Limited Liability Companies (LLCs) have quickly become the go-to business entity for most small- to medium-sized businesses. This is primarily because they combine the best aspects of partnerships and corporations.
Before we do an in-depth overview of LLC formation, it is important to define a few common terms.
- Members – owners of LLCs are called members. LLC members can be individuals, other LLCs, partnerships, corporations, trusts, etc. Essentially any person or entity which can own property can be a member of an LLC.
- Managers – managers of LLCs are like the Board of Directors of a corporation. However, unlike a corporation, managers in an LLC are completely optional. If an LLC has managers, they serve as the primary governing authority of the LLC.
- Units – units are the measure of member interest in an LLC. They are similar to shares of stock in a corporation.
- Company Agreement – a company agreement is an agreement among the members of an LLC which controls certain aspects of ownership and management of an LLC. Some jurisdictions also call this an operating agreement.
The first step in an LLC formation is registration of the entity with the Texas Secretary of State. This is done through a Certificate of Formation (sometimes referred to by its old name – Articles of Incorporation). To encourage the creation of new business (and new jobs), the Secretary of State has provided both PDF fill in the blank forms and Microsoft Word based forms which contain all the statutorily required information for formation. However, there is no requirement to use these forms. The only requirement is to have all the necessary information contained in the registration filing, which includes the following:
- Registered Agent – Every business entity in Texas must name a registered agent. The purpose of a registered agent is to be the point of contact for service of lawsuits against the entity. A registered agent can be an entity (i.e. your attorney) or an individual (i.e. one of the owners). The address listed must be a physical address and not a PO box.
- Member Name and Address – At least one member must be named in the Certificate of Formation. The address can be the home address of the member or the address of the business location.
- Signature of Organizer – The organizer of the LLC must sign Certificate of Formation.
One other consideration for the Certificate of Formation is to decide whether the LLC will be managed by its members or managers. As mentioned above, managers are optional. If an LLC has managers, it may be beneficial to designate (usually in the company agreement) the number of managers, their minimum qualifications, how they are selected, how they are removed, and how to handle vacancies.
If your LLC has more than one member, it is crucial to have a well-drafted company agreement. This is true even if the multiple members are related (i.e. siblings, husband-wife). The company agreement will provide additional protections for the members which can modify the statutory scheme under the Texas Business Organizations Code (“BOC”). The Texas BOC specifically provides language which states a company agreement can modify many of the statutory provisions.
Key Provisions for Members under the BOC
The BOC contains a number of provisions which define member rights and obligations. A few of the key provisions are below:
- Membership is personal property (Section 101.106(a)). As personal property, it is nearly impossible to divest a person of personal property absent a legal proceeding (i.e. divorce) or an agreement otherwise (i.e. the company agreement).
- A member does not have an interest in specific property of the LLC (Section 101.106(b)). If the LLC owns something – like real property, equipment, or intellectual property – the individual members do NOT own it.
- A member may not withdraw or be expelled from the company (Section 101.107). Imagine one of your partners in the business gets convicted of a heinous crime. If you do not alter this provision of the BOC through a company agreement, you CANNOT leave the company or force the partner to sell his/her units of the company.
Transfer of Member Interest
As personal property, membership units are relatively easy to transfer. However, the BOC places some restrictions on the rights of a “transferee” member. For example, the person who is assigned the interest in the LLC is not automatically a member of the LLC nor are they entitled to participate in management of the LLC or exercise membership rights. The remaining members may accept the new assignee as a full member, but it requires a vote of approval. A well-written company agreement will provide for the transition of member interests. Typically, clauses such a “right of first refusal” rights are included. In a right of first refusal, the remaining members have the right to match the purchase price of the selling member’s interest rather than selling to a third-party.