This is the second part of a several part series of articles pertaining to limited liability company operating agreements. This second installment addresses voting rights, distributions, capital accounts, buy-ins and buy-outs.
Many medical practices and other health care enterprises operate as limited liability companies (LLCs), and are, therefore, governed by the LLC’s “operating agreement.” However, the concepts imbedded in such operating agreements are often foreign or confusing to the members of the LLCs. Accordingly, the purpose of this series of articles is to shed some light on those concepts.
Voting
In a member managed company, members vote on every issue that comes before the company, whereas, in a manager managed company, the members only vote on big decisions, such as changes to the operating agreement, adding or removing members, major changes to the business, or the dissolution of the company.
Voting rights can be allocated on a proportional basis, where votes are weighted by the percentage of ownership. They can also be allocated on a per capita basis, where there is one vote per member. Members can structure these voting rights differently for different types of decisions; for instance, day-to-day decisions may be subject to proportional voting, but a decision to dissolve the company may be a per capita vote. Similar voting structures can be applied to board decisions as well.
A member with economic (or profits) interests only will not have voting rights. Those members are only entitled to allocations of income. Owners can use economic interests as an effective strategy for succession planning by awarding economic interests to young members with limited personal capital for investment. Economic interests can also be used to limit the control of the business by inexperienced members.
Distributions
Distributions are the shares of profits that go to the owners of the limited liability company.
However, members pay taxes on their share of company profits, which may or may not equal the distributions they receive from the company. Accordingly, operating agreements often require the company at least to make
distributions to the members that are equal to the presumed taxes the members will owe on their share of the profits of the company.
Operating agreements also often provide that the company is to distribute its “available cash” to the members, and the definition of such “available cash” is therefore significant. Such definitions often include the flexibility that a company may create a reserve, which will not be distributed, and, therefore, it is very important to know who has the power to set applicable reserves.
Similarly, it is important to know the frequency of the distributions of available cash, and, again, who has the power to determine such frequency.
Distributions are typically scheduled in the operating agreement, with some companies opting to provide regular distributions over the course of a tax year, and others choosing to provide a single payment at year end.
If a company chooses regular distributions, there should be language in the operating agreement allowing the company to make adjustments to the draw amount or otherwise require a true-up should the budgeted draw exceed the company’s actual cash flow.
Capital Accounts
A capital account is an account used for tracking individual member investments in the company. The operating agreement should include a schedule of the owners and their initial capital contributions. Capital accounts are increased by additional contributions and profits, and decreased by losses and distributions.
Also, in lieu of making cash contributions, some companies will place a value on a member’s non-financial contributions, such as lending their name and reputation to the company, or the member’s intended skills and labor (that is, “sweat equity”) during the start-up phase.
When a company is dissolved, the balance of the capital accounts are distributed to respective members, but only after the satisfaction of the company’s liabilities.
Buy-Ins
During the lifecycle of any long-standing company, there will be changes in ownership. Members should consider what the purchase standards should be for new members. To bring on members, the company will need to find a balance between company value, and the purchasing power of a potential member.
The purchase price for membership is typically referred to as a buy-in. A buy-in may be structured as a one-time payment, or structured subject to vesting. Vesting refers to a conveyance of rights over time during which a member eventually gains a full ownership interest, distribution rights, and termination rights.
For example, if a new member is staggering their payments over a five-year period, their ownership interest could be vested at 20% during each year of that five-year period. Vesting membership can make it easier for young doctors to achieve ownership when their own cash flow may be limited by financial considerations such as student loans.
Buy-Outs
Conversely, the applicable operating agreement should address what happens when members want to leave the company or retire, and allow or require the company to buy back the departing member’s interest, or allow or require the remaining members to acquire that interest.
When a member leaves a company, the purchase terms for acquiring their interest in the company are referred to as a buy-out. As with a buy-in, these can be structured as a one-time payment or as payments over time.
If the buy-out occurs over time, there are two typical structures to consider. The first is when the departing member gives up their entire interest at once, but the payments are made over time subject to a promissory note. The second is when the departing member’s ownership interest is sold over an extended period of time, essentially reverse vesting. This is more common when there is a planned retirement of a member, rather than other variations of departure.
If the buy-out is funded by the company, the operating agreement should address whether the non-departing members are required personally to guaranty any deferred payments.
Of course, the operating agreement should also address the price being paid for the departing member’s interest, which could, for example, be the member’s capital account, a value based on the company’s cash or accrual or adjusted balance sheet, a multiple of past annual distributions or an appraisal.
Departures can also be voluntary or involuntary. In a voluntary departure, a member and the company jointly decide it is time for the member to leave. This can be tied to a retirement age, or some other non-confrontational situation. When a member leaves voluntarily, with the approval of the company or in accordance with the operating agreement, he or she is typically paid out for the full value of their ownership interest.
Involuntary departures occur when a member leaves abruptly or the company decides to force the member out. This can be tied to bad behavior, such as breaching fiduciary duties or losing a medical license. Types of bad behavior should be specified in the operating agreement to clearly define what is considered untenable. When a member leaves involuntarily, he or she can be paid out at a discounted rate, if and only if, the operating agreement clearly stipulates the terms of that discount.
Additionally, under Maryland law, if a member is terminated but the operating agreement does not specifically allow termination, that member becomes an economic interest holder in the company. An economic interest holder does not have voting rights, but is still entitled to the full value of distributions based upon their ownership interest.
Health care limited liability companies should also include language in their operating agreements addressing continued malpractice insurance coverage of departing members. Tail coverage can be expensive, especially for certain specialists. The company may want to require that departing members maintain malpractice insurance after their departure; alternatively, the company may want to offer to cover tail coverage for retiring members, but not for those who are departing voluntarily or involuntarily.
The operating agreement should also address whether a departing member may sell their interest to an unrelated third party.