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Forming an LLC: Member-Managed or Manager-Managed?

After considering advantages and disadvantages of different forms of an entity, you have now decided that forming an LLC (limited liability company) would be the best option for your company. However, you have to go through one more step to be completely done with the entity selection process: Should you form a member-managed or manager-managed LLC?

Basically, you may choose one of two different management structures for an LLC: Member-managed vs. Manager-managed. Member means an owner of an LLC in this context. In Michigan, the default management structure of an LLC is member-managed, as is the case in most other states. However, you may choose to form a manager-managed LLC instead by designating it in the Operating Agreement.

 

Member-managed vs. Manager-managed LLCs

Member-managed LLCs:

If you choose to form a member-managed LLC, all members have an equal right to participate in managing and operating the company unless the operating agreement states otherwise. A member-managed LLC essentially leaves no room for outsiders to jump in and interfere. Consequently, a member-managed LLC allows every member to vote in the decision-making process and enter into binding agreements and contracts on behalf of the company as its agent. However, members may choose to form an LLC with different classes of members where one class would have a different level of rights than the other classes. Also, the operating agreement can limit the scope of authority that each member has in a member-managed LLC. For instance, the operating agreement may require a majority or unanimous vote of members to make certain business decisions such as contracts and loan agreements.

Member-managed LLCs also do not have boards of directors unlike manager-managed LLCs. Also, member-managed LLCs tend to be more cost-effective than manager-managed LLCs due to their decentralized management structure.

Therefore, a member-managed LLC could be a better option for you if every member of your company wants to play an active role in running the business. However, a member-managed LLC also has some downsides due to its management structure: 1) it might be inefficient if the company is too large or complicated for all members to take a part in managing and operating the business; 2) it can also turn out to be inefficient if some members are not well-versed in business management; and 3) the expulsion of a member could be difficult since it would require an unanimous approval of all the other members unless specified otherwise in the operating agreement.

 

Manager-managed LLCs:

On the other hand, manager-managed LLCs have one or more managers to manage the company and arrange business affairs on the company’s behalf without getting the members’ consent or approval first. Only designated managers have the authority to make determinations on behalf of the LLC in manager-managed LLCs. Thus, manager-managed LLCs have a more centralized management structure and enable the company to be managed more like a corporation. For this reason, manager-managed LLCs would be preferable if your company is large and complex, since getting all the members together to vote and make decisions as a whole could be inefficient for large companies. Hence, a manager-managed LLCs would streamline the decision-making process and enable members to focus more on works of their choice in such cases.

Members may select one or more of the members as managers of the LLC, or they may hire professional managers who are not members of the LLC but have adequate expertise and qualifications. Having professional managers with experiences in business management can also be beneficial for your business in terms of protecting the company’s interest, attracting investors, and protecting the investors’ money. The members may specify details such as the number of managers, required qualifications, and resignation procedure in the operating agreement.

Since manager-managed LLCs allow managers to make decisions on behalf of the LLC without acquiring members’ consent first, this management structure would be more suitable if members of your company wish to take a more passive role. For instance, if some members of your company are investors and do not want to get involved in day-to-day management of the company, manager-managed LLC could be a better option for your company. If members of your company wish to select some of the members as managers, it would be advisable to designate more active members as the company’s managers. Members who are designated as managers may also receive a separate compensation as an employee.

 

Fiduciary Duties

Members of a manager-managed LLC as well as managers of a manager-managed LLC, including both professional managers and members who have been designated as managers, owe fiduciary duties to the LLC. In Michigan, a person who manages an LLC does not owe fiduciary duties to the members of the company. Fiduciary duties mean duties of trust that mandate people who owe such duties to place the company’s interests above their own or other parties’ interests. However, the members may agree to waive some fiduciary duties by specifying that in the operating agreement.

The two most important types of fiduciary duties owed to an LLC are 1) the duty of loyalty and 2) the duty of care. A person who owes the duty of loyalty to an LLC is expected to place the company’s interests above his or her personal interests and goals. He/she also needs to conduct any transactions and deals on behalf of the company in good faith. Also, he/she must not compete directly with the company or take advantage of the company’s internal information, commercial activities or business opportunities in an inappropriate manner to earn secret profits.

On the other hand, the duty of care requires one to act prudently in good faith and exercise reasonable care when performing their work on behalf of the company. If a member of a member-managed LLC or a manager of a manager-managed LLC makes a business decision with negative consequences for the company, that person would be protected from liability as long as he/she made the decision in good faith and exercise reasonable care during the process.

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Re-allocating Equity in Your Startup

Founders often have to revisit their equity division once they begin operating their company and see the actual value that each is providing.

Founders often have to revisit their equity division once they begin operating their company and see the actual value that each is providing.

