Typical LLC operating agreements and corporation bylaws/shareholder agreements have seemingly battleship boilerplate provisions about when, to whom and under what circumstances a person, (human or entity) that owns the equity interest can transfer their equity interest.  There are usually separate provisions for voluntary transfer to affiliates, offer and sale to third parties for valuable consideration and involuntary transfers such as death, disability and divorce for human beings and liquidation and dissolution for juristic persons.

Investment Opportunity Circumstances

These provisions should be customized to the circumstances of the investment opportunity.  What’s appropriate for essentially a closely held partnership type structure where the equity owners are directly involved in the business is very different from that of a passive investor with a minority interest.  The dynamic tension is in the balance of management control against protective rights of a minority interest.  Entrepreneurs and investors should consider some of factors during drafting or negotiating terms or considering a non-negotiated investment opportunity.

Permitted Transfers

Most transfer provisions allow for “permitted transfers” which typically include family members, trusts, and estates for human beings and should include transfers to “affiliates”.  When the owner is a legal entity, permitted transfers should include, officers, managers/directors, LLC members and shareholders.  These are not sales transactions for value and are more like moving a coin from one pocket to another.  The definitions of “affiliate” should be reasonably broad and at least require “reasonable” discretion such that management cannot refuse the transfer without a good reason.   In some circumstances, such as joint development/ownership of a patent or piece intellectual property by a small group of people, the group members may desire that all equity transfers only go to the co-inventors.

Typical provisions include a Right of First Refusal whereby if a member/shareholder proposes to sell the equity interest for value and has a bona fide to purchase, the selling member/shareholder must first notify the Company and the Company and the other members/shareholders who then have a defined time to purchase the equity interest on the proposed terms.

“Drag Along” and “Tag Along”

“Drag Along” and “Tag Along” provisions are often included.  “Drag Along” applies when a majority owner or owners desire to sell their majority interest, effecting a change in control and the potential buyer is willing provided it can acquire the minority interests as well.  As a result, the majority owner/the Company can force the minority holders to include their equity in the sale and receive a pro rata portion of the sale proceeds.  Conversely a Tag Along right applies when the majority holder(s) propose to sell their position and then the minority holders have a pro rata right to include their equity into the sale, thus creating a liquidity event for the minority holders.

Not all transfers are voluntary.  A member/shareholder can be forced to transfer their equity interest for reasons beyond their control.  The most common reasons being the member/shareholder goes bankrupt and the bankruptcy trustee takes control of the equity interest in order to liquidate and pay creditors or the member/shareholder gets divorced and ownership the equity interest is to be transferred in the final divorce decree.  Other reasons may include dissolution of a member/shareholder that is a corporation or an LLC or a member/shareholder’s death or disability.  Upon learning of an involuntary transfer event, the Company then has a set period of time in which purchase the equity interest from the involuntary transferee.

Valuation

Determining the price is generally left to “as agreed” by the parties but if they cannot agree, then a valuation mechanism kicks in to set the terms.  Payment is usually made by installments over a set period with a few years at the longest.  Another element is a provision that allows the member/shareholder forced to transfer to reacquire the equity interest on the same terms after the bankruptcy or the divorce has been finalized.

Finally the method of determining “fair market value” needs to be considered.  While the classic definition is that valuation is what a willing buyer and willing seller agree upon.  Many provisions require that the Managers/Directors annually determine the valuation method used for the option to purchase due to an involuntary transfer.  While this sounds good it often fails in practice as people forget to do it for years.  Another method is to use a formula such as annual net revenue times a multiplier (1.5X, 2X etc) plus the book value of tangible assets minus liabilities divided by the number of units/shares.  Minority investors should be wary of formulae that discount the value of a minority equity interest because it lacks control.  Such are great for the Company, not so much for the member/shareholder.  Whatever initial method is selected there should be an “in case of disagreement” provision such as each side picks an appraiser and if the two appraisers can’t agree, then hire a third to break the tie.