What is an LLC Subscription Agreement?
An LLC subscription agreement is meant to be a relatively short and direct agreement that terms the investment made into a limited liability company. The LLC subscription agreement does this by stating the terms of the investment and the investor’s obligations. For example, the LLC subscription agreement can require the investor to pay their subscription amount in cash or property. Further, it can also include terms that help both sides such as requiring the investor to sign additional documents for state formation of the LLCs or providing them additional shares if certain milestones are achieved. Another important issue that many people overlook is that the LLC subscription agreement also allows an LLC to raise funds over time. To do so , the LLC can simply accept the signature pages to its subscription agreement and provide copies of the company’s operating agreement to the investor. This is far easier and much more seamless than having to go through and having an attorney prepare a stand-alone subscription agreement for each sale of units. The subscription agreement is also significantly more flexible than a securities purchase agreement even though it performs similar purposes. For instance, an LLC can use the same subscription agreement even if the units to be purchased by the other party differ significantly from the other party.
Core Elements to a Subscription Agreement
Subscription Agreements have four main components: basic information about the investor, the amount of the investment, basic information about the company, and the type of securities involved.
First, the LLC subscription agreement will request basic information from the investor. This is done for a couple reasons. First, it helps the company determine that the person who is making the investment is an accredited investor. Second, it helps the company ensure that the underlying agreement, which is a Form D, is filled out correctly. Third, it provides the company with basic information if it needs to reach out to the investor in the future, like (on the chance that certain social media outlets have been discontinued) e-mail address.
Second, the LLC subscription agreement will request information regarding the investment itself. Most of the time, this is the number of units, the price per unit and the total amount of the investment. This is also one of the ways that a company can gauge the success of its fundraising efforts.
Third, the LLC subscription agreement will have a section that includes information regarding the company itself. Typically this is the name and address of the company. In addition, it sometimes can include the name of any key executives, the name of the management company if there is one, and the date and location of the meeting of the board of directors or managers in which they authorized this funding round.
Fourth, the LLC subscription agreement will include information on what type of securities the investor is buying. There are generally four different forms of securities: common units, preferred units, convertible units and profits interest.
Why LLC Subscription Agreements are Important
The importance of LLC subscription agreements cannot be downplayed. Subscriptions are where the magic really happens for an LLC, as both the investor and the company receive value in a way that works for both parties (as compared to, say, a loan). To be clear, we do not mean "magic" as in something that appears without any effort. We mean "magic" as in "pyrotechnics," as far as company and investor are concerned. When properly drafted, the LLC subscription agreement is the document that, among other things, creates an obligation on the new member to perform its obligations under the LLC documents, and provides the individual and corporate members with an ironclad right to receive distributions from the Company.
When it comes time for the LLC to pay out profits, assuming there are any, a properly drafted subscription is key to ensuring that the company receives the funds that were agreed upon at the formation stage, while also hitting its own financing goals and maintaining its own compliance with tax, securities, and other applicable rules.
And that brings us back full circle to where we started. Because the subscription agreement can be applied to many different situations as described in our previous section, the drafting and negotiating process is essential. Investing can be hard work, and the subscription process shouldn’t be, but getting off on the right foot by adhering to clear drafting standards is essential to ensuring that the company gets its investment and the investor gets the benefit of his or her bargain.
How to Prepare an Effective LLC Subscription Agreement
Drafting a sound LLC subscription agreement can benefit both limited liability companies and their members by ensuring a legally binding, fair, and comprehensive process for dealing with membership applications and payments. An attorney should be consulted for any of these clauses, and the following is a summary of common provisions included in a subscription agreement:
Pre-requisites: Subscription agreements often include provisions that a member has read and agrees to abide by the terms of the LLC’s operating agreement and has the authority to enter into an agreement. A member also usually must submit to a background and credit check.
Payment of Fees: Legal counsel should draft provisions regarding the payment of fees in various situations, including the initial and future application and membership fees. It is common for these fees to be non-refundable if the applicant is not accepted for membership, but refundable if a member’s application to withdraw from the LLC is accepted. The agreement may indicate whether payment is required in one lump sum or whether they may be made in installments and how refunds are issued, if any.
Restrictive Covenants: The agreement may restrict a member’s ability to transfer its interests or to compete with the company during or after membership in the LLC. These and other restrictions may remain in effect for a set period of time or indefinitely.
