Written By: Hank Jackson
Businesses are started every day through a variety of legal mechanisms — sometimes lawyers assist the owners in creating the business entity, and other times the owners do it themselves. In Florida, there are currently more than 1.4 million active limited liability companies (LLCs) registered with the Department of State, making it by far the predominate form of business entity.[1] Most of these LLCs are believed to be closely held — meaning they have relatively few owners and are not publicly traded.[2]
As could be expected, once initiated such businesses do not prove everlasting. The causes for owners’ conflicts are numerous — often resulting in intractable disagreements over the control and direction of the company. Such conflicts are commonly referred to as “business divorces.” Similar to a marital divorce, collectively owned property must either be divided or possibly kept intact to maintain its highest value. There are different paths to reach final resolution, which ranges from presuit negotiated settlements to formal court-imposed remedies under Florida’s Revised Limited Liability Company Act (Florida’s LLC statute).[3]
The Rationale for LLCs
Publicly traded corporations were designed to have their ownership interests easily and freely traded through an open market platform, such as the New York Stock Exchange. Over time, they have become heavily regulated by the Securities Act of 1933, Securities Exchange Act of 1934, and the Sarbanes-Oxley Act of 2002, which were enacted to protect the public from misleading statements, material omissions, and improper accounting concerning these companies.
The advent of LLCs came much later in time. Florida first legislatively authorized LLCs in 1982.[4] At that time, LLCs were created to provide tax benefits like a partnership and limited liability like a corporation.[5] However, as also explained by the Florida Supreme Court, LLCs are characterized by restrictions and limitations on “the transfer of ownership rights” and “the transfer of management rights.”[6] It is these restrictions regarding ownership and management that make closely held LLCs desirable to own while at the same time making their business divorces more challenging.[7]
Does an Operating Agreement Exist?
Analysis of a business divorce begins with determining whether the owners (members)[8] have an operating agreement governing their relationship or will rely, by default, on the provisions of Florida’s LLC statute. Importantly, a writing is not required to find that the owners have an operating agreement. As defined by Florida’s LLC statute, an “operating agreement,” whether specifically referred to as an operating agreement or not, may be “oral, implied, in a record, or in any combination thereof.”[9] That said, companies choosing to have an operating agreement normally do so through a formal written document titled, “Operating Agreement,” which is executed by the members and contains a provision stating that it can only be modified in writing. This prevents a potentially fact-intensive threshold controversy — whether an oral or implied operating agreement exists or whether a previously written operating agreement has been orally or impliedly modified.
• Absence of an Operating Agreement — Florida’s LLC statute does not require an LLC to have an operating agreement of any type — written, oral, or implied.[10] Similar to couples marrying without a prenuptial agreement or people dying without a will, LLCs without an operating agreement will be governed solely by the default operating rules and procedures as set out in Florida’s LLC statute. Businesses that often lack an operating agreement include those owned by family members or the more modern versions of closely held businesses — such as college roommates starting a tech company from their dorm room or their parents’ garage. Indeed, the nature of the relationship between the owners or the lack of funds for professional legal advice may lead to the absence of an operating agreement. Like other types of divorces, the owners in closely held businesses sometimes fail to plan at the beginning of the relationship for what happens at its end.
• Operating Agreement Exists — Florida’s LLC statute clearly contemplates that the members of LLCs may enter into an operating agreement to govern the terms of their legal relationship.[11] Some companies have standard boilerplate operating agreements downloaded from the internet. Others have industry-specific, lawyer-drawn or highly negotiated operating agreements. Regardless, an operating agreement brings the force of contract law to bear in determining the owners’ relationship.[12] There are exceptions to this freedom to contract. There are rights and duties, as will be discussed, that are so fundamental that Florida’s LLC statute prohibits them from being waived or modified by an operating agreement.[13] Operating agreements typically include specific provisions governing issues of ownership, control, transfer of interests, and valuation. Indeed, it is the ability to customize such provisions to particular types of businesses, owners, and circumstances that makes the operating agreement such a useful tool.
Operating and Financial Records
Distrust is frequently a factor in a business divorce. As an initial step toward resolution, owners will want to assure themselves that they have accurate information about the company’s operations and finances. The cliché “knowledge is power” rings true here and is recognized in Florida’s LLC statute, which mandates that members are entitled to certain operations and financial information and that such entitlement cannot be waived through the terms of an operating agreement.[14]
This includes the absolute right, without the need to show relevance or materiality, to basic company information, including the company’s list of members, incorporation documents, then-effective operating agreements, the three most recent years of tax returns, the three most recent years of financial statements and records reflecting the amount of cash and agreed value of property or other benefits contributed and agreed to be contributed by each member.[15] These represent core documents to which all members in all circumstances are entitled.
