What Is An LLC Subscription Agreement?
A subscription agreement is a form of a contract that individuals interested in purchasing LLC membership units may use when subscribing to an LLC. LLC subscription agreements govern the rights of individuals regarding their ownership of membership units, along with the required contributions of funds or services and the distribution of LLC profits. In this way, they are similar to , yet different from, corporation subscription agreements which are used for corporations selling stock. LLC subscription agreements are not always necessary depending on what is otherwise required or provided for in other LLC documents, such as an operating agreement or members agreement but may be used as another tool to ensure that all parties understand their rights and obligations.
Essential Elements of an LLC Subscription Agreement
Typically, a Florida LLC subscription agreement will set forth the terms of the subscription for membership interest into a limited liability company. While the content may differ depending on the agreement and parties, some key components are standard:
General Information and Description of Membership Interest. To start, the subscription agreement for a LLC shall identify the parties, as well as its background. The agreement will likely have the following provisions:
Violation of the federal securities laws.
Registration under the federal securities laws.
Status of investor.
Subscription Price. Along with identifying the parties to the LLC subscription agreement and describing its relationship, it will likely set forth how much the subscriber will pay for the membership interest.
Rights and Obligations of Parties. The subscription agreement shall typically include any terms related to membership interest, such as how it will relate to other members and the rights and obligations if any situation arises that requires a distribution.
Representations and Warranties.
The LLC subscription agreement will likely set forth the representations and warranties of the subscriber and the LLC, covering (but not limited to):
Management of the LLC.
Typically, a LLC subscription agreement will provide for:
Confidentiality.
Lastly, the LLC subscription agreement will usually have a confidentiality requirement, which will prevent the parties from disclosing any proprietary information related to the limited liability agreement.
Advantages of LLC Subscription Agreements
Subscription agreements are an invaluable tool for limited liability companies (LLCs) looking to bring on new investors or issue additional equity. These agreements establish an organized framework for the conduct of equity offerings, serving as an effective means of delimiting and outlining the various rights and obligations associated with a transaction.
One of the primary benefits of subscription agreements is that they guide the terms and conditions of an investment by spelling out the nature of the financial transaction in detail. The document often goes beyond the basic outlines stated in LLC operating agreements, which are not specifically tailored to the needs of investors looking to structure their involvement under a different set of terms.
These agreements are especially useful in the context of a private placement because they have the effect of protecting the interests of companies and investors alike. For instance, an investor entering into a subscription agreement will often be subject to various restrictions on transfer, ownership and resale of the interests being acquired. This serves to safeguard the company from an influx of new owners, and can also be valuable in protecting the ongoing interests of existing members.
The protection of interests is twofold. Just as a company can use these agreements to protect itself from outside investors, an investor can protect themselves from the company through a subscription agreement. For example, many subscription agreements will contain representations and warranties on the part of the company, an assurance that certain facts presented to the investor are substantially true.
These agreements are highly customizable — for example, investors will sometimes agree to provide personal, multi-year guarantees to the company when it comes to future actions, serving to provide the LLC with a further layer of protection.
Crafting an Effective LLC Subscription Agreement
In drafting LLC subscription agreements there are few primary considerations. First, you must understand the company’s goals in issuing membership interests. Second, you must decide whether the agreement will sit on a shelf until there is a new investor or if it will be used every time there is a new investment. The former is often called a "blanket" subscription agreement. Lastly, you must determine who will sign the agreement. For example, only the investor can sign a subscription agreement. But – if this is not a blanket subscription agreement – who will counter-sign? It depends on the structure of the LLC and who in the management has authority to bind the LLC. If the LLC is manager-managed, then the manager (or its designated officers) will counter-sign. If the LLC is member-managed, that generally means all members are involved with the day-to-day affairs. In that case, you’ll need to determine who in the group has the authority to enter into the agreement.
As with most agreements, you should draft a subscription agreement in anticipation of any litigation. Given a subscription agreement is a securities-type offering, certain general anti-fraud language is needed. However, if an offering is being made only to accredited investors, much of those general disclosures required by the Securities and Exchange Commission can be eliminated. But non-accredited investors do have special protections, so you should be careful about dangling a carrot in front of them – even if you are not subject to the Act.
When drafting it, you’ll need to predict what type of information the investors want regarding the LLC. If the offering is being made online, for example, you’ll need to include that information in your offering materials. On the rarest of occasions you may have to exclude someone from investing because of "bad actor" provisions in the securities laws. However, in general terms only accredited investors are permitted to participate in an investment in your LLC.
Legal Aspects of LLC Subscription Agreements
Beneath the surface of what appears to be a straightforward purchase of an interest in an LLC is a complicated web of legal implications. Unless the value of the units or interest of the LLC is very small, the offer and sale of a limited liability membership interest will almost always be considered a "security" and be subject to federal and state securities laws and regulations.
