Who manages a limited liability company: managers or members?
Issues to determine before formation
There are several essential questions that you must discuss with your small business attorney before forming a limited liability company. The focus of this article is on one of those questions: the management structure of limited liability companies. Members may manage the affairs of the company (member-managed LLC) or managers may manage the affairs of the company (manager-managed LLC). We will first review some of the other issues that the startup founders must consider before launching a business.
Naming the Company. The first issue is the name of the company. Make sure that you have thoroughly vetted the name before you tell your startup lawyer that you want to register a certain name.
Related article: Finding a Name for Your New Business
Jurisdiction for the new company. The next critical issue is the jurisdiction in which your small business will be formed. We will devote an entire blog post in the future to choosing the jurisdiction in which your small business will be organized.
The two general choices are the state in which the business is located, say Maryland or the District of Columbia (not exactly a state but we’ll call it a state for the purposes of this blog), or another jurisdiction such as Delaware, which may have some advantages for reasons that we will explore in an upcoming blog post.
How the business will be taxed. The other issue that the small business owner will have to consider is the tax treatment of the business. The company can be taxed as a corporation or as a partnership.
Forming a LLC: Partnership or S Corporation Taxation
Traps for the Unwary: LLC Taxed as S Corp
Management of LLCs.
The other major issue is who will manage the business. In general, a LLC is either “member-managed” or “manager-managed”. You just have to love the lawyer who came up with the terminology for limited liability companies. In most states and the District of Columbia, if you do not designate in the operating agreement which management structure you want, the company will be treated as a member-managed limited liability company.
The language in a particular state’s LLC act is usually similar to the District of Columbia Code: “A limited liability company shall be a member-managed limited liability company unless the operating agreement [e]xpressly provides that [t]he company is or will be ‘manager-managed.’” D.C. Code Sec. 29-804.07.
Related article: Negotiating LLC Operating Agreements
One of the fundamental differences between a LLC and a corporation is the governance of the company. A corporation governance structure is rigid. The owners who are called shareholders appoint the board of directors. The board of directors provides policy oversight for the company. The board appoints the corporate officers, who control the daily operations of the business.
A LLC is much more flexible, offering numerous governance structures depending on the needs of the particular startup. The LLC owners are called members, not shareholders or partners. If you think that these terms are confusing, you are not alone.
The members usually negotiate how the LLC will be governed and they memorialize their understanding in an agreement called a operating agreement or limited liability company agreement. You need to be careful because in every state LLC act, there are some terms that are mandatory and you cannot negotiate them away. In general, the management structure of a LLC depends on whether the LLC is member-managed or manager-managed.
A member-managed LLC is, not surprisingly, managed by its members. It looks a lot like a general partnership in which the partners share in the management and conduct of the company. The LLC members share the responsibility for the company’s operations. The members decide important issues by a majority vote.
A manager-managed LLC looks similar to a limited partnership. The manager may or may not necessarily be chosen from the membership ranks. The manager generally is responsible for the daily operations of the company. There are numerous approaches in how much latitude the members want to repose in the manager.
The operating agreement can be very specific about what authority the manager has and which decisions the members must vote on. There may be co-managers or even a board of managers that decide matters relating to the activities and affairs of the company.
Larger companies usually are manager-managed.
The larger the business, the more likely that the LLC will be managed by a manager. If the LLC has numerous members, then it can be unwieldy to have all of them involved in management. Members will delegate to a manager or managers authority for managing the daily affairs and activities of the company. The manager does not need to be a member of the LLC.
The members in a manager-managed LLC may have considerable authority for the operations of the company. For example, they may require a member vote on all transactions over $2500 or whatever threshold they want. That would mean that the manager would need member approval for these relatively small transactions. The members may simply be passive investors. In either event, the members retain authority for issues outside the ordinary course of the company’s activities, such as a merger or acquisition or dissolution of the company.
Related article: Dissolving a Small Business
Authority to bind the company.
Each member in a member-managed limited liability company can bind the company. As an example, if there are ten members, then each of the ten may sign a contract on behalf of the company. In a manager-managed limited liability company, the manager is the agent of the company with the power and authority to bind the company. The members do not have authority to bind the company unless they have been delegated specific authority.
Fiduciary duties imposed on those who manage the company.
This may sound like legalese but in practice who bears the fiduciary duty and the extent of that duty has practical implications. The members may in some states limit the duties imposed on those managing the company.
In general, members of a member-managed limited liability company owe to the company and the other members “fiduciary duties”. A manager has fiduciary duties to members and to the company in a manager-managed LLC. The extent of these duties varies widely from state to state. The extent to which the members may vary fiduciary duties in the operating agreement also differs widely.
Fiduciary duties usually include the duties of loyalty and care.
Fiduciary duties usually refer to the duties of loyalty and care, but the extent of these duties varies depending on the jurisdiction and whether the members have varied these duties in the operating agreement.
These duties are not trivial and are often overlooked by the founders or their small business lawyer. The duties of loyalty or care may require you to refer business opportunities to the company; or whether you have the right to compete with the company; whether you may engage in business with the LLC; what you need to disclose to other members of the LLC.
The duty of loyalty may include things like refraining from dealing with the company in the conduct of the company’s activities as or on behalf of a person having an interest adverse the company or refrain from competing with the company in the conduct of the company’s activities before the dissolution of the company.
If you are the manager in a manager-managed LLC or a member in member-managed LLC, you should know that you cannot use the LLC’s property for your personal use or if there is business opportunity presented that falls within the purpose of the LLC, you make have limitations on whether you can take it for yourself or whether you need to present it to the LLC and its members so that they can exploit it.
In certain jurisdictions, the members may not vary these obligations and duties. But in Delaware the members may agree to expand, restrict or eliminate any fiduciary duties, other than the implied contractual covenant of good faith and fair dealing.
Some states require a manager to discharge his or her duties in good faith with the care an ordinarily prudent person in a like position would exercise under the same circumstances, and in a manner that the manager reasonably believes is in the best interests of the company. Many small business owners do not recognize that they have this duty once they assume the mantle of manager in a small business.
Subject to the business judgment rule, the duty of care of a member of a member-managed limited liability company in the conduct of the company’s activities is to act with the care that a person in a like position would reasonably exercise under similar circumstances and in a manner the member reasonably believes to be in the best interests of the company. In discharging this duty, a member or manager may rely in good faith upon opinions, reports, statements, or other information provided by another person that the member reasonably believes is a competent and reliable source for the information.
Know what management structure suits your small business
Before you decide on forming your startup business, you should know what are the implications of choosing between a member-managed and manager-managed LLC. The duties imposed on the members or managers can be vastly different. You should consult with your startup lawyer and discuss with the other founders and investors before and not after your form your business.