Getting offered an equity stake in a business feels good. Whether it’s a percentage of an LLC in exchange for your expertise, a sweat equity deal, or an investment in a friend’s venture, I see these arrangements all the time in my practice. Most people focus on the upside. What percentage am I getting? How much could this be worth?
Those are reasonable questions. But in my experience, the questions that actually protect people are different ones. Once you sign an operating agreement, you’re bound by what’s in it. The time to ask hard questions is before you sign, not after something goes wrong.
Here are five questions that you should understand before taking an equity stake in a venture:
1. Can the Majority Issue New Interests Without Your Consent?
In most LLCs, the majority of members or the manager has broad authority to admit new members and issue new interests. That means your 30% stake could suddenly be 20% without your approval. This is called dilution. Unless the operating agreement gives you preemptive rights (the right to buy your proportional share of any new issuance before it goes to outsiders), it can happen unilaterally. Ask whether preemptive rights are in the document. If they’re not, know that going in.
2. What Happens to Your Interest if You Leave or Are Asked to Leave?
This is where many people get hurt. Operating agreements often include forfeiture provisions, language that says if your employment or service relationship ends under certain circumstances, you lose your interest, sometimes with little or no compensation. Ask how your interest is valued if you’re bought out. Fair market value, determined by a qualified appraiser, is what you generally want to see.
3. What Do You Actually Get to Vote On?
In a manager-managed LLC, the most prevalent structure I see in small-business deals, members are often passive investors with limited voting rights. Most agreements give minority members almost no say in day-to-day decisions. That may be acceptable, but it’s worth knowing which decisions require your consent and which don’t. Key matters worth protecting in writing: changes to how profits are distributed, amendments to the operating agreement that affect your interests, and transactions between the company and the manager’s other businesses or family members.
4. Can You See the Financials?
You’d be surprised how often operating agreements are vague on this. A general right to “inspect the books” isn’t the same as receiving quarterly statements, annual tax returns, and K-1s on a fixed schedule. Ask for specific deadlines in writing. For a minority member with no management role, financial information is often the only window into what’s actually happening.
5. What’s Your Exit If You Need One?
Unless the operating agreement addresses it, there may be no clean way out. Tag-along rights let you sell alongside a majority member if they sell their stake. A right of first offer gives you the chance to buy out a departing member before they sell to a third party. Without these provisions, you may be locked in indefinitely, even if the relationship breaks down.
The Bayer Bottom Line:
- The operating agreement is the law between the parties. Get the answers before you sign!
- Dilution can happen without your consent unless preemptive rights are in writing
- Forfeiture provisions can leave you with little or nothing; fair market value is the standard to ask for
- Most voting rights in manager-managed LLCs are limited; identify what’s protected
- Financial reporting deadlines should be specific, not general
- Without tag-along or exit rights, you may have no way out