Remedies For Failure To Contribute Capital
Every business needs capital, so what happens when members form an LLC and promise to contribute capital but fail to follow through? The breach of such a promise is foreseeable, so plan for it. Consider drafting provisions in an LLC Agreement that outline remedies when a member breaches their promise to contribute. Our discussion this week will include four remedies including: interest dilution, damages, forfeiture of interest, and a deemed loan. The key to evaluating each remedy is to consider which will keep the LLC property capitalized, whether by encouraging members to make up the shortfall or discouraging a member from defaulting in the first place.
If a non-defaulting member contributes capital to cure a shortfall by a defaulting member, the non-defaulting member’s interest increases and the defaulting member’s interest decreases (dilution). Interest dilution may increase the benefit to the non-defaulting member if the value of the venture’s equity has increased over time and exceeds the aggregate amount of capital invested in the venture or changes the balance of control over the LLC. On the other hand, if the value of the venture’s equity has decreased over time and is worth less than the aggregate amount invested by the members in the venture, then interest dilution based on capital contributions could result in the non-defaulting member benefitting less than was intended. To avoid these results, dilution could be based on the value of the venture’s equity at the time of the default contribution rather than on contributed capital.
Forfeiture of Interest
If a member’s promise to contribute capital in the future is critical to the success of the venture, a default in contribution by a member would be catastrophic to the entity. Although a rather drastic remedy, forfeiting some or all of a defaulting member’s interest may be the “encouragement” a member needs to plan for the contribution. In addition, forfeiture by one member may enable the entity sufficient negotiating leverage to find capital from other sources, or a new member. Allowing a member to remain a member while having failed to contribute the critical capital is more than harmful to the entity: it may be fatal.
Another alternative is a deemed loan from the non-defaulting member to the defaulting member, which may be secured by the defaulting member’s interest in the LLC. The “deemed loan” remedy does not result in a change in the balance of control over the entity and does not change the relative interests of the members. Accordingly, this remedy may be just the middle ground that works when members are similar in financial strength. However, the “deemed loan” may not provide sufficient encouragement to the defaulting member, so use this remedy carefully.
Liquidated damages allow the LLC to recover damages in predetermined amount based upon the anticipated damages suffered by the LLC. To provide for the possibility of recovering such damages, an LLC agreement should state the amount and identify that the liquidated damages are an estimate of the actual damages caused by a failure to contribute. In addition, the LLC agreement should state that liquidated damages are not exclusive remedy. Resulting to litigation is likely not the timely remedy an LLC will need, but liquidated damages in sufficiently large amounts may discourage a member from defaulting in the first place.
A failure to contribute capital may be fatal to the entity’s success. Plan for such a problem by including remedies for default in your LLC agreement or shareholder agreement. Regardless of which remedy you choose, it is essential to discourage default and encourage others to contribute in the event of a default. Building in such remedies may save the venture and avoid unnecessary litigation.