State Securities Laws
Most states, like federal law, require that any offer and/or sale of securities be registered with the state securities authorities and be preceded by a disclosure document, or "prospectus." In fact, many states impose even stricter standards upon issuers of securities than the federal government. Thus, an offer and sale of membership interests to residents of many states may need to comply with the laws of those states.
The determination of whether an interest in an established venture such as an LLC qualifies as a "security" is often the subject of litigation. It depends, among other things, on the expectations of the economic return which will be provided by the investment in the entity, the involvement of the members in managing the enterprise and the level of risk attendant to the purchase of the interest. The federal Securities and Exchange Commission has developed a variety of tests to determine if a membership interest is a "security" and which, thus, trigger certain federal disclosure and registration requirements.
Federal Securities Laws
Section 5 of the federal Securities Act of 1933 (the "Securities Act") provides, among other things , that no security shall be offered or sold after the first sale unless a registration statement is in effect as to that security, or an exemption from registration is available. Section 2(3) of the Securities Act states that the term "sale" includes every contract of sale, contract to sell and every disposition of a security or interest in securities for value. Thus, under the statute each of the offers of membership interest in an LLC is a "sale" and, absent an exemption, should also be undertaken pursuant to a prospectus which is registered under the Securities Act. A similar provision is found in Section 802.01 of the Ohio Revised Code which states that every sale of securities in the State of Ohio must be registered prior to its sale.
No one wants to spend a large sum of money to acquire interests in a limited liability entity, only to discover very soon thereafter that stated earnings were in fact non-existent or improperly stated. States want to protect their citizens from unsafe securities transactions. Thus, because the investment in the limited liability entity is almost certainly a "security" transaction, that transaction will trigger application of Ohio’s Securities regulations under chapter 1707 of the Ohio Revised Code.
This is an area filled with liabilities. Directors and officers have individual and corporate exposure to liability for violation of securities law. Understanding the law and building it into the way the operation of the enterprise is structured are ways in which these individuals can reduce their risks.
Subscription Agreement Pitfalls and Prevention Tactics
A common error made in connection with LLC subscription agreements is signing the agreement as the wrong entity, as an individual instead of an entity, as an entity that is not the ultimate owner, or as an entity with no real ownership interest in the business and no real expectation of control. Assuming that an individual is signing on their own behalf, a subscription issuer may be unaware of other entities that share common ownership with that signatory and the possibility that the subscription agreement can be signed by parties that might have minority interests and might not have a sufficient level of control of the business to create any liabilities or protections for that issuer.
Further, an issuer may be unaware that a subscription signatory does not have the proper authority to bind the entity on which the membership interest is being purchased. The limitations on an entity’s authority can be found in the operating agreement, bylaws, formation documents and other governing documents or internal rules of the entity. In many cases, those limitations can be ignored if the entity with limited authority has taken steps to ratify or approve the transaction to limit the liability of any parties to the transaction.
Many issues can be avoided by requiring a certification from the signatory, known as a subscription representative, that the signatory agrees to the terms of the subscription agreement and is sufficiently familiar with the issuer’s business so that the subscription representative can fairly assess the risks relating to the subscription agreement and associated investment. Many issuers and investors may also be protected by a "sovereign wealth fund" clause in the subscription agreement, in which case an investor commonly accepts that it will be acquiring a security attached to certain rights of an interest in an entity exempt from compliance under the securities laws.
While liability may be limited to a single class of membership interests, difficulties can arise if a subscription issuer forgets to issue another class or fails to adequately disclose the difference between the classes of membership. If the subscription issuer has issued multiple classes of affiliated interests or has issued interests that are converted equity awards, the subscription agreement may require detailed disclosure of the rights attached to each of the classes and a clear description of any conversion rights.
As a condition to closing, it is critical for an issuer to obtain a "registered status" with the Internal Revenue Service, rather than relying on a prospective registration. Issuers can also negotiate the timing for funding of the subscriptions, including a possible escrow of the subscription funds until a minimum amount of subscriptions or a minimum number of subscriptions have been received.
Similarly, issuer can limit liability under the subscription by including a "basket" amount or "tipping" basket for multiple breaches of representations made in connection with the subscription agreement, or by limiting damages to the return of funds paid by the investor in connection with the subscription.
Wrap Up: Significance of Thoughtful Planning
Whether a limited liability company subscription agreement is used to regulate the economic rights or the governance rights of the members, careful planning is always required. Given the complexity and importance of the issues arising from limited liability company subscription agreements, and the fact that many practitioners do not regularly deal with limited liability company subscription agreements, we will often engage in a detailed discussion with our client about the issues addressed by a subscription agreement, and the relevant provisions in their existing operating agreements, governing instruments, purchase and sale agreements, and shareholder agreements .
As a result, we have developed a set of templates for subscription agreements, and negotiate and structure make-ready forms for each transaction before drafting a subscription agreement.
Needless to say, given the atypical nature of these transactions, expert legal advice is essential.