Release of Claims: Many subscription agreements contain clauses wherein the member acknowledges its understanding that by agreeing to the terms of the LLC, it waives certain rights and releases the company from liability for various things, such as claims of discrimination or other violations of applicable laws.
What to Watch Out For
LLC subscription agreements can be straightforward documents that outline capital contributions and percent interests, but there are a few common pitfalls and issues that every business owner should keep in mind to avoid complications, provide clarity, and guide future decision-making. The following are a few of the most frequent issues I have seen come-up when dealing with LLC subscription agreements, along with tips on how to avoid these pitfalls in your own documents.
Notice that in my list of common issues, the word "negotiated" does not appear (although it is certainly a common issue as well). I did not include this category because I have found that "negotiation issues" primarily arise when the parties fail to accomplish the primary goal of an LLC subscription agreement, which is to provide a clear contract at the outset that can guide the parties in the future. In other words, negotiation issues are typically caused by an unclear or contradictory agreement, and can usually be avoided through careful planning and drafting.
With respect to LLC subscription agreements, these common pitfalls can lead to confusion in the future in the event a member seeks to withdraw, a new member seeks to join the LLC, or in the event of a change in control among the owners . They may also result in a dispute between LLC members or between the LLC and outside creditors. In a worst-case scenario, an improperly negotiated LLC subscription agreement can even result in a court finding that an individual or entity is not even an LLC member, and thus has no rights to the LLC’s assets or company information.
Likewise, many of these issues are easily avoided by providing for an alternative method of calculating capital contributions and percent interests under certain conditions. Think of each example I provided above, and then think of who else (other than the contributors themselves) would be the best person to make that call in the future. Under nearly all circumstances, a calm and level-headed liquidation committee would be better at determining an appropriate valuation of the LLC than two warring LLC members who can’t agree on the color of the curtains, let alone the value of a minority interest in a closely-held company.
Each LLC subscription agreement is different based upon the facts and circumstances of the members that comprise the LLC, and every LLC should consider working with an attorney to draft an agreement that fairly reflects their own business needs.
Other Legal Factors and Considerations
An area that often raises a number of potential issues is the legal obligations associated with LLC subscription agreements. Primarily, the association of the subscription agreement with securities laws ought to be considered if the LLC is selling interests to one or more investors. With respect to such private placements of LLC interests, there are a panoply of rules and regulations that the offering must comply with. These range from certain antifraud provisions to other provisions included in several different federal securities laws. Of course, each of these rules have their own tests as to when they are satisfied and a full discussion of these requirements is outside the scope of this article. Nevertheless, all interested parties are advised to consult with an attorney, accountant and/or other appropriate professional for further assistance with respect to these requirements, as failure to follow them can yield dire consequences, up to and including personal liability. With respect to state laws, each state has its own regulatory requirements for sales of membership interests. Each state law has their own test (or tests) as to when they apply, and therefore, it is important to consider whether such state filings and disclosures are required prior to being able to offer the subscriptions.
Conclusion: Best Practices
Businesses utilizing subscription agreements can adopt a few best practices for ensuring legal security, facilitating investment and promoting good investor relations. Ensure Quality Control. A well-drafted subscription agreement is the foundation of a successful investment in an LLC. We recommend having all your subscription agreements drafted or reviewed by an attorney before presenting them to existing and potential investors. Be transparent. Present indirect compensation opportunities such as finder’s fees to your investors in a clear and direct manner. Clearly outline the process that you or a third party will use to determine whether the investor is "accredited", if that is required for the subscription . Even if the money gets into your coffers, the investor’s due diligence may reveal after the fact that you did not take all the steps you should have taken to determine whether your non-accredited investors were accredited, opening yourself up to personal liability. Protect Your Investors. Subscription agreements should always include a risk factor sheet or acknowledgment acknowledging that the investment being made is risky and is not suitable for all investors. You also want a separate acknowledgement that the consideration (investment) is illiquid and cannot be converted to cash. Update Your Investors. Amendment to a subscription agreement can include an increase in the amount of money being raised. However, a minority of amended subscription agreements permits members to convert debt into equity. In situations where a conversion option is available, it is important to provide adequate notices in writing.