Preferred Interests, Waterfalls and Financing

Scope of the chapter. Most LLCs that raise outside capital do so by issuing interests with economic rights that differ from those of the founders. An investor may receive a preferred return, a priority return of capital, a liquidation preference, a right to require redemption, or a combination of these. A sponsor may receive a promoted or carried interest that participates disproportionately once the investors have received a stated return. A lender may take a pledge of the members' interests and the right to step into the members' position on default. This chapter examines the statutory foundation for these arrangements, the drafting of preferred returns and distribution waterfalls, the limits the statutes place on distributions and redemptions, the distinction between preferred equity and debt, the pledge of LLC interests under the Uniform Commercial Code, and the remedies of lenders and preferred holders. It closes with a checklist for term sheets.

The contractual character of the subject. No LLC statute prescribes the economic terms of a preferred interest. The Delaware act provides that profits, losses and distributions are allocated "in the manner provided in a limited liability company agreement," and supplies a default rule only where the agreement is silent. Del. Code Ann. tit. 6, §§ 18-503, 18-504. The uniform act supplies a default of equal shares in distributions before dissolution. Rev. Unif. Ltd. Liab. Co. Act § 404(a) (2013). Every preferred return, waterfall and redemption right is therefore a creature of the agreement, construed under the principles examined supra chs. 7 and 8. The statutes matter in three places: the authority to create classes and to subordinate existing members, the limits on distributions that protect creditors, and the rules governing the transfer and pledge of interests.

Relation to the tax chapters. The economic terms described here are reflected for tax purposes in capital accounts and allocations under I.R.C. § 704(b), and a preferred return may be treated either as an allocation of income or as a guaranteed payment under § 707(c). This chapter outlines those consequences where they affect drafting (see infra ¶ 1680.06). The partnership tax rules are examined infra chs. 40 and 41, and profits interests issued to a sponsor or to employees infra ch. 15.

Organization. The chapter proceeds as follows:

1. classes and series of interests (¶ 1610);
2. preferred returns and liquidation preferences (¶ 1620);
3. distribution waterfalls (¶ 1630);
4. clawbacks, escrows and tax distributions (¶ 1640);
5. redemption rights and their limits (¶ 1650);
6. preferred equity and mezzanine debt (¶ 1660);
7. pledges of LLC interests and the UCC (¶ 1670);
8. lender remedies, control rights and a tax outline (¶ 1680); and
9. a term sheet checklist (¶ 1690).