Additionally, members are entitled by Florida’s LLC statute to an even broader scope of information regarding the company’s activities, affairs, and financial condition to the extent such information is “material to the member’s rights and duties”[16] or “reasonably related to the member’s interest.”[17] What company information may be material or related varies depending on the dispute and circumstances in each case. Sometimes members can easily identify the specific information that is material or related — other times members are so far removed from the company’s management that they have difficulty knowing where to begin. The company’s financial and accounting records are most always a good place to start — especially where issues of either mismanagement or valuation of a member’s interest are involved.
The company’s financial and accounting information is probably entered, kept, and organized through an accounting software program. It is often wise for a member or a member’s attorney to hire an accountant to assist in formulating specific requests, obtaining the information in usable form, and reviewing and analyzing the information ultimately provided. Without the proper accounting software and understanding of its full functionality, a member’s ability to obtain and analyze the company’s financial and accounting information can be substantially hindered. An expert accountant consulted in the beginning of the process can save a member significant time and money in the long run.
If the company refuses to allow a member access to material and related information, Florida’s LLC statute accords them the right to compel access through court intervention.[18] If the court orders access, the court “shall” also order the company to pay the costs, including reasonable attorneys’ fees incurred by the member to obtain the order.[19] A court may have difficultly (at least initially) determining which party is the more aggrieved — similar to a messy marital divorce. But it is comparatively easy for a court to decide that a substantial amount of the company’s operational and financial information should be shared with its owners and to award attorneys’ fees against those that obstructed such sharing.
Not surprisingly, the first step of sharing information can be so beneficial to the owners in understanding and evaluating the conflict that it sometimes leads to an early resolution of the business divorce.
Transfer and Valuation of an Owner’s Interest
As mentioned earlier, the restrictions on the transfer of an owner’s interest is one of the hallmarks of an LLC. Unless an operating agreement states otherwise, a member can transfer their purely economic interest in the company, but the transferee may not participate in the company’s management or have access to records and information relating to the company’s activities and affairs.[20] The inability to transfer management and information rights substantially impacts the worth of the interest and the number of potential buyers for such an interest. Simply stated, the transfer restrictions make it harder to sell the member’s interest. However, looking at the transfer limitations from the perspective of the remaining members, the restrictions are a key advantage to a closely held business. They prevent an outsider from gaining control or influence over the company — an outsider that the other members never agreed should become an owner.
That said, the members, through an operating agreement, can either slightly tweak or greatly modify the default rules that limit the transferring of interests.[21] For example, they can require all members to agree to every type of transfer, permit transfers of full interests, specify to whom transfers can be made, set the timing as to when transfers may occur, determine the value to be paid for interests, or otherwise customize the transfer requirements to fit the specific business, people, and circumstances involved. Some common operating provisions regarding transfer of interests are called buy-sell provisions.
Buy-Sell Provisions: Offer Determines Value
A buy-sell provision is an agreement (often within the operating agreement) that an owner’s interest can be transferred under certain specified conditions. Such conditions include to whom the interest can be transferred and how the price is determined. One type of buy-sell provision states that the price for the full interest is determined at the time of an initial offer by the offer’s terms. In essence, it is the offer itself that determines the price.
• Traditional Buy-Sell — The traditional buy-sell is such a provision. It is frequently employed when there are two members, each owning 50% of the company, and it is particularly useful when a company is in deadlock, i.e., the owners cannot agree on how to manage the company. It allows one member to initiate a narrowly termed offer to buy the other member’s entire interest for a sum determined by the offeror. Upon receiving the offer from the initiating member (offeror), the member receiving the offer (offeree) has only two options: 1) accept the offer — meaning sell the entire interest for the sum stated in the offer, or 2) actually purchase the offeror’s interest from the offeror for the identical price. Most traditional buy-sells require a short time, such as 30 days, for the offeree to accept the offer or agree to buy the offeror’s interest for the same price. If the offeree fails to act within the proscribed time period, the offeree is deemed to accept the offer by default. Under such a process, the transfer occurs quickly.
