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Should We Create a Corporation or an LLC? – From a Minority Owner’s Point of View

When starting a new company, your first decision is often whether to create a corporation, or an LLC.  Unfortunately, this election is frequently made without fully understanding how this decision impacts the rights of minority owners, either positively or negatively.  And without knowing what this impact means, it is impossible to realize why this issue is even important.

Taking this lack of information one step further, new business owners many times elect not to spend the money on having a qualified attorney draft a shareholders’ agreement (corporation) or operating agreement (LLC) once the company is actually formed.  Or, worse, they find a form on the internet to use.  (These forms are often well written for their intended purpose, but are simply not a one-size-fits-all solution.)

In both instances, there exists a failure to appreciate the ramifications of not making a fully informed decision, which is then put into effect by a well-written agreement.

What do I mean?  For starters, the difference between creating a corporation versus an LLC is different for majority and minority owners.  From the viewpoint of a minority owner, the difference can be critical.  In a corporation, if you decide you “want out” of the company, a shareholders’ agreement typically addresses whether, and to whom, you may sell your shares.  But what if there is no buyer, and you simply do not want to be an owner any more?  In that case, you must essentially prove fault, or what’s known as shareholder oppression.  In such an instance in New Jersey, if “oppression” (mistreatment) can be proven, a minority shareholder often has the right to be bought out of the corporation at fair market value.  However, this right is not automatic, and a shareholder cannot simply seek to be bought out without some compelling reason, usually fault on the part of the majority shareholders.

In a New Jersey LLC, however, the ability to be bought out of the company depends entirely on what the operating agreement says or does not say.  If there is no operating agreement, or if there is one that does not prohibit withdrawal, then any member may withdraw and be paid for his shares without having to prove oppression or any type of mistreatment.  An apt analogy is the difference between a no-fault divorce (in an LLC), and one where you have to prove some type of fault (in a corporation).  But, if the operating agreement says no member may withdraw, then the right does not exist.

This distinction is often surprising to clients who have never had it explained to them before.  While a member with a twenty percent interest may be thrilled to find out that he merely has to write a withdrawal letter, to create a right to be paid for his shares, the LLC itself is often not quite so happy to find this out.  What if a member wants to exercise his or her right to withdraw, but the LLC cannot afford to pay for his interest?  If it is ordered to do so by a court, what happens?  How can the company find itself in this situation?

If the founders had sought legal counsel about these and other issues when forming the company, these issues could have been dealt with, taking into account the interests of all the owners.  Crisis-induced decisions are usually less than ideal in almost all situations.

In my next post, I will discuss the distinction between corporations and LLC’s from the point of view of majority owners, as opposed to minority owners.  As explained above,  without a written agreement of any kind, a minority owner may benefit from using an LLC, since his right to withdraw will exist intact.  However, in my next post, I will explain how, with majority owners, the opposite may be true.  Without a written agreement of any kind, majority owners just may be better off using the form of a corporation, rather than that of an LLC.