All About Membership Interest Purchase Agreements
A Membership Interest Purchase Agreement (MIPA) is a legally binding contract to acquire membership interests in a limited liability company (LLC). In simpler terms, it is an agreement between an owner of an LLC and a prospective buyer whereby the seller agrees to sell their ownership stake in the LLC to the buyer. An MIPA is a legally binding contract and can be drafted to protect the seller and the buyer.
The buyer typically purchases the membership interests to assume percentage of ownership, and the seller will be paid either immediately or delayed. Depending upon the terms of the agreement, if certain conditions are not met, the payment might not occur and/or the transaction will be voided .
Why would I need a Membership Interest Purchase Agreement?
SELLER PROTECTION: The MIPA will typically require payment in full if the buyer (or a related party) violates any of the agreements and certifications. An MIPA should be drafted strictly in order to protect the membership interest (i.e. business) from any future risk.
BUYER PROTECTION: If the membership is being sold to a third party, it is important that there are method for removal of the seller if the LLC has problems or a drop in value. (Section 13g of N.C. General Statute § 57D-6-03 must be followed and a 2/3 vote must be conducted to remove a member).
Essential Components of a Membership Interest Purchase Agreement
At its essence, a Membership Interest Purchase Agreement is a simple device by which one member of an entity transfers its membership interest to another entity or person. However, there are a variety of other terms and conditions that are usually included in a Membership Interest Purchase Agreement, such as the purchase price for the membership interest (which can be paid in cash, tangible or intangible property or services); representations and warranties made by the buyer and seller of each other or matter; covenants or promises made by the parties; conditions to closing; and indemnification provisions in favor of or against the seller or buyer.
The Advantages of a Membership Interest Purchase Agreement
Membership Interest Purchase Agreements provide a number of advantages for both parties to the transaction. They help protect the interests of sellers and buyers through establishing expectations and standards that must be adhered to. In addition, having a written agreement helps eliminate confusion and provides clarity throughout the entire process.
The Members often include language representing that no lawsuits or judgments adversely impact the owner’s ability to sell membership interests. These can take many forms such as bankruptcies or court proceedings that can affect ownership. Membership Interest Purchase Agreements also typically require the seller to provide copies of all documents relating to the company. The seller and any authorized signatories may be asked to represent that the company’s organizational documents and any other related documents are accurate, complete and in good standing.
It is imperative that any Membership Interest Purchase Agreement includes a due diligence period, where the buyer has the right to review all of the documents relating to the company before the deal is signed. Once a membership interest agreement has been signed, there are often many conditions that have to be satisfied and it is important to know what they are. For example, if a seller has to prove he/she is not part of a bankruptcy proceeding, these conditions can sometimes be confusing and difficult to identify. It is critical to know exactly under what circumstances a buyer can walk away from the deal.
Having a Membership Interest Purchase Agreement in place can also streamline the sale process and make the transaction faster and more efficient. This is because the agreement can ensure that both sides are on the same page while also eliminating any problems that can create delays. There can be major issues with the internal structures of some LLCs that need to be clarified to make the sale go smoothly. If a company has not been operating under the proper statutory formalities, such as holding organizational meetings that their operating agreement requires, this can result in some serious problems.
By including a Membership Interest Purchase Agreement as part of the transaction, the parties will have the protection of having the law in their corner, as well as the certainty they need when going through the sale process.
Ultimately, utilizing a Membership Interest Purchase Agreement allows both the buyer and seller to avoid headaches and complications, ensuring that the transaction proceeds smoothly.
Common Membership Interest Purchase Agreement Clauses
A Membership Interest Purchase Agreement (MIPA) comprises various key clauses that address specific contingencies and build the foundational elements of the transaction. These clauses serve to protect the interests of each party during and after the transaction. Some of the standard clauses are discussed below.
Confidentiality Agreement
Generally, a confidentiality provision will require the seller to avoid disclosing any information about the company: including its current business activities and business plans — to third-parties without the written consent of the buyer. It can also apply to the buyer by requiring it to keep confidential any information regarding the company that is not already publicly available.
