the corporation’s advisors, but the bad news is that the parents haven’t been able to convince their son otherwise and there is no agreement in any regard. The parents leave the meeting upset that their plans have been derailed and are unsure of what to do next.
Upon being given the background information, the advisors concluded that the parents need to sell the store, yet they must structure the deal so that they will be able to realize the benefit for themselves and for their other children (including providing for the college education of their grandchildren). In the course of the conference call with the corporate counsel and the financial advisor for the parents, the advisors developed the following plan.
The parents have agreed to transfer their shares in the corporation in exchange for cash and notes. The corporation has approached the other shareholders about purchasing their shares in the corporation to complete the transaction. The parents have agreed to have the distributions from the store made through the corporation to their estate prior to the transfer of stock. The corporation has agreed to loan funds from its current line of credit to the selling entity and to enter into a membership interest buy-back arrangement at a later time. A membership interest transfer agreement has been put in place to document the transfer of the store from the corporation to the LLC. An employment agreement has been entered into with a former employee for management of the store on behalf of the LLC. This entire plan can be accomplished in less than a month, with the corporation and the LLC closing on the same day.
Case Study 2: Sale of Real Estate
Four brothers inherited a parcel of land, which has been in the family for many years due to the fact that three of the brothers wished to retain ownership of it in order to farm the land. The fourth brother, who is the only brother living outside of the state, wishes to sell the real estate immediately.
Upon the death of one of the brothers, it was decided that all of the brothers would enter into an arrangement whereby the fourth brother would receive ongoing income from the parcel of land via his siblings’ farming activities, and afterwards, he would have the option to purchase the other brothers’ interests in the land. The siblings agreed to this arrangement, and the fourth brother has signed a buy-sell agreement to purchase the other brothers’ real estate interests upon the occurrence of an event of his choice. The brothers are willing to make payments to him for his interest in the real estate, and have agreed to work with him in structuring a deal that will remove him from the ownership interest of the company prior to his death, allowing him to leave the property to his entrepreneur wife, who will assume the debt and deal with the farming operations.
The Role of Legal Counsel
Implementing an MTA involves significant legal and business considerations, particularly when the MTA includes a right of first refusal for the membership interest being sold. Such provisions and their enforcement often hinge on questions of interpretation of the operating agreement of the entity and statutory law governing limited liability companies. Also, an MTA must be properly documented and executed to protect the parties against, among other things, claims by other owners and the entity that an improper transfer has been made. Failure to properly document an MTA could expose the purchasing member to claims of individual liability , including under the federal securities laws if the purchase involves securities and under state corporate and securities laws. For these reasons, it is important that legal counsel be involved at the outset in the negotiation and drafting of MTAs. Legal professionals are best positioned to advise clients as to the risks associated with a transfer of membership interests and how to effectively deal with those risks through appropriate drafting and implementation of an MTA.
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