A more comprehensive review of the vagaries of profits interests and UARs is beyond the scope of this post, but the key message is that there are effective ways to incentivize employees of an LLC and that care must be taken to determine the optimal way for particular companies and individual employees.

In counseling entrepreneurs, one of the first questions that arises is about choice of entity type – in other words, should the entrepreneur’s business be contained in a C corp, S corp, LLC, limited partnership or general partnership, or be structured in some other way? While there are obviously a number of factors that must be considered when answering this question, my answer is – with few exceptions – that an LLC is the best form. This is not yet the universal view, and some excellent attorneys have a different predisposition. So, I’ll lay out my basic reasons here, and I’ll be curious for comments – especially from people with a different viewpoint.

To keep it simple, my reason is that an LLC provides the benefit of limited liability for the owners, pass-through tax treatment (that is, no double tax), and ultimate flexibility in structuring the equity ownership and management rights of owners. No other entity form has this combination of features.

I sometimes word my advice on when to switch from an LLC to a C corp in this way: “when dragged kicking and screaming into being a C corp”. The main downside of C corps is that they result in double tax – once at the corporate level, and once again when profits are distributed to owners. Even if the profits are not distributed, upon the sale of the business there will either be two levels of tax (in case of a sale of assets) or an implicit reduction of sale price (in case of a stock sale that does not permit a write-up of the value of the assets for tax purposes).

Here are three main downsides to LLCs, along with my counter-arguments:

• First, the legal and accounting costs to set them up and administer them properly are somewhat higher than with corporations. This is true – with all the flexibility comes some complexity, and partnership (pass-through) accounting is, I believe, intrinsically more difficult than corporate accounting. However, the effect of double taxation can be almost 15 percentage points of tax on all of the business’ profits and ultimate exit value (above the original investment). Such big dollars, in my view, outweigh the transaction costs and complexity of operating an LLC.
• Second, most venture capital firms don’t want to (or refuse to) invest in LLCs. This is also true, at least for now. The most common and well-understood form of venture investment is still preferred stock in a corporation, and it is difficult to exactly match that in an LLC. Also, something called UBTI (unrelated business taxable income) that can result from ownership in a pass-through entity, can create a problem for some VCs. I have three responses to this:  (1) a small but growing number of VCs, and even more strategic investors, are willing to invest in LLCs to get the tax savings; (2) a transaction can be structured so the VC invests through a “blocker” C corp that, in turn, invests in the LLC; and (3) this is no reason to start out as a C corp – only to become one later if you have a VC that is willing to invest and demands it (getting a lot of capital is a good reason to let go of the “kicking and screaming”).
• Third, equity compensation arrangements for employees are somewhat more complicated in LLCs than in corporations. Again, guilty as charged. In corporations, the tried-and-true method – albeit not without its own problems – is stock options. In LLCs, the most common method is “profits interests”, which are inartfully named but are in fact equity interests in the LLC. More on these creatures in another post, but, again, I view the absolute dollars of tax savings as outweighing the challenges of equity compensation in LLCs.

Please share your experience and views on these topics.

In Aviad Meitar’s book, An Unimaginable Journey: How Pepsi Beat the Odds in Romania, he recounts his incredible experience in launching, building and selling the Pepsi business in Romania. His focus is on the business lessons and personal highs and lows (mostly highs) of that experience. Although he is also a lawyer (non-practicing), the book does not delve into the legal lessons of our journey.

As the General Counsel of Pepsi Romania from 1991-2006, here are the top 10 legal lessons that I learned, which I regularly have the chance to apply in current representations. Many of these lessons can be gleaned from the stories presented in Aviad’s book.

1.  Control the draft – you get countless opportunities to impact the deal in ways that you never could if you merely commented on the other side’s draft.

• See my blog post entitled “Control Freak“.

2.  Contracts matter, including so-called boilerplate - yes, it is true that contracts are often put in a drawer and not looked at for long periods of time; but very often, eventually, significant business and economic rights or obligations will flow from just a few words in a contract – and you will be glad if sufficient thought was given to those specific words at the time the contract was negotiated.

• See, for example, my blog post about “The ‘Notices’ Provision“.

3.  People matter more than contracts - the value of the relationship established by a contract, and the ease of working with the contract over time, depend more on the quality and intentions of the people on both sides than on the precise terms of the contract. One key thing to evaluate during the contract negotiations is your sense of the other party’s style and character, which are likely to impact you in the future – for better or worse.

4. In negotiating with people from another country or region, don’t be overly critical of their system - for every outrageous law or business practice in their country or region, you can think of an outrageous law or business practice in your home area. This is a good exercise to avoid ‘getting on your high horse’, which is important for building trust and understanding with your negotiation partner.

5. If you’re building a business around someone else’s brand or technology, make sure you have strong, long-term rights – reduce the risk of losing a business or technology into which you’ve invested enormous amounts of time and money.

6. Always play by your own (high) rules of ethics and legality, or don’t play - the excuse that “everyone here does it” is neither a justification nor will it be a good defense in the press or the courts if bad behavior comes out. Operating with high integrity occasionally has a short-term cost but is by far the better long-term strategy.

7. In negotiating with people from another country (especially with a different primary language), don’t forget that understanding each other’s words is not the same as understanding each other’s meanings – the opportunities for misunderstandings, both in literal meaning and in context, are countless. Effective communication takes patience, double- and triple-checking meaning, and flexibility to correct misunderstandings once discovered.

8. What you don’t think of or don’t know can be as important as what you do think of and do know – it’s critical to constantly expand your horizons in thinking about legal opportunities and risks. The most valuable or most costly ones may be overlooked if you do not spend dedicated time trying to ‘think outside the box’.

• See, for example, my blog post entitled “The Taxman Always Rings Twice‘.

9. The worst compromise can be better than the best dispute – except in rare cases, the management distraction and dollar cost of a dispute is too great; and no one says you’re guaranteed to win anyway. It is rarely a good idea to pursue litigation out of principle; rather, litigation should be pursued only if it is expected to yield a good economic return on its ‘fully loaded’ costs.

10. At the beginning, plan for the end - it is sometimes awkward to talk about the end when you’re negotiating the beginning, but all things – good and bad – come to an end. The long-term value of a relationship often depends as much on your rights on ‘exit’ as it does on ‘entrance’ and throughout the term. Make sure to create a setting in which you can exit well.

• See my blog post called “Joint Venture Tips“.