We have previously written about considerations for founders in splitting initial equity in their startup.  No matter how thoughtful founders are in dividing their initial equity, it is common for founders to realize after a period of time operating their company that their initial equity allowances do not accurately reflect the actual contributions or value from each team member.  Founders often believe they can simply create their own document redefining their split of equity %’s.  In the case of an LLC, founders often try to simply amend the cap table exhibit to their Operating Agreement.  While these steps are better than nothing, reallocating equity %’s involves transferring shares (for a corporation) or units (for an LLC) and therefore could trigger some tax and securities issues.  Additionally, it is important to generate clear documents, signed by all involved parties, in order to avoid later disputes over the number of shares/units held by individuals (especially when those shares/units hold more value).   Just as importantly, maintaining a clean and clear cap table is really important for early stage startups.  Investors will typically want to see clear documents showing the issuance from the company to each shareholder of shares that correlate to the numbers of shares indicated on the cap table.   This post provides a few specific methods for properly reallocating equity in an early-stage startup.  The specific approach will spend on the specific governance documents and circumstances for your startup, so please consult your attorney.  This post assumes a few important things:

  • the company is pre-financing and it can issue equity at a nominal valuation (in the case of a corporation, at or near par value of $.0001 or $.00001).
  • all stockholders are remaining involved with the company, in other words, no one is terminating an employment or contractor arrangement with the company.
  • the company’s board of directors (for a corporation) or board of managers (for a manager-managed LLC) are remaining the same.
  • the company has implemented standard vesting procedures for all founders (to learn more about vesting, see this primer on vesting.)

Calculating the Adjustment

The first step in reallocating equity is to figure out how much stock (for corporations) or units (for LLC’s).  Presumably, you have determined your new desired %’s.  You might think about your desired outcome in terms of %’s, but in order to get there, you need to think about the number of shares or units held by each individual.  For example, assume three individuals (Founders A, B, and C) currently own respectively 40%, 40%, 20% of the issued equity in a company, reflected by having been issued 2M, 2M, and 1M shares respectively.  They’ve decided to reallocate equity so that the three founders will own 30%, 30%, 40% of the issued equity respectively.

There are a variety of ways to achieve this outcome.

1) Issuing More Shares/Units to the Founders Desiring to Increase Their %.

For example, the company could simply issue Founder C more shares so that Founder C holds 40% of the new total.  In the above example, this would mean issuing Founder C 1,666,667 shares so that Founder A and B would still each own 2,000,000 shares and Founder C would own 2,666,667 shares and the equity would be divided 30%, 30%, 40% respectively.

When issuing more shares to Founder C, if the startup is a corporation, it would ensure it does not exceed the number of authorized shares in its Certificate of Incorporation.

The following documents would typically be used to execute the above:

  • Board consent (signed by all directors or managers) authorizing the issuance of 1,666,667 shares/units to Founder C.
  • A Restricted Stock/Unit Agreement between the Company and Founder C selling to Founder C 1,666,667 shares/units and implementing a vesting schedule (by way of granting Company a repurchase option in the shares/units that lapses over time).
  • Founder C would likely need to file an 83(b) election with the IRS within 30 days of signing the Restricted Stock/Unit Agreement.
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.

2)Repurchasing Unvested Shares/Units from Founders Desiring to Decrease Their %.

Another way to reallocate equity using the above example, is to repurchase unvested shares from Founders A and B.  Using the above example, the Company could repurchase 1.25M shares/units from each of Founders A and B, so that they would each own 750,000 shares/units and Founder C would still own 1,000,000, providing the desired 30/30/40 split.  Note that repurchased shares go into the Company’s treasury (ie., as authorized but unissued shares).  They effectively disappear into the ether, which allows Founder C’s % to increase even though she maintains the same number of shares/units.

The following documents would be used to execute the above:

  • A Board consent (signed by all directors in the case of a corporation or managers in the case of an LLC) authorizing the company to repurchase 1.25M shares/units from each of Founder A and B.
  • Repurchase Agreements between the Company and each of Founders A and B.  Note that most standard Restricted Stock Purchase Agreements require stock recipients to sign an “Assignment Separate From Certificate” preauthorizing the Company to repurchase unvested shares.  While this document is sufficient to reclaim unvested shares, in the situation of a willing seller, a separate document specifying how many shares are being repurchased and how many remain with the individual will typically be drafted.
  • Amended Restricted Stock/Unit Purchase Agreements between the Company and Founders A and B that amend the vesting schedule for Founder A and B’s remaining equity, as desired.  (Most vesting schedules will talk about some fraction of the totally number of shares/units held by the recipient vesting each month, so in the situation where the the totally number of units has decreased during the course of a vesting schedule, the fraction of shares eating each month may need to be revised).
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.
  • If the Company has issued Stock/Unit Certificates or Notices of Issuances, those documents should be returned and/or amended accordingly.  Most startups will keep Certificates for unvested shares in escrow.

