When forming a new company, your first step is to determine the type of business entity that best suits your needs. For many startups and entrepreneurs, this analysis results in the choice of a limited liability company (LLC). LLCs offer the liability protection of corporations and the managerial flexibility of partnerships; and as a result, they are suitable for a broad range of different types of business ventures.
However, once you determine that an LLC is the best choice for your new business, you are not ready to simply download an operating agreement online and file articles of organization to form an LLC in your local jurisdiction. There are other questions you need to answer as well. One of these questions, which we have discussed previously is: Which state should you choose to form your LLC? At this point, you also need to decide, should you form a member-managed or a manager-managed LLC?
Member-Managed vs. Manager-Managed LLCs
In the context of an LLC, “management” refers to exercising control over significant decisions impacting the company as a whole and directing the day-to-day operations of the LLC. When you form an LLC, your operating agreement should include clear delegation of management responsibilities, as battles for control amongst co-founders and co-owners (referred to as “members”) are among the top reasons why startups fall apart despite having significant market potential.
1. Member-Managed LLCs
In a member-managed LLC, each of the members participates in the company’s management. The members typically each have an equal say, and operating agreements for member-managed LLCs with an even number of members will typically include provisions for breaking ties when the members fall equally on both sides of an important decision.
The member-managed approach works best with LLCs that have small numbers of members who are all actively involved in the business and who generally have the same vision for the company’s trajectory. Each co-founder plays a role in determining the company’s fortunes; and as a result, it is generally harder to point the finger at any one member in the event that something goes wrong. On the other hand, making decisions can be more difficult when everyone has an equal say, and disagreements can often get in the way of moving the company forward.
2. Manager-Managed LLCs
In a manager-managed LLC, certain appointed individuals (referred to as “managers”) assume responsibility for the company’s affairs. An LLC can have one or more managers, and these managers may or may not be members. The manager-managed structure is essential for large LLCs in which joint decision-making by all members would be impractical, and it can serve to improve and streamline the companies operations in various other circumstances as well.
For example, suppose that two co-founders form an LLC together. One founder is a top-notch programmer who spends his or her days coding on a laptop, and the other is a business school graduate who previously co-founded and sold a successful startup. In this situation, it may make sense for the business school graduate to have sole responsibility for the LLC’s management, while the experienced programmer remains dedicated to building the product that the company will eventually sell. Of course, this is an overly-simplified example, and each individual may bring different insights and skill sets to the table; but if both co-founders agree that their roles should be different, then the manager-managed model may be their best option.
The manager-managed model is also generally best when the co-founders are planning to seek (or have already obtained) outside investment. Equity investors will need to have membership interests in the LLC, but their ownership should be passive (in other words, they should be set up as silent investors). In a member-managed LLC, this is not an option. However, in a manager-managed LLC, one or more co-founders can manage the company while silent investors have non-managerial ownership rights. In some cases, potential investors may also prefer to see that decision-making authority has been delegated to a team of leaders rather than being spread among an entire team of company founders.
A third situation in which a manager-managed LLC may be the more-desirable model is where the company’s members wish to hire an outside executive. This is an approach that many startup founders choose to take when seeking to bring their products to market or attempting to grow beyond the initial startup phase. Regardless of whether the hired executive acquires an ownership stake in the business, structuring the company as a manager-managed LLC will be essential to making this arrangement work.
Considerations for Forming Member-Managed and Manager-Managed LLCs
When deciding between the member-managed and manager-managed LLC models, company founders should carefully assess each of the relevant considerations in light of the general concepts discussed above. In order to make their decision, company founders will want to answer questions such as:
- How many members will the company have initially? The less members your LLC has, the more likely it is that the member-managed model will be a viable option. When too many owners have a say in company-level decisions, there is a greater potential for the decision-making process to become unmanageable.
- Are all co-founders qualified to make decisions affecting the direction of the company? If some co-founders are putting in sweat equity while others are bringing operational or managerial experience to the table, this is a situation where the manager-managed model may be palatable to everyone involved.
- Are some co-founders willing to relinquish management rights? The potential for disagreements about company structure and management is one of the primary reasons why company founders should work with an attorney and not rely on the standard LLC forms that are available online. If some co-founders are willing to relinquish management rights, this can make the company formation process easier; but if everyone is intent on running the company, then some difficult decisions will need to be made.
- Are disagreements among co-founders likely to lead to roadblocks or confrontations? If you and your co-founders have a history of butting heads, this could mean that you are all equally passionate about your startup’s success. But it could also mean that you are likely to have problems making joint decisions down the line. A certain amount of disagreement can be good, but too much can get in the way of getting business done.
- Are you planning to pursue outside equity investment? If you are planning to seek outside investment and you have chosen the LLC structure over the corporate structure, you will need to form a manager-managed LLC. The member-managed mode will not work for you or your passive investors, and restructuring your LLC from a member-managed company to a manager-managed company later will involve unnecessary time and expense.
In any case, choosing between a member-managed LLC and a manager-managed LLC is not a decision to be taken lightly. Co-founders should think critically about their long-term goals, and they should focus on choosing the management model that best services the needs of their business venture.
Speak with an Experienced Business Lawyer about Your LLC
At Jiah Kim & Associates, we help company founders make informed decisions and prepare custom legal documents that protect our clients’ immediate and long-term interests. If you would like more information about how to choose between a member-managed or manager-managed LLC, we encourage you to call (646) 389-5065 or contact us online to schedule an initial consultation.
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.