Consultant’s Corner: Adding a Member to an LLC

I have a Single Member LLC. What are the issues and process to add a partner and how does it affect the closing out of the original Single Member LLC and setting up a new entity?

It is common for members or owners of single member LLCs to take on partners by converting their LLCs to multi-member LLCs, so adding a partner does not necessarily require closure of your business, the dissolution of your single member LLC and the formation of a new business entity (another LLC or a corporation) for the multi-owner business. Typically, the single to multi-member conversion process involves selling a membership interest in the existing LLC to the new member; however, converting a single member LLC to a multi-member LLC involves potential regulatory, governance, business valuation, financial, and income tax considerations. For example, you will need to prepare or amend the LLC Operating Agreement, which governs the relationship between the members. The following are additional considerations when adding a member to a single member LLC:

Business valuation

When selling an ownership interest in an existing business, small business owners have discretion in deciding what percentage of the business they want to sell and the amount they will accept. However, an accurate valuation of the business is typically important in order to establish a price for the ownership interest, allocate the ownership, and account for the other financial and income tax aspects of the ownership sale. Also, business owners often need to engage or consult professional business brokers or local financial professionals to provide an independent appraisal or otherwise help them value their businesses.

Certain industries have rule of thumb valuation factors, such as a multiple of revenues, cash flows (EBITDA), or net income. However, industry guidelines vary based on profit and cash flow potential and cannot always be applied to an individual situation because of asset values, rent and labor costs, financing, and other elements unique to that operation. Historical operating results are one part of the valuation; however, businesses are generally valued more for the future potential than the past operations.

As to valuing a particular business, the best information generally involves determining the present value of future cash flows. The key financial statement is the statement of cash flows that will yield the “cash available to service debt.” The future cash flows are then discounted to present value using a discount rate that reflects the amount of risk inherent in the forecast assumptions. The key question is “How much would someone pay for the opportunity to earn a certain annual income?” The answer generally depends on how secure the income is and how easy it would be for the buyer to start from scratch without buying the business. If the business has growth potential, it may be worth 10 to 20 times earnings compared to 3 to 7 times earnings for a company with limited, or no, growth potential. Service businesses may sell from 40% to 150% of revenues, for example.

Ownership allocation

Business ownership allocation decisions must be negotiated between the partners and are generally based on the financial investment, technical talent/skill contribution, and retention of control. While ownership of most business ventures is based on the amount of financial investment, many owners and executives are allocated equity based on their business expertise and expected contribution to the day-to-day business operations and success. It is common for individuals with complementary talent and resources to form business partnerships and for certain minority partners to receive a portion (5 to 10%, for example) of the business for their skill contribution in lieu of a capital investment. However, in other cases, where the partners will more equally invest, share, and contribute to the business operations and development, the split may be more even: 50%/50% for example. In addition, if one partner plans to maintain management control of the business, that partner would generally retain 51% of the entity’s voting stock/membership certificates or other equity.

LLC conversions

Taking on a member, or providing another party with a specific percentage or profit split of a single member LLC, is an ownership change that requires reorganization of the business from a single member LLC into a multi-member LLC. This is the case even if the incoming member is not actively involved in managing the business. Converting a single member LLC to a multi-member LLC by taking on a member may be personally taxable to the existing LLC member depending on how the incoming member purchases his or her interest in the LLC. Basically, the existing member has the choice of either selling a portion of his or her existing membership interest to the incoming member or having the LLC sell (and receive the capital from) a new membership interest to the incoming member. Selling a portion of your membership interest to an incoming member would generally be a taxable transaction for you. Depending on the fair market value of your membership interest, selling a portion of your interest may also be a taxable transaction to the incoming member if it is sold to the incoming member for zero consideration (a sales price of $0).

We do not know the value of your LLC; however, it may be possible for you to award, or gift, ownership in your LLC to the new member without a cash or other asset investment by him or her and without any immediate income tax implications, though gifting LLC membership interests can have gift and estate tax implications depending on all the facts and circumstances. Typically, gifting techniques are utilized with family members rather than unrelated equity investors. Also, if your LLC has been operating for a period of time, it will be necessary to value the business in order to value any membership interests sold or gifted to the new member.

LLC new member paperwork

As to documenting the investment and addition of an LLC member, the required documents can vary depending on the structure of the transaction and regulatory requirements. While small investor solicitations may not be subject to many complex state and federal securities laws, from a general business perspective, you should still clarify the appropriate investor disclosures, LLC investor agreements, and governance paperwork (LLC certificates, minutes, any regulatory filings, etc) with your lawyer.

When forming an LLC with partners, including family members and friends, it is generally advisable for the business owners to use buyout contracts, LLC Operating Agreements, non-compete, and/or non-disclosure agreements to adequately protect their interests and provide a solution to disputes and other ownership changes. Generally, an Operating Agreement in the case of a multi-member LLC delineates the legal, operational and financial relationships between members and serves as a legally binding contract in the event of any disputes.