3) Combination of #1 and #2 Above.

Another way to reallocate equity in the above example would be to repurchase 500,000 shares/units from each of Founders and and B and issue 1,000,000 new shares/units to Founder C.  This would keep the number of issued shares/units constant at 5,000,000.  This method might be preferable if the startup didn’t have enough authorized but unissued shares/units to issue Founder C without repurchasing some from Founders A and B (making method #1 impractical because it would require amending the Certificate of Incorporation for a corporation), Founders A and B didn’t have enough unvested equity to repurchase the necessary shares/units (making method #2 above impractical), or the startup otherwise wanted to maintain the existing number of issued shares/units.

To implement this approach, the Company would use the following documents:

  • Board consent (signed by all directors or managers) authorizing the issuance of 1,000,000 shares/units to Founder C and the company to repurchase 1.25M shares/units from each of Founder A and B.
  • A Restricted Stock/Unit Agreement between the Company and Founder C selling to Founder C 1,000,000 shares/units and implementing a vesting schedule (by way of granting Company a repurchase option in the shares/units that lapses over time).
  • Founder C would likely need to file an 83(b) election with the IRS within 30 days of signing the Restricted Stock/Unit Agreement.
  • Repurchase Agreements between the Company and each of Founders A and B where the Company repurchases from Founders A and B 500,000 shares/units each.  Note that most standard Restricted Stock Purchase Agreements require stock recipients to sign an “Assignment Separate From Certificate” preauthorizing the Company to repurchase unvested shares.  While this document is sufficient to reclaim unvested shares, in the situation of a willing seller, a separate document specifying how many shares are being repurchased and how many remain with the individual will typically be drafted.
  • Amended Restricted Stock/Unit Purchase Agreements between the Company and Founders A and B that amend the vesting schedule for Founder A and B’s remaining equity, as desired.  (Most vesting schedules will talk about some fraction of the totally number of shares/units held by the recipient vesting each month, so in the situation where the the totally number of units has decreased during the course of a vesting schedule, the fraction of shares eating each month may need to be revised).
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.
  • If the Company has issued Stock/Unit Certificates or Notices of Issuances, those documents should be returned and/or amended accordingly.  Most startups will keep Certificates for unvested shares in escrow.

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Changing the Registered Office of a Michigan LLC

Some economic development organizations may require your company to have a registered office in a certain vicinity.

Some economic development organizations may require your company to have a registered office in a certain vicinity.

Michigan has several economic development organizations that require startups to maintain an office in a certain city or vicinity in order to receive funding from that organization.  Some of these organizations will merely require that the startup maintain an office or a principal place of business in a certain location.  Others, however, will require that the startup’s “registered office” be in that vicinity.  This post: (1) explains what is a “registered office;” and (2) describes how to amend the location of your registered office for a Michigan LLC.

What is a Registered Office?

The Michigan Limited Liability Act (Section 207) requires Michigan LLC’s to maintain a “registered office.”  Simply put, this is the address where the state can send your company important information and assume your company received it.  The registered office is identified in Article IV of the company’s Articles of Organization, which are publicly available and filed with the state of Michigan.

Article IV Articles

We have previously discussed the Articles of Organization here.

It is important to note that the registered office does not need to be the same as the company’s principal place of business.  In fact, because many early-stage startups operate from work sharing spaces, incubators, or accelerators, the company’s principal place of business will, in fact, differ from the registered office (which will ideally be a more permanent address where the company is more certain to receive important state documents).  Many student entrepreneurs will use a parent’s permanent address (in Michigan) for the Michigan registered office.  Accordingly, before taking the time to change your registered office in your Articles of Organization, confirm that the funding organization does indeed require the registered office (as compared to a principal place of business) to be in a certain vicinity.

Amending Your Registered Office

If you determine that you need to change the registered office identified in your Articles of Organization, here is how to proceed.  The fee is $5, although expedited service is available for the higher fees described on page 3 of the Certificate of Registered Office (Form 520).

  1. Locate your ELF account number.  Or, if you have not set up an ELF account with the state of Michigan, do so.  This post discusses the benefits, and process of establishing, an ELF account.
  2. Complete the Certificate of Change of Registered Office (Form 520).
  3. Complete your MICH-ELF COVER SHEET, which will be filed along with the Certificate of Change of Registered Office (Form 520) that you completed in Step 2.
  4. Following the instructions which you received in the Response to your ELF Application, file the documents you completed in Steps 2 and 3 above.  As of the date of this post, ELF account filers may electronically file via email at cdfilings@michigan.gov.
  5. Filers without an ELF account may submit the above forms along with a check or money order to:

Michigan Filing Address

Once you have changed your registered office, understand that this is where the state will send important information, such as your annual statements.  If you change locations, and your registered office is no longer a valid mailing address for your company, you will need to use the above process to change the registered office identified on your Articles of Organization.