When starting a business, many entrepreneurs choose to form a Limited Liability Company (LLC). LLCs offer several advantages, including liability protection for their owners and flexibility in how the business is managed and taxed. When forming a California LLC with multiple owners, one of the most important decisions is determining how ownership will be divided among the members and what rights and responsibilities each member will have.
California LLCs are governed primarily by the California Revised Uniform Limited Liability Company Act (RULLCA). Under RULLCA, the owners of an LLC are called “members,” and a “membership interest” means a member’s rights in the company, including the member’s transferable interest, right to vote or participate in management, and right to information concerning the company’s business and affairs.
What Does It Mean to Own a Membership Interest in a California LLC?
A membership interest represents a member’s ownership rights in an LLC. These rights can include the right to receive distributions, participate in management, vote on certain matters, and obtain information concerning the company’s business and affairs.
When forming an LLC, the members should establish how ownership will be divided among them. For example, a company with two members might be owned 60% by one member and 40% by the other. Ownership percentages can also be divided in more complicated ways when an LLC has several members or different classes of interests.
The members should document these arrangements in the LLC’s operating agreement. California law gives operating agreements broad effect: the agreement governs relations among the members, the rights and duties of managers, the activities of the company, and the means of amending the agreement. RULLCA also recognizes oral and implied operating agreements, not only written ones. Members who never sign an agreement do not thereby avoid having one; they simply leave its terms to be reconstructed later, often in litigation.
It is also good practice for the LLC to maintain an up-to-date capitalization table, or “cap table,” showing each member’s ownership percentage, capital contributions, and other equity interests. Accurate records are more than good housekeeping. Several of RULLCA’s default rules, including the defaults governing distributions and the allocation of profits and losses, are measured by the value of each member’s contributions “as stated in the required records.”
Why Do LLC Membership Interests Matter?
Membership interests are an important component of an LLC’s structure because they can affect how the company is managed, how profits and losses are allocated, and how important business decisions are made.
RULLCA supplies default rules governing LLC management, most of which the operating agreement may modify. An LLC is member-managed unless its articles of organization contain a statement that it is manager-managed. In a member-managed LLC, management is vested in the members, and each member has equal rights in the management and conduct of the company’s activities. Voting is a separate question. RULLCA’s statement that members have equal voting rights is qualified: the articles of organization or the operating agreement may set voting on a per capita, financial interest, class, group, or any other basis, and if neither document addresses voting, the members vote in proportion to their interests in current profits. Under the default rultes, amendments to the articles or the operating agreement require a unanimous vote, and an act outside the ordinary course of the company’s activities requires the consent of all members.
Ownership percentage and voting power need not be identical, but a departure from proportional voting has to be written into the articles of organization or the operating agreement. It is not what the statute supplies on its own.
For example, a member holding 70 percent of the economics may agree to a different voting arrangement, or to vest specified management responsibilities in another member. RULLCA gives members wide latitude to structure these arrangements by agreement, subject to statutory limitations.
Membership interests also matter when the company distributes cash. Distributions made before dissolution are shared among the members in accordance with the operating agreement; absent a contrary provision, they are made on the basis of the value of the contributions the company has received from each member, as stated in its required records. The same default governs the allocation of profits and losses. This is a California-specific choice: the uniform act on which RULLCA is based defaults instead to distributions in equal shares.
What Are Key Considerations When Deciding Membership Interests?
Several factors bear on how ownership of a California LLC should be divided. The ownership structure should reflect the members’ respective contributions to the business as well as the roles they will play going forward.
One consideration is each member’s capital contribution. A member who contributes a significant amount of money to launch the business may receive a larger ownership interest. However, financial contributions are not the only factor that can justify a particular ownership percentage.
Members may also contribute time, specialized knowledge, intellectual property, industry relationships, equipment, business opportunities, or other resources. A member who contributes substantial services or expertise may receive a significant ownership interest even if that member contributes less cash, although an interest issued in exchange for services carries tax consequences that should be evaluated with tax counsel before the interest is granted.
Members should also consider how many owners the LLC will have. With two members the arithmetic is simple, but an evenly divided LLC is the structure most prone to deadlock, and the members should agree in advance on how a deadlock will be broken. As additional members join, however, it becomes increasingly important to establish clear rules concerning ownership, voting, distributions, management, and transfers.
Some LLCs may also benefit from creating different classes of membership interests. Different classes can provide different economic or management rights, depending on the company’s structure and the provisions of its operating agreement. California law allows considerable flexibility in structuring LLC rights, although certain statutory requirements cannot be varied by agreement.
These decisions are considerably easier to make before a disagreement than after one.
What Are the Responsibilities of LLC Ownership?
