Too many times in my practice, clients have come to me in the midst of a tumultuous intracompany squabble. Owners who once thought they were going to start the next Microsoft or Apple are now at each other’s throats, lobbing all sorts of accusations and wrestling for control of the company. Sadly, the owners are often members of the same family.
In “You’ve Got Mail” Tom Hanks told Meg Ryan that business isn’t personal, it’s war. His Godfather references notwithstanding, if he’s right, it might benefit all business owners to employ good military tactics when entering the fray. Any commander worth his rank will establish strict protocols not only for formation and operation, but he or she will also formulate a clear and effective exit strategy to get out of a situation unscathed when the bullets start to fly. Invariably, my worst business breakups occur when the owners failed to implement or even consider an effective exit strategy.
In Ott v. Monroe, 282 Va. 403 (2011), the Virginia Supreme Court addressed a case involving a dispute in a family run business. The facts are as follows:
- Dewey and his wife, Lou Ann formed a Virginia limited liability company called L & J Holdings, LLC (the “Company”).
- The Company had an operating agreement, which provided:
- Dewey (80%) and Lou Ann (20%) were the sole members of the company
- The operating agreement named Lou Ann the managing member
- Dewey died and left his entire estate to his daughter, Janet.
- Janet called a meeting of the members of the company for the purpose of removing Lou Ann as managing member
- Lou Ann responded that Janet only inherited Dewey’s right to share in profits and losses and that she did not have the power to remove Lou Ann as the managing member. The dispute made its way into the courts.
- The operating agreement stated “Any member…may transfer all or any portion of the member’s interest at any time to…other members [or] the spouse, children or other descendants of any member.”
The Virginia Supreme Court held in favor of Lou Ann. Even though she only owned 20% of the membership interest, the transfer of the 80% interest from Dewey to Janet by will did not give Janet any interest other than a profits interest. Thus, Janet had no authority to remove Lou Ann as managing member of the company.
Virginia Code §13.1-1039 provides that an assignment does not entitle the assignee to participate in the management and affairs of the limited liability company or to become or exercise any rights of a member. Such an assignment entitles the assignee to receive, to the extent assigned, only a share of profits and losses and distributions to which the assignor would be entitled. That section can be overwritten by language in an operating agreement.
Virginia Code §13.1-1040(A) provides the method by which an assignee of a profits interest may become a full member. Unless otherwise provided in an operating agreement, an assignee must obtain the consent of the majority of the other members to become a full member. Janet certainly was not going to get Lou Ann’s consent, so she relied upon the operating agreement.
The court ruled that the language in the operating agreement, which allowed a member to transfer his or her interest to children, lacked the specific language that would constitute an exception to the statute.
Thus, while the parties tried to implement an exit strategy, they did so poorly. The bullets started flying and the operating agreement provided no cover. If Dewey wanted to ensure that his daughter would get his full membership interest, and thus the ability to remove Lou Ann as managing member, he needed to include a more specific provision in the operating agreement. Such a provision would state that Dewey’s assignee would become a full member, with all rights of ownership as a member under the Virginia Code and cite the relevant sections. This assumes that all the members signed the operating agreement, thus consenting to such a provision.
The moral of the story is, even if times are good and the owners still think that they will be neighbors of Bill Gates or Mark Zuckerberg in the near future, they should review their operating agreement to make sure their exit strategy will legally bring about the desired result. A member needs to know that without careful planning, his or her successor may only inherit a profits interest, without the power to manage the company, regardless of how great the percentage ownership is. Let me guess, Lu Ann and Janet are not Facebook friends.