Equity Incentive Compensation in LLCs
In a recent post, I recommended that the typical startup should start as an LLC (limited liability company) and remain an LLC as long as possible. One ever-present challenge with LLCs is that most entrepreneurs (present company included) like to try to force-fit corporate concepts and structures into an LLC format. This is not always easy or even possible — pass-through (partnership-style) taxation means that LLC membership interests are very different than corporate stock. These differences have a big impact on equity incentive compensation for employees.
In the corporate context, options are far and away the most common form of equity incentive compensation. In the LLC context, options are rarely used because they have uncertain, and largely unwelcome, tax consequences. So, how do an LLC’s employees get to share in the growth of an LLC’s value?
Capital Interest and Profits Interests
An LLC membership interest can either be a capital interest or a profits interest. A basic capital interest is similar to common stock — it has the right to a proportionate share of the capital, profits and residual value of the LLC. A basic profits interest is just like a capital interest, except that it gets a zero dollar interest in the value of the company on the date of grant. Like capital interests, profits interests share in the profits and residual value of the LLC (other than the initial value on the date of grant). In other words, the profits interest starts out with a zero dollar value and grows in value as the LLC grows in value. In this way, it is most similar to SARs (stock appreciation rights) in the corporate context.
One of the things that routinely causes confusion is that the term “profits interest” is a partial misnomer. The word “profits” in this term includes both actual profits and “value accretion”. Of course, true profits are allocated to members as they are earned. In addition, when an LLC grows in value and an allocation event occurs, the LLC allocates the value accretion as if it were profits. (Note that allocations of value, unlike actual profits, do not automatically result in taxable income for the recipient of the allocation.)
Profits interests are, in fact, a great way to provide equity compensation to LLC employees. Assuming certain tax rules are met, the profits interest is not taxable on the date of grant but still participates in the upside growth of the business. The problem is that an employee who owns a profits interest is a member (owner) of the LLC and, therefore, cannot be treated as an employee for tax purposes (they may still be considered an employee for federal and state employment law purposes). Instead of receiving income reported on the standard W-2 tax form, they receive their income reported on a K-1. This simple difference has several corollaries: (1) the employee has to file quarterly estimated tax payments instead of having taxes withheld from every paycheck; (2) the company does not match FICA payments but instead the employee has to pay ‘both sides’ of the tax; and (3) certain benefits to the employee, such as medical insurance, may be taxable. Generally speaking, an employee who receives a profits interest needs to receive higher compensation in order to have the same after-tax money as an employee who does not hold a profits interest.
Unit Appreciation Rights
An alternative to profits interests for an employee that does not want to have the tax attributes of a member is the issuance of UARs (unit appreciation rights). UARs have similar (not identical, but similar) economic consequences to profits interests, but still allow the employee to be treated as an employee for tax purposes. It should be noted that profits interests give rise to income that is taxed at either ordinary income rates or capital gains rates depending on the source of the underlying company income (typically the sale of the business will create mostly capital gain), while UARs will always give rise to income taxed at ordinary income rates.
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.
What Type of Entity Should Your Startup Be?
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. Read more
The Taxman Always Rings Twice
In the past few years, I’ve worked on an unusually large number of matters requiring complex tax analysis in high-stakes situations. While I’ve always had a healthy respect for the importance of tax issues, these more recent engagements have left me in absolute awe of the risks associated with the tax code. Seemingly harmless transactions consummated years before can dramatically alter your tax position years after.
The notion I wanted to get across with this post’s hopefully catchy title is that there are always at least two occasions on which tax advice is critical for any transaction or business arrangement: first, at the time of entering into the transaction or arrangement; and second, at the time of exiting the transaction or arrangement. Read more
How Early to Get Your Lawyer Involved
I sat in a conference session yesterday and heard the presenter say that you should negotiate all the “deal points” of a strategic alliance before getting your lawyer involved. Lawyers can be expensive and also might introduce complications and delays into a business arrangement, so I understand the temptation to feel that way. Nevertheless, I strongly recommend the opposite course — discuss your business strategy with your lawyer early in the strategic alliance process.
A business-minded lawyer will be sensitive to cost, complexity and timing issues. But he or she can also guide you on key structural issues arising out of a strategic alliance. In the simplest case, you might negotiate the “deal points” of a distribution arrangement by establishing the price and market area. Your lawyer might then be given those terms, discuss your overall objectives with you, and then recommend an altogether different structure that will serve you better (for example, perhaps you should ask for a long-term license agreement instead of a customary distribution agreement). If you knew that early, you might easily get your business partner to agree; however, after the deal points of an alternative structure are set, it might be tougher to change course. Read more
A Short Primer on Business Financing
Basic Financing Principles
Unlike not-for-profit organizations, for-profit businesses are typically unable to rely upon government funding or private grant sources to meet their cash requirements. Therefore, they generally must raise capital by either selling equity or borrowing debt in order to finance their activities. A few of the major uses of cash by for-profit businesses are described below:
- Businesses must incur start-up expenses, such as for research and development, in order to first make the product or service ready for sale to customers.
- For ongoing operations, the cash expenses to run the business and produce the product or deliver the service must generally be paid before the cash income from sale of the product or service will be received.
- When the business is growing, the need for cash is often the greatest because the investment necessary to achieve growth usually occurs before the generation of revenue from new sales. Read more
