Managing a company without having to take responsibility for your assets? This is possible with a limited liability company (LLC) and this is the reason that many business owners in the US choose this legal structure. We explain what an LLC is, its hierarchy, as well as naming some of the advantages and disadvantages of this kind of business structure.
A limited liability company’s assets and an unlimited company’s assets involve capital provided by its shareholders. However, under certain circumstances, additional capital deposits may be required. The obligation to make a supplementary payment is set out, where appropriate, in a company’s operating agreement.
Additional capital contributions: a brief definition
Like a limited company, the limited liability company has share capital provided by all of its shareholders pro-rata. The same applies to a private limited company (LTD). An investor will make a capital contribution as set out in an operating agreement. Members agree to make payments to the company at the rate and time specified in the agreement. But sometimes an LLC may require urgent cash to stay afloat or finance an acquisition. To cover these costs, LLC operating agreements will often include a clause on additional capital contributions. When a company requires additional funding, it may issue a capital call.
A capital call is a request issued by an LLC for additional funds from its shareholders.
Types of initial capital contributions
There are initial and additional capital contributions. LLC owners can usually secure initial capital contributions in the following ways:
- Equity investment: When a person or business invests money into your LLC in the form of equity, they will usually receive a stake in your business in return. It is often a preferred type of initial capital investment because LLC owners will not be required to pay back the money whether their business succeeds or not. At the same time, the addition of a qualified investor may also add a knowledgeable partner to the business.
- Debt investment: Debt investments are essentially loans. Investors and business owners will usually agree on an interest rate and time frame during which they will be required to pay back any investments made.
- Convertible debt investment: Convertible debt investments are a combination of equity and debt investments. LLC owners can accept a loan investment that can later be converted to an equity stake in the company.
Failure to make an initial capital contribution could result in a penalty or forfeiture of a shareholder’s stake in the LLC. However, whether the shareholder loses their share in a business or not will depend on the stipulations set out in the original agreement. There’s usually also a grace period during which shareholders can make contributions.
If the defaulting shareholder has previously taken over their share of the business from someone else, then the legal predecessor is liable for the outstanding amount. However, they may purchase the share in the business against the amount owed.
Additional capital contributions and capital calls
An operating agreement may contain a clause which stipulates that shareholders contribute additional capital to meet unexpected demand for cash. Cases where funding may be required unexpectedly include tax payments, paying off debt or paying for repairs. The agreement may contain a set percentage of capital or variable amounts. There may also be a cap on the amount of capital a company can request from shareholders. It’s important that prospective shareholders check their responsibilities in regard to additional contributions before entering into an agreement.
The need for additional funding is usually decided by the decision-makers or members board. If the majority vote for additional capital contributions, a capital call can be initiated.
Failing to fund a capital call
In many cases, the operating agreement will grant shareholders a set amount of time to respond to a capital call. If a shareholder fails to make the additional investment, there could be drastic consequences. Investors could be expelled from the LLC and their share in the company may be diluted. The latter is referred to as “squeeze-down”. The freed-up shares can then be distributed among other members.
To prevent loss of funding (or in the worst case the collapse of the company), agreements often allow other members to loan the money another shareholder is unable to provide. The loan is then repaid at an agreed interest rate. The shareholder who failed to respond to the capital call will be penalized.
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