When filing Articles of Organization with the Colorado Secretary of State to form a limited liability company (LLC), in the midst of providing various addresses, you are asked whether you would like to form your LLC as "member managed" or "manager managed." This organizational choice is much more complex than it appears at first and deserves careful consideration.FN1
In my experience, when a single individual or even a few people form an LLC without the assistance of experienced counsel, their LLC is typically created as a member-managed LLC. I imagine the thought process is something like this: “If the members are going to be making the management decisions anyway, why create a separate class of managers? Isn’t that a needless complication?”
This logic does make sense for some businesses. But, generally, it is advantageous for both single- and multi-member LLCs to be organized as manager-managed companies. Although there are also some drawbacks (e.g. generally, a more complicated operating agreement), on balance, it usually makes sense to form an LLC as manager managed and this is generally a safe default choice. In order to see why, it is important to first understand what these two options mean.
In a member-managed LLC, each member – or owner – is an agent of the LLC, no matter how much or little of the company is owned by that particular member. This gives each member the authority to make certain decisions related to the day-to-day activities of the company. For example, under the default rules of the Colorado Limited Liability Company Act (C.R.S. 7-80-101, et seq.), each member will be able to open bank accounts, make deposits, or take out lines of credit on behalf of the company. Each member will also be able to enter into company contracts, whether those contracts are for employees, contractors, office space, vendors, or anything else that the company may wish to contract for. Additionally, these agency powers allow the members to initiate or pursue lawsuits on behalf of the company.
Once the Articles of Organization are filed indicating that the LLC is member managed, any member of the company can legally bind it, create contracts, and otherwise act as an agent of the company.
Where there is more than one member in a member-managed LLC, certain management decisions will require the approval of members with more than a fifty (50) percent interest (a “majority interest”) in the company - and some decisions may require a higher threshold than that, up to the point of unanimous approval. How high the threshold is will depend either on the operating agreement or, if the operating agreement is silent on the issue, the Colorado LLC Act, but each member in a member-managed LLC will be allowed to participate and vote in these decisions. This all seems quite helpful for the functioning of the business, so what’s the problem?
The biggest concern when forming a member-managed LLC relates to the agency authority of its members. Specifically, once the Articles of Organization are filed indicating that the LLC is member managed, any member of the company can legally bind it, create contracts, and otherwise act as an agent of the company. This includes not only the original members, but also additional or substituted members.
Importantly, even if the company’s operating agreement attempts to limit the agency authority of its members, anyone who is unfamiliar with the terms of this agreement will be entitled to continue to treat its members as agents of the company. In other words, even though the operating agreement, for example, states that no member can pledge the company’s credit, a lender who is unaware of this provision will still be able to rely on the fact that the person taking on the debt is a member of a member-managed LLC and the company will be held liable for any debt the lender approves.
This is the concept of “apparent authority,” which has already been discussed in a previous entry, and it explains how even unauthorized members or partners in a business may nevertheless bind that business in certain ways. As a result, once an LLC is structured as member managed, the burden is on the company to make sure anyone who may potentially deal with that business understands the actual authority, whatever that may be, of the members, as agents, to bind the company. A company that fails to do so risks liabilities and obligations that it never intended to create.
The alternative is to form the LLC as manager managed. In a manager-managed LLC, as the name suggests, the management of the LLC is reserved to managers instead of the members. By opting to be manager managed, an LLC is able to adopt a more corporate structure and, as a result, improve the liability protection offered by the separate LLC form, at least in theory.
Just as shareholders of a corporation appoint directors, the members of a manager-managed LLC are able to designate managers in order to run the day-to-day activities of the company. But the members themselves do not manage the company or conduct its business.
As a result, in a manager-managed LLC, the managers, not the members, are the agents of the company and have the authority to bind the company and make management decisions. But note: just as shareholders retain the authority to make certain decisions – for example, whether to dissolve the entity or to merge with another – the members of a manager-managed LLC likewise retain authority over some decision making. The limits or extent of the authority retained by members may be defined by the LLC’s operating agreement.
The same person (or entity) may be both a member and a manager in a manager-managed LLC. This is why even a single person or a handful of business partners who all wish to participate in the management of the company can benefit from the manager-managed structure; any such person can be both a member and manager of the company, despite the fact that the company is organized so as to separate the ownership and management of the company.
A manager-managed LLC allows its members, as members, to be passive owners, much like equity investors of corporations or limited partnerships. That is, they provide capital to the company and are entitled to share in the profits in the form of distributions, but are not involved in the day-to-day decision making of the company. Those decisions belong to the managers, and this separation between management and ownership generally provides for less risk of liability for the company’s owners and helps to protect their personal assets. (But note: the limitation of liability and resulting protection of personal assets depends on more than the management structure selected in the Articles of Organization. Please see this previous entry for a fuller discussion of veil-piercing law in Colorado.)
The same person (or entity) may be both a member and a manager in a manager-managed LLC... despite the fact that the company is organized so as to separate the ownership and management of the company.
Although each manager has the authority to act as an agent of a company and, as a result, issues with apparent authority can still arise when a manager exceeds that authority, by separating that agency from ownership, it is easier to designate who and how many people have it. Accordingly, it is easier to control and limit issues with apparent authority in a manager-managed LLC than it is in a member-managed one.
The manager-managed structure also allows management to be limited to a only a few of individuals (or entities), regardless of whether the managers are also members or not. This allows for the hiring of professionals (for this full-time job), the development of expertise, and frees others from having to participate in the management of the company. This small group of managers is also able to respond more quickly to changes in the conditions that the business operates, whether economic or otherwise.
Furthermore, those acting in management, whether members or not, can – but do not have to – be compensated for their efforts and responsibilities as managers. Where compensation for managers is provided, those managers should be paid a reasonable salary and payroll taxes must be withheld. In certain cases there may be tax advantages for providing salaries to managers who are also members.
Your company’s operating agreement can broadly or narrowly define the roles and responsibilities of managers and members.FN2 In doing so, it is possible to modify, limit or expand the authority of managers and to have members retain more or less responsibility for company decision making. For example, member approval can be required to settle lawsuits or authorize large expenditures, particularly if those expenditures are part of an expansion of normal business activities.
It is also possible to have the authority of managers restricted to certain kinds of activities, much like officers in a corporation. In doing so, it is possible to grant the titles of officers to these persons who have management authority limited to certain types of actions or decisions.
Whichever way you go, it is important that your operating agreement is informed by the choice you’ve made in your Articles of Organization, since an operating agreement for a manager-managed LLC would not be a good fit for a member-managed LLC, and vice versa.
If your LLC does not have an operating agreement at all, or if it does not address a particular matter, the default rules of the Colorado LLC Act will apply. Generally, it is to a business's advantage to be able to specify, e.g., the roles and responsibilities of members and managers as well as how company decisions, like distributions, are made.
If you would like assistance with an operating agreement or the Articles of Organization, or would like to find out whether your operating agreement is tailored to the needs of your business, please Reach out, Today!