Owning a membership interest in a California LLC comes with more than simply receiving a percentage of the company’s profits. Members may have obligations relating to management, capital contributions, voting, confidentiality, and other matters established by the operating agreement. Fiduciary duties, by contrast, follow management structure rather than ownership percentage: the duties of loyalty and care are owed by the members of a member-managed LLC and by the managers of a manager-managed LLC, and a non-managing member of a manager-managed LLC owes no fiduciary duty to the company or the other members solely by reason of being a member. An operating agreement may not eliminate those duties, although it may identify categories of activity that do not violate the duty of loyalty and may prescribe standards for measuring performance, in each case if not manifestly unreasonable.
The LLC must also satisfy California filing and tax requirements. A California LLC must file a Statement of Information within 90 days after filing its articles of organization and biennially thereafter, and must file an amended statement when the reported information changes. Separately, a California LLC is subject to the $800 annual minimum franchise tax and, once total California income exceeds the statutory thresholds, an additional annual LLC fee.
California also requires an LLC to maintain specified records at its principal office. Members and transferees have statutory rights to inspect and copy those records and to obtain other information concerning the company’s activities and financial condition, on reasonable demand for a purpose reasonably related to the member’s interest.
Members should also understand the distinction between ownership rights and management authority. A member may own a substantial percentage of an LLC without necessarily having unilateral authority to make every business decision. Whether a particular member may act unilaterally turns on the company’s management structure, its operating agreement, and the default rules described above.
What Happens When Ownership Percentages Need to Change?
Ownership interests may change for many reasons. A member may want to sell part or all of their interest, a new investor may join the company, an existing member may make an additional contribution, or the members may agree to restructure the company’s ownership.
California law distinguishes between transferring an economic interest and becoming a member with management rights. A transferable interest is the right to receive distributions from the company in accordance with the operating agreement. A transfer of that interest does not, by itself, entitle the transferee to participate in management or to conduct the company’s activities.
After formation, a person may become a member as provided in the operating agreement, through a merger or conversion authorized by statute, or with the consent of all the members.
An LLC’s operating agreement should therefore address transfers before they occur. The agreement can establish procedures for approving new members, restrictions on transfers, rights of first refusal, buyout provisions, valuation procedures, and other protections designed to keep an involuntary transferee, such as a divorcing spouse, a judgment creditor, or an heir, from being admitted as a member.
Conclusion
Determining ownership percentages is one of the most important decisions when forming a California LLC with multiple members. Membership interests can affect economic rights, distributions, voting, management, and the ability to transfer an interest in the company.
For that reason, members should carefully consider their ownership structure and document their agreement in a comprehensive operating agreement. A well-drafted agreement can provide clarity about each member’s rights and responsibilities and reduce the likelihood of costly disputes later.
If you are forming a California LLC or need to establish or restructure LLC membership interests, an experienced business attorney can help you evaluate the ownership structure and prepare an operating agreement that reflects the members’ intentions.
Contributions to this blog by Kennedy McKinney.
Photo by Sasun Bughdaryan on Unsplash
Frequently Asked Questions
Can an LLC member own a different percentage of profits than their ownership percentage?
Yes. A California LLC operating agreement may establish how profits and distributions are allocated among the members, and those allocations need not mirror ownership percentages. An allocation that departs from the members’ respective capital interests must, however, have substantial economic effect, or otherwise accord with the members’ interests in the company, to be respected for tax purposes under the Internal Revenue Code. The structure should be documented and reviewed with tax counsel before it is adopted.
Can a California LLC member be removed from the company?
Removing a member is rarely as simple as taking a vote. The operating agreement may establish circumstances and procedures for a member’s dissociation, withdrawal, or buyout. RULLCA separately specifies the events that cause a member to dissociate, including expulsion by unanimous consent of the other members in defined circumstances and expulsion by judicial order. LLCs should address removal procedures and valuation methods before a dispute develops among members.
What happens to an LLC membership interest if a member dies?
A member’s death can raise questions about both economic and management rights. An heir or beneficiary who receives an economic interest does not thereby receive the deceased member’s management or voting authority. A well-drafted operating agreement can establish succession, buyout, valuation, and transfer procedures to reduce uncertainty following a member’s death.
Can an LLC membership interest be used as collateral for a loan?
In some circumstances, a member may seek to pledge an economic interest in an LLC as collateral. However, the operating agreement may restrict transfers, pledges, or other encumbrances. Members and lenders should review the agreement and applicable law carefully: a security interest in a transferable interest confers no management or voting rights, and a judgment creditor of a member is generally limited to a charging order against that member’s transferable interest.
How should a California LLC value a member’s ownership interest for a buyout?
There is no single valuation method that works for every LLC. An operating agreement may establish a formula, appraisal process, or other method for determining a member’s interest. Factors can include company assets, earnings, liabilities, market conditions, and applicable discounts. Establishing a valuation procedure in advance can help reduce disputes during a buyout.
