LLP Agreements and Shareholders' Agreements: "same same but different"?

One of many decisions facing founders of new businesses is the choice of legal entity. In the UK, where the founders are individuals who will also be involved in running the business (rather than just providing capital), it may be a case of deciding between a private company limited by shares (which we’ll refer to simply as a company) and a limited liability partnership (LLP). The decision hinges on various distinguishing features of companies and LLPs, which necessarily mean that there are differences in the arrangements.

Still, at the highest level, the commercial objective remains the same irrespective of the entity chosen: a vehicle through which to run the business. It might then seem to follow naturally that the same commercial principles governing ownership and operations should apply whether a company or an LLP is chosen. In particular, someone more familiar with companies and shareholders’ agreements might be inclined to apply the principles used in shareholders’ agreements to LLP agreements (LLPAs).

At a helicopter-view level, this is true. But, applying the same concepts (especially ones that apply to shareholders’ agreements between non-individuals) without modification can lead to a number of pitfalls. This, rather than the more general differences between companies and LLPs, is the focus of this note.

Why are LLPAs different to shareholders’ agreements?

Shareholder arrangements are, fundamentally, about ownership. A person may be a shareholder, a director and an employee, but the latter two are distinct roles that can be separated from that person’s role as a shareholder.

LLP membership (the term members, rather than partners, is used in the context of LLPs) is a broader concept; in the case of individuals involved in running the business, it entails elements of ownership (akin to a shareholder), governance (akin to a director) and operations (akin to an employee), but unlike a company, the functions are typically combined into the single concept of LLP membership. Separating the functions is far more complex.

The result is that an LLPA is not just the equivalent of a shareholders’ agreement, but also incorporates elements of employment contracts and articles of association.

Why does that matter?

Consider profit sharing arrangements as a starting point.

In a company, an individual may be remunerated as an employee or a director and, separately, also hold shares and receive dividends.

Where LLP members are involved in working in the business (which is usually the case, and whom we’ll refer to as working members), their economic entitlement may be thought of as covering both concepts:

• an amount more akin to remuneration, and
• an amount more akin to holding shares in a company.

Where a working member has a right to a minimum amount paid out periodically (often referred to as priority distributions), this clearly falls into the former category (being an amount that would otherwise be salary if he or she were an employee). Other amounts will naturally fall to be profit shares. But in the middle there is a grey area: could some payments be construed as remuneration for performance akin to a bonus (ie they are contingent on services being provided to the business), or are they profit shares that are not connected to services provided?

This has a number of consequences for:

• transfers of membership interests to third parties
• permitted transfers to family members and trusts
• tag-along and drag-along rights, and
• rights on retirement or removal.

Transfers to third parties

A typical shareholders’ agreement (or articles of association) might permit share transfers subject to certain restrictions (like rights of first refusal and, perhaps, lock-up periods).

In an LLPA, if working members transfer their interests, what are they transferring? Which aspect of their profit sharing entitlement is contingent upon continued service, and which is not? Typically, a non-founder’s entire interest is predicated upon that member continuing to work in the business, so a transfer would be akin to transferring employment-related rights - in other words, an anomalous concept. A founder (or more senior member) may be considered to have interests that also represent an interest in goodwill built up over time - and so not intrinsically linked to continued service - but even here a transfer by a founder to a third party may not make sense if the LLP’s value relies on that founder’s involvement in the business.

For these reasons, LLP interests are often non-transferable save in the case of a joint (or super-majority) decision of the founders or senior members to transfer LLP interests together. This allows minority stakes to be sold to third party investors (which is often seen in LLPs), but is often also accompanied by a drag-along right to ensure that all LLP interests in the LLP can be sold as a whole.

Permitted transfers

Shareholders’ agreements (or articles of association) often include the right for individual shareholders to transfer interests to permitted transferees, like family members or trusts, without restriction. Again, a transfer of rights that are necessarily connected to services provided (as well as potential complexities relating to the tax treatment of profit allocations made to that transferee) is typically not permitted as a matter of course, and any such estate planning would then only be carried out on a consensual basis agreed at the relevant time.

Tag-along and drag-along rights

Where tag-along rights or drag-along rights do apply, the LLPA must carefully stipulate how each tag-along or drag-along member’s interest is valued. For example, if a junior working member has a right to income profits, but not capital profits or rights on a winding-up, then he or she should not share in the capital value of the business in the way that a shareholder would do in a company. Instead, it may still be prudent to include a drag-along right to ensure that all of the membership interests in the LLP can be sold together, but the amount payable should be compensation equivalent to the amount the member would receive on account of his or her interest in income profits for the relevant year as a leaver, but not a share of the capital value of the business.

Rights on retirement

In a company, ceasing to be an employee or director does not necessarily mean that a shareholding is relinquished (although it can be, such as in the case of employee incentivisation plans).

For working members of an LLP, ceasing to work in the business typically means ceasing to be a member. But what does this mean for long-standing members who have helped to build up goodwill in the business? Is it, for example, inequitable for such a member not to benefit from the proceeds of an exit (sale) that occurs shortly after he or she ceases to be a member (and was a “good leaver”)?

A possible solution is for that member to remain as a “silent” member, with a specified economic interest over a “tail” period of a few years. This might only include the right to participate in capital profits (in other words, share in the proceeds of a sale of the business) but can also include a right to share in income (ordinary trading) profits for a specified period. These rights are often expressed to reduce over time, to reflect the gradual reduction in the significance of the former member’s previous contributions to the business as time progresses.

The exact mechanisms invariably require careful commercial thought. It may never be possible to cater for every eventuality, but incorporating concepts similar to these are one way to contend with the idiosyncrasies of the hybrid owner-and-worker LLP membership model.

Tl;dr (too long; didn’t read)

LLPs may ultimately serve the same purpose as companies - vehicles through which a business is operated - but key differences between the two mean that some elements of the commercial deal unavoidably operate differently. This can result in pitfalls for the unwary (or those more familiar with companies and who are working with LLPs for the first time, or vice versa), but careful consideration of the parties’ commercial intentions can ensure that appropriate arrangements are agreed, irrespective of the legal entity chosen.