If, however, one of the parties has agreed to share trade secrets with the other, it should also provide a term that identifies what is and is not considered a trade secret for purposes of the agreement. If there are any disclosures of the other party’s business secrets by either party, its affected by such a breach may seek either a temporary or permanent injunction, as well as other equitable relief from the court to prevent further disclosures. In some cases, the damaged party may also pursue damages remedial actions such as compensation for lost profits.
Non-Compete Clause
Buyers will frequently seek a covenant from the seller to compete against the business for a set period of time in exchange for the purchase price. A non-compete clause typically lasts for two years but could last longer depending on negotiations. In setting the duration, courts look at factors such as the time needed to train a person to run the business, the non-compete’s radius of prohibitions, and the harms to the party that continues competing once the respective non-compete period has expired.
Dispute Resolution Provision
One way to resolve potential disputes between the parties is through an Arbitration/Mediation clause which will require all parties to submit conflicts to arbitration before pursuing any other legal action. Mediation involves a neutral third-party who attempts to resolve a conflict while arbitration relies on an arbitrator to issue a binding decision. In New York, for example, a successful mediation will produce a settlement agreement with the assistance of a mediator; while arbitration is typically held similarly to a trial, except the process is more informal.
An arbitration will allow the parties to get a quick resolution to the conflict. In arbitration, a three-step process can be used to encourage settlement of the dispute, including: (1) exchange of pleadings and a hearing, (2) a hearing, and (3) a decision (if the case is not resolved prior to a hearing).
How to Draft a Membership Interest Purchase Agreement
When it comes to drafting a membership interest purchase agreement, you want to ensure that the document is comprehensive and legally binding. A step-by-step guide to drafting this type of document includes:
- Structuring of the document. The document should be structured to reflect the intentions of the parties, but it also needs to comply with the laws that govern your state. By having a lawyer look over the document, you make sure that it is all-encompassing and legally binding, protecting you from future liability.
- Clarity in your obligations. You will need to clearly state what your obligations are to the other party and what the other party’s obligations are to you.
- Payment of money. The purchase price will need to be clearly stated, including any warranty bonds or other financial instruments that will be included in the transaction.
- Information pertaining to the membership. You will need to state what the legal structure of the business is (in most instances, a limited liability company), and you will need to state who the parties are , including if family members or friends will also be joining.
- Closing. The closing info should already be in your Articles of Organization. Also include on this document a statement of when the effective time of the closing is, as well as when the transfer of the membership interest will occur.
- Other terms. This can include such provisions as representations or warranties, indemnities, remedies, general release, governing law and severability.
- Signatures. As with most contracts, a membership interest purchase agreement must be signed by both parties and witnessed by a lawyer and a notary public.
What attorneys do?
When it comes to drafting a membership interest purchase agreement, it’s a good idea to have an attorney look it over. He or she will ask questions such as the tax benefits that are involved with the purchase, if you will want protected assets and land, how to divide the income fairly, if ownership needs to be transferred in a specific way and if the minority interest of the company will be purchased separately.
Membership Interest or Share Purchase: The Distinction
A purchase of a membership interest is quite different than a purchase of shares in a corporation. A membership interest is not stock, and it does not represent an ownership interest in a formal corporation. An LLC does not have shareholders. Rather, members (an owner of an interest in a limited liability company) own units of "membership interest" in the LLC.
Membership interests do not confer any direct right to control or manage a limited liability company. By statute, the members of a limited liability company delegate powers to manage the business and affairs of the limited liability company to a group or person that is designated as "managers" under the operating agreement. If there is no written agreement, the managers are the members, and the consent of all members is required.
As a practical matter, however, purchasers of membership interests often are able to control a limited liability company. One reason is that a purchaser will be required to sign a new operating agreement if he or she buys more than a nominal interest in an LLC. The purchase often will lead to a renegotiation of its governance provisions, with the preference by members who are seeking to maintain control of the LLC, and by members who are seeking to obtain that control.