• Right of First Refusal — The right of first refusal is a typical buy-sell provision used when there are several owners of an LLC. It provides that a member who has obtained a bona-fide offer from a third party to buy the member’s interest must first provide the company and the other members the opportunity to purchase at the same price. If the company and the other members refuse such offer, then the interest can be sold to the third party. This type of buy-sell presupposes that a third party may be willing to buy an interest in an existing closely held company. This may or may not be realistic depending on the type of business and the relationship (if any) between the third party and the other members.
• Right of First Offer— The right of first offer is the opposite of the right of first refusal. Pursuant to this buy-sell provision, a member wanting to sell must first offer to sell to the company and existing members. If the company and the other members do not accept the offer, then the selling member may, within a limited time, sell the interest for the same price to a third party. Similar to the right of first refusal, it may be improbable that a third party would be willing to buy into a closely held business.
Buy-sell provisions where the price is set by the offeror at the time of the offer are not ideal for all businesses. It may work well when it is easy to assess the value of a company’s assets, such as a company holding real property or an established manufacturing business. However, in the context of complex businesses or service companies — such as where the members are also paid employees, like accountants or physicians, serving particular patients or customers — these types of provisions may not be apt.[22]
Buy-Sell Provisions: Financials or Appraisals Determine Value
The owners can also agree to buy-sell provisions that value members’ interests based on the company’s recent financials or current professional appraisals. These can provide more intricate valuations than simply letting the offer itself set the price.
The company’s financials can be used to value a member’s interest through applying a predetermined formula to the company’s recent financials. An easy illustration is a basic earnings multiplier formula: The company’s total value is determined by multiplying its annual earnings in the most recent year-end income statement by a multiplier, which often ranges from one to 25 depending on the particular business and industry. The value of the member’s interest is then determined by multiplying their percentage ownership by the company’s total value. Notwithstanding this simple example, valuations based on the company’s financials can be much more detailed and complex, if needed, depending upon the type of business, the nature of the company’s assets and liabilities, and even the events prompting the transfer. Because of these differences, the ability to customize this type of buy-sell provision in the operating agreement is particularly critical. Also key, this type of valuation process relies on having accurate company financials, which is not always a certainty in some closely held businesses.
The owners may also agree to value members’ interests through a third-party professional appraisal as of the date of the transfer. Although seemingly straightforward and arguably more precise, contentious issues can still arise: the specific appraiser to be used, whether each side can pick their own appraiser, the information the appraisers have access to, the method utilized in the appraisal, and discrepancies between appraisals. Unlike valuation based on a predetermined formula, appraisals are subject to considerable variation. As with the other types of valuation, its applicability and usefulness depend on the nature of the business and its assets.
Importantly, these types of buy-sells (using recent financials or current appraisals to determine value) will still need to specify to whom and under what circumstances the interests can be transferred. Transfers may be limited to other members or family of the transferring member. And transfers may be limited to or even required based on the occurrence of certain events, such as a member’s termination of employment with the company, incapacity, or death.
In summary, the range of buy-sell provisions that can be included in an operating agreement are as broad as the types of industries, kinds of business owners, and the business acumen of the lawyers representing the owners.[23] Sometimes such provisions assist in the business divorce process. Other times, they become the subject of a contested contract dispute based on the terms and interpretation of the operating agreement.
Default Procedures and Remedies Under Florida’s LLC Statute
If the owners have not agreed on how interests can be transferred in the event of a business divorce, then the default rules under Florida’s LLC statute will govern.
