Question: I formed an LLC with a partner a couple years ago, and it didn’t work out. I left him with a 70% stake and bowed out. I just heard that he licensed off the software for a pitance, then he joined the company that licensed it, getting a salary and a huge signing bonus. I didn’t get a dime from this transaction, even though I own 1/3 of the LLC. Is this legal?
Answer by Ethan Stone, Stone Business Law
First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish a lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site. The information below is general in nature and should not be understood as a substitute for personal legal advice.
Now to the question:
Unfortunately, there’s no definitive answer to this question.
To rephrase what I think you mean, you suspect that your partner’s signing bonus (and maybe some of his salary) represents an under-the-table kickback for licensing the software to his new employer for less than its value.
If that’s true, the guy breached his fiduciary duties to the LLC and the LLC should be able to recover a lot of that money from him (maybe even more than he got) and/or terminate the license.
Before you get too excited, though, there are a lot of potential hurdles in the way of getting to that result.
First, you don’t control the LLC, and it’s the LLC that has a claim, not you. There is a procedure, called a “derivative suit,” by which you can go to court representing the LLC if you can prove that the person controlling the LLC can’t be objective about the claim. This seems like a classic case in which that could be shown, so there is hope.
That said, state LLC laws are not at all uniform. So you’d need to seek competent advice on the laws of the state where the LLC was formed to determine whether a court would be likely to let you bring a derivative suit on your precise facts.
Second, you need to look at the laws of the state where the LLC was formed and at the operating agreement to see if either one limits or eliminates your partner’s fiduciary duties. Some states (e.g. Delaware) allow complete elimination of fiduciary duties. Some allow very little limitation.
Third, you’re going to need to convince a court that your partner’s signing bonus represented the value of the software. I know it seems obvious to you, but it could be very tricky. On the good side, in a breach of fiduciary duty case, your partner should theoretically have to prove that the transaction was fair to the LLC (rather than you having to prove that it wasn’t). But that’s theory. In practice, you should think about how clear it will be to a court. If the court thinks you’re whining, it’s not likely to end well for you.
Finally, if you win, the money goes to the LLC. But you still don’t control the LLC so it might not be easy to get the money out. You can ask a court to force dissolution, but it doesn’t have to do that. Again, it depends a lot on the state where the LLC was formed, the terms of the operating agreement and the precise facts. So that’s another level of uncertainty.
Bottom Line: You might have a very good case, but it depends a lot on the relevant state law, the operating agreement, and whether there’s enough money at stake to justify the prospect of possibly long and difficult litigation. The best course of action is to find a good litigator who is familiar derivative actions and the law of the state where the LLC was formed.
I’m assuming you aren’t asking if you’re entitled to 30% of the “pittance” for which the software was licensed. If that is your question, though, the answer is that you will be entitled to it whenever the LLC distributes it or dissolves. As a 30% member, you wouldn’t normally be entitled to force a distribution or dissolution, but it really depends on (1) the laws of the state where the LLC is formed, and (2) the terms of the operating agreement. As noted above, in extreme circumstances, you might be able to convince a court to force dissolution. But it would have to be a fairly large “pittance” to justify going to court.
I’ll take this opportunity to step back from the question and note that this kind of thing should be taken care of in the operating agreement. Assuming that you were really partners when you went into this, it would have been a good idea, for example, to provide that your consent was required in order to sell or license substantially all of the company’s assets (a very typical provision to protect a minority member). I know that’s water under the bridge with respect to this LLC, but readers should bear it in mind as they go into privately held corporations and LLCs. It can be very helpful to think through in advance: (1) what will happen if one person leaves, and (2) what kinds of control rights minority members/shareholders need to give them a good shot at getting their fair share if the majority isn’t acting fairly. For a more detailed discussion of how to get this right at the outset, look here:http://www.stonebusinesslaw.com/resource/company-formation/business-pre-nups-%E2%80%93-issues-consider-starting-business-co-founders.