Choosing the Right Acquisition Vehicle: Delaware Limited Liability Companies as the Vehicle of Choice
The choice of acquisition vehicle, and more broadly speaking the choice of investment structure, can profoundly impact a fund's experience with an investment in a variety of significant, and often economically relevant, ways. Historically, most businesses were organized as corporations. Over time, however, the trend has been increasingly in favor of using limited liability companies, or LLCs, and other "alternative entities." These alternative entities, in particular the LLC, can help an acquiring fund to avoid many of the pitfalls of corporate jurisprudence, enhance the sponsor's flexibility across a range of equity and debt financing strategies and may provide substantial tax advantages not otherwise available to entities organized in corporate form. Moreover, the use of an LLC creates opportunities – at least for the time being – to structure management equity compensation arrangements in a tax-advantaged manner, potentially enabling the sponsor to differentiate itself from other bidders.
In the State of Delaware, which continues to be the domicile of choice for entities used by sophisticated parties in complex business transactions, LLCs have swelled in popularity over the past ten years. In 2010, of all entities formed in the State of Delaware, 70% were LLCs, 24% were corporations and approximately 5% were limited partnerships. Since 2001, Delaware has experienced a 171% increase in the number of LLCs formed. As described below, we believe there are good reasons for this boom in LLC formation.
In structuring an investment, parties will often gravitate toward LLCs and other alternative entities because of their ability to provide "pass-through" tax treatment. That is, rather than being taxed as a separate entity, the profits, losses and other tax attributes of the business conducted by the LLC will pass through to the members of the LLC. However, an LLC has the flexibility to elect to be taxed as either a partnership or a corporation under the Internal Revenue Code. Therefore, even in situations where pass-through treatment is not desired or the acquired business is already in corporate form (thereby limiting some of the benefits of using a pass-through acquisition vehicle), the use of an LLC can nevertheless afford a number of significant benefits. In these instances, the LLC can still be used as a holding company for the acquired company where any co-investment interest and management equity compensation arrangements also reside.
The real hallmark of the LLC is the virtually limitless flexibility it affords from a governance perspective. Freedom of contract is the central tenet of the Delaware Limited Liability Company Act, or DLLCA, which governs all LLCs formed in Delaware. As embodied in the DLLCA and applied by the Delaware courts, this freedom of contract means that the parties will have extraordinary freedom and flexibility under Delaware law to establish the rights and obligations of the LLC, its members and its managers.
The statutory framework of the DLLCA provides certain "default" rules. In most instances, however, the parties can opt out of these default rules or customize them in the LLC's operating agreement. Delaware courts have consistently upheld clear, unambiguous provisions in operating agreements that override the statutory default requirements. The DLLCA therefore affords the members of an LLC the ability to: structure complex protocols for the distribution of profits and the allocation of tax attributes; design securities with flexible voting rights and powers; develop internal rules and standards for the interaction of the members (including to impose restrictive covenants or to permit related party or interested transactions); structure transfer restrictions, redemption rights, limits, gates and clawbacks; and restrict information rights of the LLC’s members. The DLLCA also provides the members of an LLC with broad discretion to limit or eliminate traditional fiduciary duties of managers and members, as well as the ability to eliminate personal liability for breaches of fiduciary duty.
Of further note are the private nature of an LLC's governance arrangements and the relative ease of its operation. The LLC's operating agreement is a private contract protecting both the identities of the parties and the contents of the agreement. LLCs also provide considerable flexibility in defining the scope of information rights available to members. Although the DLLCA contains a statutory default right of members to access the books and records of the LLC, this right can be limited or be made subject to reasonable restrictions in the LLC's operating agreement. As such, the LLC affords its owners a greater ability to protect confidential information, including trade secrets and proprietary information, as well as financial information, capitalization tables and member information. Further, there are no minimum capital investments required for LLCs and there are no obligations to maintain records, hold meetings or conduct business activities within the State of Delaware. Investors and managers need not be natural persons or U.S. citizens, thereby enabling the use of offshore feeder entities.
Like other limited liability vehicles, a properly formed LLC that observes appropriate formalities will insulate the LLC's members and managers from personal liability for the debts and obligations of the LLC. Creditors of the LLC generally may not attack the interests of the members or managers in the LLC. Moreover, under a recent Delaware Supreme Court decision, creditors of an LLC have no standing to assert derivative claims on behalf of the LLC, even if the LLC is insolvent. As such, the sponsor, its employees and managers on the board of the LLC are all protected with respect to the LLC’s debts and obligations. Similarly, creditors of individual members or managers generally may not attack the assets of the LLC in order to satisfy the debts and obligations of the members or managers.
The Delaware LLC also provides significant advantages in the design of equity securities, allowing the creation of traditional common and preferred units, as well as a variety of profits interests for compensatory and non-compensatory uses. This flexibility can provide a valuable tool when seeking to incentivize and reward a portfolio company's management team. While stock options are the customary approach to equity compensation in the corporate setting, options are less ideal in the LLC context because of the associated tax consequences. An LLC profits interest provides the recipient with a right to participate in the post-grant appreciation of the LLC through an allocable sharing in the LLC's net profits. LLC profits interests can be designed to replicate the economics of a stock option or a restricted stock grant, but can also provide considerable flexibility in designing tiered incentives for higher levels of performance. As with other terms of the LLC's operating agreement, the terms of the profits interests issued by the LLC may be structured in virtually any manner the parties’ desire. For example, profits interests may be structured to generate value for the recipient only after the sponsor has realized a preferred return, or the profits interests can be separated into multiple classes or tranches which share in appreciation of the LLC at successively higher thresholds. Moreover, under the current state of the law, LLC profits interests can provide the recipient with capital gains treatment in an exit transaction, providing a considerable benefit relative to corporate equity grants.
Given the tremendous flexibility afforded to the members of a Delaware LLC in structuring their arrangements, the deference given to these contractual arrangements by reviewing Delaware courts and the potential advantages afforded by the LLC's flexible capital structure, private equity sponsors and other investors should carefully consider the use of a Delaware LLC in structuring their investments.
Steven J. Daniels has a broad-ranging corporate practice, focused primarily on mergers and acquisitions, private equity transactions and securities law matters. He also advises clients on issues of Delaware law, has significant experience representing private equity sponsors, and has represented public and private companies in connection with negotiated acquisitions and dispositions in both distressed and traditional settings. Mr. Daniels works extensively with the structuring and formation of limited liability companies and other alternative entities for use in private equity transactions, joint ventures and other complex business arrangements. He has repeatedly been included in Chambers USA: America’s Leading Lawyers for Business. Steven can be contacted on +1 302.651.3240 or by email at firstname.lastname@example.orgFaiz Ahmad is an associate in Skadden’s mergers and acquisitions practice. He has advised public and private companies, private equity funds and hedge funds in a variety of transactions, including negotiated and contested acquisitions, dispositions, mergers, auctions, tender offers, going-private transactions, and minority investments. Mr. Ahmad previously served as counsel to a global social venture capital fund investing in the delivery of critical goods and services to the impoverished in India, Pakistan, and East Africa. He also advises local and regional non-profits on corporate governance and has served in various leadership positions with the North American South Asian Bar Association. Faiz can be contacted on +1 302 651 3045 or by email at email@example.com