• Voluntary Dissociation by an Owner — Florida’s LLC statute grants a member, unless stated otherwise in the operating agreement,[24] the power to withdraw from the company by notifying the company of their express will to do so.[25] The withdrawal or dissociation is effective without regard to whether there are sufficient grounds to do so.[26] The determination of whether the dissociation was rightful or wrongful is ultimately determined after the fact of dissociation. Pursuant to Florida’s LLC statute, dissociation is wrongful when done in breach of an express provision of the operating agreement or if it occurs before the company is wound up.[27]
The benefit to a member voluntarily dissociating under Florida’s LLC statute (whether rightly or wrongly) is that the member no longer owes fiduciary duties of loyalty and care to the company or other members regarding matters occurring after disassociation.[28] This can create a helpful legal separation from the company and other members, but that separation comes at a cost. Voluntary dissociation reduces the member’s interest to purely an economic one. The member retains the right to interim distributions if the other members decide to make such distributions.[29] However, the disassociated member loses the right to participate in the management and conduct of the company’s activities and affairs.[30] Additionally, if the disassociated member in fact withdrew wrongly, the member is liable to the company and other members for any damages caused by the wrongful dissociation.[31]
• Involuntary Dissociation (Expelling) of an Owner— In addition to a member volunteering to disassociate, the other members can involuntarily dissociate or expel a member. The operating agreement can state what events cause a member to be so dissociated.[32] Also, Florida’s LLC statute contains default provisions (unless otherwise prohibited by the operating agreement) that set out the conditions under which a member is involuntary dissociated. Some of these conditions involve changes in the member’s capacity or status, such as death or incapacity of a member who is an individual, or the termination or dissolution of a member that is an entity.[33]
Other grounds for involuntary dissociation center on the unlawfulness of operating the company with a particular member participating or the improper conduct of a member. Florida’s LLC statute provides that a member may be involuntarily dissociated through unanimous consent of the other members together with the fact it would be unlawful to carry on the business with the person remaining as a member.[34] Additionally, Florida’s LLC statute states a member or the company may bring a direct action against a member that can result in expulsion based upon the member having 1) engaged in wrongful conduct adversely affecting the company; 2) willfully or persistently breached the operating agreement or the fiduciary duties of loyalty and care; or 3) engaged in conduct making it not reasonably practicable to carry on the company with the member part of the company.[35] All these grounds are to some extent subject to a trial judge resolving issues of fact and interpretation.
As an example, in Zell v. White, No. 18-CA-182, WL 8106054 (Fla. 13th Cir. 2019), a Florida circuit court found that a member, Mr. White, had withdrawn $100,000 from the LLC’s account without authorization and kept it for his personal use. The judge concluded that Mr. White’s misconduct damaged the LLC and made it “not reasonably practicable to carry on the businesses with Mr. White as a member.” Relying on Florida’s LLC statute, the court ordered Mr. White expelled as a member.[36] Then, the court went further holding that Mr. White’s misconduct was sufficient to dissolve the LLC and ordered that Mr. Zell, the remaining member, manage the business and affairs of the LLC until final dissolution.[37]
Importantly, unless the operating agreement provides otherwise, involuntary dissociation — like voluntary dissociation — does not extinguish the member’s purely economic interest, but only strips the member of management and informational rights.[38] While the same misconduct that supports a member’s expulsion, as was the case in Zeller v. White, may support dissolution, this is not always the case. Additionally, dissolution is not always the best approach for the members (including the expelled member) to divest the expelled member’s economic interest. This is a situation where an operating agreement can be particularly helpful.
Merger and Appraisal Rights
Members owning a majority-in-interest of the company, absent a provision in the operating agreement to the contrary, can force a sale of the company through merging the company with another entity. Under Florida’s LLC statute, a plan of merger requires the approval of members holding a majority-in-interest in the company.[39] The company can be merged (sold) to an unrelated third party or merged into an existing or newly created entity that is also owned by the majority-in-interest member(s). Merging into a company also owned by the majority-in-interest member(s) is commonly referred to as a “squeeze-out merger.”[40]
When the majority-in-interest member(s) approve a merger, the objecting members who own minority interests are entitled to the “fair value” of their interests — statutory appraisal rights.[41] Fair value is defined as the “customary and current valuation concepts generally employed for similar businesses.”[42] In determining fair value, the interests are not to be discounted for the fact that they are not otherwise marketable or make up only a minority interest.[43] This makes sense considering that these members owning minority interests did not volunteer to give up their interests or participate in any unlawful or improper conduct toward the company or other members.
Procedurally, how is fair value determined? The company offers the minority member what the company contends is fair value.[44] If a minority member is dissatisfied with the offer, the member must make a demand stating what they believe is fair value.[45] If the company does not accept the minority member’s demand, then the company “shall” commence a court proceeding requesting the court to determine the fair value.[46] A trial, typically with competing expert appraisers opining on the fair value of the member’s interest, is then held.
A “squeeze-out merger” can be an efficient mechanism to effectuate a business divorce. Also, through an operating agreement, all the members can agree if there is a merger to waive their statutory appraisal rights in favor of an alternative valuation technique.[47] However, it is important to remember that waiver of appraisal rights and use of an alternative valuation method may not be completely unfettered. Some level of reasonableness should be maintained. As mentioned earlier, fiduciary duties of loyalty and care of members and managers cannot be unreasonably restricted in an operating agreement.[48]
Grounds for Dissolution of the Company
A more drastic measure in business divorces is dissolution. The grounds for dissolution can be set out in the operating agreement.[49] Also, a member or manager of an LLC may seek judicially imposed dissolution under Florida’s LLC statute based on any one of five grounds.[50] These five grounds, which cannot be eliminated or varied by the operating agreement, are the following:[51] 1) The conduct of the company’s activities and affairs is unlawful; 2) it is not reasonably practicable to carry on the company’s activities in conformity with the company’s articles of organization and the operating agreement; 3) the managers or members in control of the company have acted, are acting or are reasonably believed to act illegally or fraudulently; 4) the company’s assets are being misappropriated or wasted causing injury to the company or its members; and 5) the managers or members are deadlocked in management of the company and irreparable injury to the company is threatened or being suffered.