At times, this process can lead to an impasse. In that case, the law provides a remedy that is inconsistent with routine corporate law practice. In most states, the courts are given authority at the request of any member to dissolve a limited liability company if it appears that the LLC is "so conducted that it is reasonably practicable to carry on the business to the advantage of the members."
An LLC is similar to a general partnership in another important respect: An LLC purchase lacks most of the protections for purchasers of interests in a corporation. For example, unless the LLC file has been converted to a corporation, California law provides no assurance that there are no bankruptcy judgments or court orders against the LLC. This is because the division of assets into separate membership interests is not decisive, unlike divisions into stock and preferences such as common or preferred stock.
The similarity between the general partnership and the LLC structures also is highlighted by the ability of judges to grant creditors the power to reach into an LLC to seize the interest of a recalcitrant or debtor member. This so-called "charging order" is the equivalent of the seizure of a general partner’s ownership or share of partnership assets by a creditor.
Another difference is that when someone purchases an interest in a limited liability company, the purchaser typically does not buy a pro-rata interest in the assets of the LLC. Delaware, for instance, has declared that the assets of an LLC do not belong to the LLC. Hence, the purchaser cannot simply show up and demand his or her proportionate share of the assets. In short, a buyer purchasing an interest in an LLC does not take the assets with him or her.
Perhaps the most important tax difference occurs when an LLC is electively taxed as a corporation under Sub Chapter C of the Internal Revenue Code. In that case, the sale of an interest in the LLC is taxed as the sale of shares in a corporation, and not the sale of a partnership interest as would normally be taxed. In the past, it was common for purchasers to prefer this tax treatment, because a corporation may set the price of its shares based on the opinion of one or more appraisers or accountants. A member of an LLC may have more trouble obtaining a fair appraisal of his or her interest in the LLC.
Terms to Avoid in Membership Interest Purchase Agreements
Membership Interest Purchase Agreements are unique in that they do not have the institutional knowledge of commonly used terms and clauses for various industries. As a result, it is mostly up to the parties, the parties’ attorneys, and a good MIPA commentary (covered here) to determine what is included and how a MIPA transaction will occur.
One pitfall is that the parties may feel pressured to close a deal before all the details of the MIPA are ironed out. This could cause problems because both parties may not be clear with what the MIPA actually entails and the MIPA could ultimately be based on faulty information. This is one of the reasons why it is best to consult an attorney in these types of transactions. An attorney’s expertise will assist in easily identifying issues that could cause problems down the road in the transaction.
Another pitfall is how a MIPA handles any disputes the parties may have over the MIPA. For example, if the buyer believes the seller committed fraud in the sale of the membership interest, the seller may disagree with the buyer. The MIPA should include a dispute resolution that not only handles what will happen if the buyer wins a lawsuit against the seller but also what will happen if the seller wins a lawsuit against the buyer. Without a dispute resolution clause that specifically lists what will occur, the parties could be left with no recourse for claiming the other party acted inappropriately.
Potential issues could occur if the MIPA is simply a boilerplate MIPA that has been changed a little bit for the current transaction. If the boilerplate MIPA does not have a specific provision for an issue that arises in the current transaction, it is possible for the parties to have a dispute that was unexpected, resulting in bad outcomes for both parties.
Closing Thoughts
It’s also important for the seller, for example, to ensure that all taxes and other outstanding payables are paid from the proceeds of the sale of your membership interest. Failing to do so can create problems down the road for the seller if debts are still outstanding.
In conclusion, it is important to keep in mind the following considerations when finalizing a Membership Interest Purchase Agreement: the risks of personal liability as a member , taking care to fulfill all obligations that a buyer or seller commits to in a Membership Interest Purchase Agreement, and the possibility of increased purchase price and problems after the deal closes depending on how the transaction unfolds.
Since the legalities of a Membership Interest Purchase Agreement can be rather complex, parties should seek the advice of an experienced attorney before entering into any agreements to sell or purchase membership interests.