This article discusses the transfer provisions commonly found in LLC agreements, including transfer restrictions, rights of first refusal (ROFR), rights of first offer (ROFO), drag-along rights, tag-along rights, and buy-sell provisions.
Most LLC agreements have a rule that members cannot sell or otherwise transfer their LLC interests unless approved in advance — typically by the manager or some percentage of the members — or allowed under another provision of the transfer section, such as an ROFR or ROFO.
LLC agreements with a general prohibition typically permit certain transfers to closely related people, such as immediate family members, affiliates, and controlled entities, such as family trusts. Transfers made in connection with an initial public offering of the LLC's securities are also usually permitted.
Despite any permitted transfer or other provision of the LLC agreement, if the LLC is treated as a partnership for U.S. federal income tax purposes, any transfer — or withdrawal — that would cause the LLC to be treated as an S corporation for U.S. federal income tax purposes is generally prohibited.
The ROFR requires a member who has received a bona fide third-party offer for a sale of its LLC interests to first offer those interests to the other members before completing the sale to the third party. In some agreements, the offer is also made to the LLC, which can be simultaneous with the offer to the members, or the company can have a right of first refusal before the other members can exercise their rights.
Any offer to the company, the members, or both must typically be made on substantially the same terms offered by the third party. Interested members can then buy the offered interests pro rata in proportion to their current holdings. The agreement can include provisions that allocate all the offered interests to the members so that if any member declines to exercise their right of first refusal, the remaining members can acquire the declined interests.
Similar to the ROFR, the ROFO requires a member to offer its LLC interests to the other members or the LLC before offering to sell to third parties. However, with a right of first offer, the selling member does not need to identify a third-party buyer before offering its LLC interests to the other members or the LLC.
If an LLC agreement includes an ROFO, the LLC agreement should not also include an ROFR. Although there are no legal constraints against including both provisions, the procedures that must be followed in both cases can be lengthy and ultimately achieve the same goal, making it impractical to include both provisions.
Drag-along rights protect the majority member of the LLC by allowing it to require the minority members to sell their stakes in the company if doing so will aid in the sale of all or a significant portion of the company to a third party. LLC agreements generally include drag-along provisions where one of the members owns a majority of the company's LLC interests, such as a sponsor in a buyout transaction.
They are also sometimes included in minority investments with multiple rounds of financing when no investor holds a majority on their own. When the members own an equal percentage of LLC interests — as in a 50/50 joint venture — the members do not typically have a drag-along right.
The flip side of drag-along rights, tag-along rights protect the minority members of the LLC. These rights typically provide that if the controlling members sell all or some portion of their LLC interests, they must allow the other members to participate in the sale and sell their interests on a pro-rata basis on the same terms and conditions as the controlling member.
Buy-sell provisions describe the events and related procedures for when members are permitted or are required to buy or sell LLC interests from each other. These provisions are often used to plan for certain situations, such as:
Valuing the transferred LLC interests is a critical part of any buy-sell provision. It is essential to include a clear procedure for valuing the transferred LLC interests when the parties first enter into the LLC agreement — or buy-sell agreement, if separate — because the parties' interests are more likely to align at that time.
If the valuation procedures are ambiguous or the agreement is silent on the matter, the parties will need to negotiate the valuation of the LLC interests when they may have opposing interests. This situation can lead to time-consuming and costly negotiations.