The Risky Business of LLCs

One of the criticisms leveled at the option agreement for the Chalmers project centers on the fact that the city has entered into an agreement with an LLC (a Limited Liability Corporation). I guess the underlying issue is not the LLC itself but the concern that the LLC will provide cover to the developers/partners of the LLC should the Chalmers project not materialize or worse, should a future liability occur. If a future liability were to occur, the LLC would be shielded from the consequences and the city would ultimately be liable. I think this is the argument being advanced.

To the extent that the criticism reflects a desire to prevent the city from assuming an unknown liability, I think the criticism is fair. But I think the criticism is being used to bolster opposition to the project by associating the notion of an LLC as a way to evade transparency, accountability and responsibility by the developers. It’s the latter argument with which I have the issue.

One or more individuals may form an LLC as a way to shield personal assets for the debts and actions of the LLC. (IRS Website) Given the nature of the Chalmers project, I’d be shocked if any private investor(s) would even consider entering into any agreement without some form of personal liability protection given the risks involved with the project. While I favor the project, I share no doubts that this is indeed a risky venture given the environmental risks and the financial risks involved. Keep in mind that the biggest risk to investors will be the marketability of the project once it is complete. Ultimately the success of Chalmers hinges upon people paying to live in the building either once rented or purchased.

What often gets overlooked in this discussion is the relationship of risk and return. The only reason Kaufman and his investors would undertake the risks in this project is that they believe the returns will be worthwhile and significant. It’s finance 101 that investments with potentially high returns have significantly higher risks.

Just because the investors in this deal have chosen to mitigate their risks via an LLC should not get the red flags waving. I’d argue the opposite– if a group of investors entered into this with no attention or thought to the risks or no corporate umbrella to shield their liability, I’d be the first to wave a red flag as it shows a profound lack of business sense.

While it’s true that the city has been burnt by LLCs wrapped in LLCs as in the sewage treatment plant debacle (you remember: the city would make money by ‘packaging’ sewage ) , the nature of the deals is radically different. The risks in the sewage plant were related to technology risk and to financial risk. Technology risk in the sense that the new, innovative process would work at all (which in the case of sewage plant did not). Even worse, the funding of the sewage plant was tied to a long term bond issue for financing so you have a speculative technology investment tied to a long-term liability via a bond issue tied to a mission critical operation of the city.

For Chalmers, the technology risk is strictly related to the remediation of the site and by any objective measure, significantly less than the risk with the sewage process. But most importantly, the city has not (caveat here: to my knowledge) entered into any long term agreement for funding the deal. Finally, the LLC for Chalmers has great incentives via great returns to the success of this project and in many ways the LLC  ‘owns’ the deal whereas in the sewage plant the city ‘owned’ the deal and all the risks.

The bottom line in all this boils down to the interplay of risk and return. My take is that the city should take a risk with this as the return could be quite significant. Or said another way, if the city takes no risks, the city will see little returns.

I’ll leave with a note on how venture capitalists view deals and what they look for when deciding to invest or not invest in a new and risky venture:

Venture capitalists consistently emphasize the importance of the management team in an entrepreneurial venture and focus much of their due diligence on the key people involved. They assert that a good idea is only executable when implemented by a top-notch executive team. (Stanford Graduate School of Business)

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