When forming an LLC, the owners must decide how the LLC will be managed. This decision requires the owners to choose between two primary management structures:
- Member-Managed LLC – All members may bind the LLC to contracts and to make day-to-day decisions regarding the operation of the LLC.
- Manager-Managed LLC – The members appoint one or more managers—who may or may not also be members—to manage the LLC. Only the managers may bind the LLC to contracts and participate in the day-to-day operation of the business.
Because the members must specify their choice on the certificate of formation or other formation document that is filed to create the LLC, the members must decide at the outset how they want the LLC to be managed. This article discusses the relevant considerations and explains why manager-managed LLCs are often the better choice.
Statutory Rights of LLC Members
Ownership of an LLC involves two broad categories of rights:
- Management rights include the ability to participate in the management of the LLC by voting, participating in member meetings, obtaining information about the LLC, fiduciary responsibilities, and agency rights.
- Economic rights deal with the right to the economic benefits of LLC ownership, including a right to distributions of profits from the LLC.
These rights can—but need not be—combined. If the LLC is a member-managed LLC, each member may have both management rights and economic rights in his or her capacity as a member. Alternatively, the management rights can be divided from the economic rights by creating a manager-managed LLC. With a manager-managed LLC, the management of the LLC vested in the managers and the economic rights remain with the members. The managers are usually members, but need not be.
It is important to recognize that, when talking about member-managed LLCs vs. manager-managed LLCs, the terms “member” and “manager” each refer to roles relating to the LLC, not to specific owners. A single owner can serve in both roles. It is possible—and not uncommon—for the members to also be listed as the managers.
Example: Walt and Jesse form Chemco LLC to manufacture chemical products. Even though Walt and Jesse will be the only two owners and the only parties involved in the business, they could set Chemco LLC up as a manager-managed LLC. Walt and Jesse could manage the LLC in their capacity as managers and share in the economic rights in their capacity as members. Each owner would be both a member and a manager.
As discussed below, even if the LLC will be owned and managed by the same parties, the division of the LLC into members and managers provides strategic planning opportunities for LLCs that are organized as manager-managed LLCs.
How to Choose Between Manager-Managed and Member-Managed Structures
In some situations, it is clear that the manager-managed structure is needed. For example, some LLCs are set up with a “silent partner” that is not involved in the day-to-day affairs of the organization. In this situation, a manager-managed LLC is usually the better choice.
Example: Walt and Jesse form Chemco LLC to manufacture chemical products. Walt is a silent partner who will provide chemistry expertise if needed, but will not be involved in the day-to-day operation of the LLC. Because Jesse will be involved in the day-to-day operations and management of the LLC, they decide to use a manager-managed LLC with Jesse named as the sole manager. Both Walt and Jesse will be members, but Jesse is the only manager.
What is less clear to new business owners is why a manager-managed LLC would be used if the same parties will hold all of the economic rights and all of the management rights. Going back to our first example above, where Walt and Jesse will be the only owners and will both be involved in the day-to-day management of the LLC: Why would Walt and Jesse use a manager-managed structure? Why not just use a member-managed structure since the same parties will both own and manage the company?
The answer has to do with the purpose of the LLC. LLCs are formed primarily for liability protection (hence the name limited liability company). All else being equal, manager-managed LLCs offer more protection than member-managed LLCs. If a creditor of a member obtains an interest in a manager-managed LLC, the creditor only obtains the member’s economic rights. The management would remain vested in the manager. This can prevent a creditor from arguing that the creditor has management rights in the company.
Example: Walt’s ex-wife Skyler obtains a judgment against him as part of a divorce. Skyler seeks to seize his interest in Chemco LLC and liquidate the company to satisfy the judgment. If Chemco LLC is member-managed, Skyler may argue that she has management rights and seek to use those rights to liquidate the company. This would be unfair to Jesse, who is still operating Chemco and does not want to liquidate the company. Using a manager-managed LLC keeps management rights separate from the economic rights and prevents this argument. The most that Skyler can obtain is the economic rights associated with Walt’s interest. She has no claim to management authority.
Although the protection provided by member-managed LLCs is similar to that provided by charging order protection and anti-assignment provisions, using managers provides an additional layer of protection at no cost to the owners.
Member-Managed LLC with Managing Member vs. Manager-Managed LLC
As stated above, the manager-managed vs. member-managed distinction is somewhat simplistic. There are situations where a member-managed LLC can function similarly to a manager-managed LLC. The most common of these situations is when the LLC is member-managed, but gives the members the authority to appoint a managing member.
Like a manager of a manager-managed LLC, a managing member of a member-managed LLC has authority to bind the company to contracts and to otherwise act on behalf of the LLC in the day-to-day management of the LLC’s affairs. This authority is known as agency authority.
It is not always clear how the agency authority of a member of a member-managed LLC differs from the agency authority of a manager-managed LLC. Third parties do not know whether a “managing member” is one of many members with managerial authority or whether the managing member is really a manager. This creates ambiguity that can only be resolved by reading the operating agreement—something that is not ideal when dealing with third parties.
Because the law that applies to manager-managed LLCs is more defined, there is little reason to use a member-managed LLC with a managing member. If the owners want the company to be managed by designated managers, it is better to use a manager-managed LLC than to create a member-managed LLC with a managing member.
Other Enhancements to Management Structure
The distinction between manager-managed LLCs and member-managed LLCs can blur. In practice, a properly drafted operating agreement can add a great deal of flexibility to the management structure. Depending on the owner’s goals, an operating agreement can:
- Create different classes of membership interest with different voting rights;
- Require different voting thresholds for significant company events like mergers, acquisitions, or sales of substantially all of the business assets;
- Organize a board of managers to function like a board of directors of a corporation;
- Provide a clear mechanism for changing managers or dealing with the death or resignation of a manager.
The ability to specify the management and economic rights of owners and managers through the operating agreement sets LLCs apart from corporations and other more restrictive forms of business.