Does an LLC Need to Place a Value on Each Membership?

by William Pirraglia
LLC operating agreements should state the formula to value memberships.

LLC operating agreements should state the formula to value memberships.

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An LLC should place a value on each membership. A membership interest is the value of all of the rights enjoyed by LLC owners, called members, including their monetary investment, voting rights and ability to share in the LLC's profits. A member's interest is based on the value of the company as a whole. Two popular methods are used to establish an LLC's value, and a member's interest is then valued by the conditions and percentage of his membership.

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Membership Value

LLC members own a "bundle" of rights in the company. Unlike corporations, LLCs have wide flexibility in assigning these ownership rights. For example, an LLC with two members, with one investing 80 percent of the money and the other investing only 20 percent, can still agree to share profits and losses on a 50/50 percent basis. The value of the 20 percent investor is, therefore, higher than the investment because of the ability to receive a higher percentage of profits than the larger investor.

LLC Valuation Methods

The two common approaches of LLC valuation include the appraisal and the capitalization of earnings methods. The appraisal method involves hiring one or more experienced commercial appraisers to establish a value for the company. Disagreements in value by the members can result in multiple appraiser evaluations, which can become expensive. Capitalization of earnings involves examining a "rolling average" of profits over a 24-month period. Subtracting liabilities, or debts, and adding cash to the number completes the first part. Then a "multiplier" -- previously agreed to by members -- is used to establish a value for the LLC.

Operating Agreement

Much like a corporation's bylaws, an LLC's operating agreement can explain the criteria for membership value along with many other operating and organization rules. While member values are not stated, the formula for establishing members' values should be clearly defined. The operating agreement should also state the rules to determine the value of a membership. Establishing the initial membership value by formula may permit your LLC to simplify valuation in the future.

Future Changes in Membership

Regardless of the formula for membership valuation, most LLC operating agreements have restrictions for ownership transfers. Since the formula for membership values is established at the inception of the LLC, the amounts should not be a major issue. However, if one member wants to sell her ownership to another, many operating agreements mandate that the remaining members must unanimously agree to permit the sale and to approve the buyer. Should a member die, the operating agreement should outline the procedure for the transfer of the deceased member's interest, as well as the value for the transfer.