These grounds for judicial dissolution require a member or manager to make serious factual allegations, which are likely to be vigorously contested. Indeed, if all the members agreed to dissolve, the company could more easily be dissolved through a simple unanimous vote, without the need for judicial intervention.[52] Requesting a judicially imposed dissolution of a company, like involuntary judicial dissociation of a member, is a bold step that may intensify the acrimony in a business divorce.
Powers of the Courts in Dissolution
Seeking judicially imposed dissolution under Florida’s LLC statute has the effect of immediately giving substantial control of the company to the courts. Once a dissolution proceeding is brought, the court’s powers become expansive — not limited to merely requiring or not requiring the members to dissolve the company. As a result, requesting dissolution is not an advisable technique to simply pressure other members to come to the negotiating table.
In particular, Florida’s LLC statute empowers a court, once a dissolution proceeding has begun, to quickly issue injunctions, appoint a receiver or custodian pendente lite and take other actions necessary to protect the company’s assets.[53] Additionally, upon a showing of sufficient merit, the court has the power to appoint a receiver to actually run the business (not just protect its assets), to initiate and defend lawsuits on its behalf, and to dispose of all or part of its assets.[54] This also includes the court’s power to order the receiver to be compensated from the company’s assets.[55] The court’s powers even include a broad catchall — if there is good cause, it may employ other remedies that it “deems appropriate in its discretion.”[56]
Election Rights Created by Seeking Dissolution
Requesting dissolution can also be a procedural trap for the unwary. A member filing a petition for judicial dissolution immediately creates statutory election rights for the company or the other members (if they choose) to purchase the petitioning member’s interest. Florida’s LLC statute provides that the company or the other members can elect to purchase the petitioner’s entire interest in the company for its “fair value.”[57]
Such an election, if made, must be filed with the court within 90 days after the petition for dissolution is filed.[58] Then, after the election, if the parties cannot agree to the fair value of the petitioner’s interest, the court will make that determination and direct the purchase upon the terms and conditions it deems appropriate.[59] Also exemplifying the petitioning member’s loss of control, once a petition for dissolution is filed and an election to purchase is filed, the petitioner may not discontinue or settle the dissolution proceeding, or sell or dispose of the interest in the company, without obtaining court approval.[60] And such court approval is to be based upon what is equitable to the company and the other members — not the petitioning member.[61]
As previously discussed, the major benefit of a closely held business is that the owners maintain control of the business. Seeking judicial dissolution puts that control at risk for all the members — especially the petitioning member. It may be wise for the parties to consider a negotiated settlement before instituting potentially expensive and uncertain litigation.
Pre-Suit Mediation
Pre-suit mediation (in essence voluntary settlement negotiations with the assistance of a neutral third party) can frequently resolve disputes in closely held businesses. In addition to thorny transfer of interests and valuation issues involved in a business divorce, there are emotional aspects. Such emotional aspects are practically never resolved and are often exacerbated in the public, confrontational litigation process. The format and flexibility of mediation allows the parties to express and address in confidence sensitive, difficult matters. Even if presuit mediation does not resolve the entire dispute, it may serve to either narrow the issues or create a framework for eventual final resolution.
Conclusion
The increased pace of closely held businesses starting and terminating will likely continue. Consequently, the need for business divorces will also accelerate. Business divorce disputes are as varied as the types of businesses and the owners’ personalities. The topics raised in this article are not meant to be conclusive or all-encompassing — instead, they are a starting point. As a reminder, it is particularly important in the context of closely held businesses that owner disagreements do not deteriorate into the destruction of a valuable business.
Florida Bar Journal – May/June 2021 Issue; By: Hank Jackson is board certified in business litigation and focuses on representing business owners and executives in closely held business break-ups and separations. He is also a certified civil court mediator, which broadens his skills in bringing potential solutions to contentious business disputes. Jackson is a partner with Shutts & Bowen LLP.