Different Membership Classes Can Help Meet LLC Financing Needs
In an orchestra, not every violinist plays the same music. There are first violin and second violin parts. Although these are labeled “first” and “second,” in a professional orchestra, every violinist performs at a high level. Neither the first nor second violin section is “better” than the other.
Rather, the two violin parts traditionally have different functions. The first violin part focuses on the melody and plays more on the upper registers (tonal range) of the instrument. The second violin part provides musical texture and rhythm.
Although the second violin section serves in a supporting role, the second violin part is essential to the music. Without it, the melody’s color might sound different and the music might lack rhythmic stability.
Separate classes a limited liability company (LLC) are like the different violin sections in an orchestra. The owners of all classes of units are LLC members.
The LLC classes may be called Class 1 and Class 2, but neither is better than the other. But, like the different violin sections, different classes of units in an LLC serve different purposes. And like the different violin sections, together, all the classes of units in an LLC comprise a unified equity financing structure, which increases the stability of the investment.
What are Classes of Units?
Equity classes aren’t a new thing. For hundreds of years, corporations and their predecessors have used different classes of stock, most commonly called “preferred” and “common.”
It’s not a surprise that after LLCs first were created in 1977 that people would want to replicate the corporate ownership structure in the new LLC format. Today, section 18-302 of the Delaware Limited Liability Company Act expressly allows the LLC agreement to provide for different classes of members. Maryland’s Limited Liability Company Act less clearly allows separate classes of units by stating that an LLC agreement may describe the ”manner in which the members will share in the assets and earnings” of the LLC.
Often, especially in real estate investments, an LLC will have two classes of ownership–one for those who make equity contributions to the LLC and a second for the manager, who is responsible for LLC operations. Since the Great Recession, many LLCs have added a third “preferred” class of units, which functions like short-term debt.
This article discusses the typical classes of LLC units and how they work together to create a more stable equity structure. Although the classes of units may have different tax benefits and burdens, that is beyond the scope of this article.
Before the Great Recession, many companies and real estate investments were heavily leveraged with 90% or more of the acquisition costs being financed with debt. Although leverage can help investors to make a higher return on their investment, it also can make it difficult for the investment to survive an economic downturn.
Due to this high leverage, when the 2008 economic crisis hit, many real estate investors found themselves “under water,” with their debt exceeding the value of the real estate. This made foreclosure an attractive option. Mezzanine lenders and second mortgage holders, who had provided debt subordinated to first mortgage holders, frequently weren’t paid.
Companies that provided mezzanine and second mortgage debt were in financial trouble. And heavily leveraged companies facing reducing revenues found themselves unable to make debt payments, resulting in bankruptcies.
The financial community responded by reducing the leverage allowed in new investments. Use of second mortgages and mezzanine debt reduced dramatically. However, investors continued to want the high returns that can come from highly leveraged investments.
At the same time, interest rates plummeted as the Federal Reserve lowered rates to incentivize economic recovery and growth. Debt investors accustomed to receiving a good return from bank certificates of deposit and bonds faced a drastic reduction in their income.
They were looking for a way to increase their returns. Some were willing to assume more risk to accomplish that. These debt investors and real estate investors seeking a replacement for mezzanine debt both addressed their needs through preferred equity in LLCs.
Preferred membership units in an LLC typically have the following rights:
Are subordinate to secured debt, such as mortgage debt, as well as unsecured debts.
Receive a preferred return, which is a percentage of the capital account. This return is similar to interest from mezzanine debt
Receive the preferred return payment and frequently also, return of their capital investment, before other members receive a return.
Do not have voting rights.
Units usually are redeemed when their capital is returned. Therefore, they are shorter-term investments than other classes.
Sometimes are guaranteed regular monthly or quarter payments of the preferred return.
Common units are subordinate to preferred units. They have more control, more risk, and the possibility of a greater gain–or loss–than the preferred units. Common membership units in an LLC typically have the following rights:
Are subordinate to debt and preferred units.
Usually receive return of capital after the preferred unit holders but before the manager’s interest receives payment.
Are not considered redeemed when their capital is returned.
Shares in any profits the company makes after paying debt and the preferred unit holders.
Usually have voting rights at least for major decisions, such as removal of the manager and sometimes whether to buy, sell, or refinance assets.
Manager Carried Interest
Day-to-day LLC operations may be managed by an LLC manager. In an investment, the manager frequently is the party that put the investment together.
The manager may receive a fixed management fee or a percentage of the revenues or net operating income. However, those fees incentivize short-term performance at the expense of long-term profitability.
Therefore, many managers receive a class of membership units which compensates the manager if the LLC produces a favorable long-term return for the members. This manager’s class, also called a “carried interest,” will be included in the LLC’s operating agreement. Sometimes, it is described as a separate class of units. Other times, the manager is given certain rights to gains or profits without those rights being classified as a class of membership.
Regardless of how it is described, the manager’s class usually has the following rights:
Subordinated to all debt and preferred units, either directly or through a clawback. Also frequently is subordinated to the common members’ right to receive any preferred return and a return of their capital contribution.
Receives a percentage of profits/gains after the preferred and common members receive return of their capital. Frequently, the manager’s units and common units will split all profits/gains above specific benchmarks.
Makes no cash capital contribution and is considered to have zero value when awarded. Future value based upon LLC performance is speculative. Depending on the structure, the manager may obtain long-term capital gain tax treatment for manager unit payments.
The LLC may have to compensate the manager for the value of its units if the manager is removed. This disincentivizes the members from terminating the manager after years of excellent performance to eliminate the manager’s right to share in long-term gains/profits.
Usually has no voting rights. However, the LLC operating agreement may give the manager significant decision-making authority as manager.
Flexibility in Structuring
Although most orchestra pieces have two violin parts, composers have flexibility to write the parts necessary to meet their needs. Occasionally, there are third violin parts. Frequently, these supplement the viola part. Other times, the first and second violin parts may have a “divisi,” where half of the section plays one part and the other part plays another. And sometimes, the first and second violin parts play the same notes.
Although preferred, common, and manager’s units are the most common structures, most state laws allow LLCs to structure equity to meet their business’ needs. Just as a composer orchestrates a musical piece to match the composer’s vision, people forming an LLC for a business should work with an experienced business attorney to help them create an operating agreement to accommodate their plans.
© 2019 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality
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