In most cases if you intend to offer equity to employees then you should probably organize or reorganize your company as a corporation. It makes things simpler in terms of documentation, internal tracking and HR management. However, if you have a good accountant (see final paragraph of this post) and a good reason to operate as an LLC (see post here), offering employees equity in the LLC is a totally viable, possibly advantageous, option.
Like a corporation, LLCs (along with any other entity taxed as a partnership) can grant equity and options to acquire equity, the practical difference (for an equity holder) just being that LLC equity is called "membership interests" (or sometimes "units" but there's no legal distinction) and corporate equity is called "stock." FN1
As a matter of law, however, membership interests do not fit within the portion of the IRS tax code that applies to employee incentive stock options. From a implementation standpoint this means LLCs cannot simply have their lawyer draw up a standard Stock Option Plan and concommitant Stock Option Agreement (to be signed by each participating employee), make the necessary accounting adjustments (a certain portion of company stock - the stock option pool - will have to be reserved) and call it a day.
Instead, the LLC has to set up a mechanism (usually in the Operating Agreement) to grant employees "membership interests". The implementation of this may be a little tricky but it's not conceptually complicated. The upshot is that somewhere in the LLC Operating Agreement terms and provisions will have to be inserted that a) distinguishes between the "members" (i.e., partners/founders) and the "employees" and the kind of membership interests being received by each, b) describes any applicable vesting requirements and c) identifies (usually as an exhibit) the employees receiving the equity and how much and the vesting schedule (if any). FN2
As a threshold matter, however, an LLC has to choose what KIND of membership interest to grant, and this is where the complexities start.
In essence, while a corporation typically grants employees common stock options, an LLC has a choice to grant employees "capital" interests or "profits" interests. The capital interest is effectively like common stock - it carries the right to a proportionate share (whenever distributed) of the a) existing capital base, b) future profits and c) future appreciation of the company. The profits interest, on the other hand, is only 2/3 of this. It incorporates future profits and appreciation but not existing capital value (which makes it a bit like a stock appreciation right, which is also similar in that (unlike a stock option) it doesn't have a strike price and the employee would at time of distribution just receive the amount of the appreciated value without having to pay anthing). Thus, the profits interest starts out with zero dollar value (since it doesn't share in the capital base of the company) and grows in value as the LLC grows in value.
An example: imagine an LLC grants a new employee a 5 percent profits interest and that the LLC is valued at $10 million. If the LLC later sold for $14 million, the new employee would be entitled to $200 grand, which represents 5% of the $4 million appreciation. The remaining partners would be entitled to 100 percent of the $10 million and 95% of the $4 million appreciation.
The big benefit of a profits interest (and why it exists) is that under current tax law the grant of it does not impose any taxes on the recipient at the time of the grant. FN3 It's not taxable because, as noted, it does not grant the employee a share of the capital base; all the value is forward-looking, thus at the time of grant there is no value being transferred. With a grant of capital interest, by contrast, the employee will have to pay (in the year of the grant) tax on the difference between the value of the capital interest being received and the amount of money that the employee contributes (if any), which partially undermines the value proposition to the employee (or, depending on the value of the LLC, might be flat out cost prohibitive to the employee). FN4
Three administrative issues also merit mention: First, LLCs face a special problem that corporations don't in so far as under tax law a member of an LLC will not be treated as an employee of that LLC by the IRS. He'll be treated as a partner. This means any wages paid to the employee by the LLC won't be subject to taxes by way of a W-2. FN5 Instead, the employee, if paid any wages, would be subject to self-employment taxes (at a rate of 15.3 percent) rather than a share of FICA (at a rate of 7.65 percent) (as is the corporate case).
Second, employees should file what is called a 83(b) election when being granted any membership interest. The 83(b) election ensures that the employee will be taxed only at the time of grant (for the excess between price paid (if any) and value receive in the case of the capital interest and for nothing in the case of the profits interest) and not taxed incrementally over time as the value of the interest goes up or, if any vesting requirements are put on the interest (as usually in the case) the vested portion of the interest.
Third, and most importantly, when an employee is granted a membership interest or leaves the company prior to full vesting, your accountant is required by tax law to "book up" or "book down" the capital accounts of the members. Generally, each member's capital account is adjusted to reflect the member's share of any gain or loss that would be triggered if the LLC had sold all of its assets at the time of the adjustment. This activity can be difficult and expensive (basically because book-ups must be based on a fair market value of the LLC's assets and require special tax allocations afterwards). Accordingly, any compensation program that requires multiple book-ups (employees are coming and going with regularity) might not be practical.
FN1
Because the majority of the strategic issues around equity incentives relate to tax law and LLCs are partnerships according to the IRS, most of this discussion also applies to limited liability partnerships.
FN2
If the employees are receiving "profits" interest, it will also probably require a separate profits interest grant agreement (pursuant to the LLC agreement) with that employee.
FN3
The specific "safe harbor" rules here are that there is a tax exemption so long as (1) the interest represents an interest in profits and value accretion (not current capital), (2) the interest is being received for the provision of services, (3) no transfer is made within 2 years of receipt, (4) the interest is not related to a substantially certain stream of income of partnership assets (such as income from debt securities), (5) the partnership is not publicly traded. Revenue Procedure 93-27.
FN4
Note that in very newly formed companies this difference tends to be very small (since the capital of the company will likely be valued at a very low price) and thus not a concern.
FN5
There are creative ways to handle this. A company, for example, could have an operating arm that is a corporation and that pays the employees and a holding arm (which is the LLC). The employees could be given membership interests in the LLC and receive a salary from the corporate entity.
Monday, January 3, 2011
Monday, December 27, 2010
A Rich Man's Dilemma: LLC or Inc.?
The prevailing wisdom on the matter of entity choice is that if you're a start-up you should organize as a corporation (either a C or an S). FN1 And if you reasonably anticipate seed or venture financing at any time in the future, this is eminently sensible.FN2
The more relevant question is whether the LLC is the preferred entity form in all other scenarios, at least given extant tax law and related legal and business trends. The answer is: yeah, mostly, or at least, probably, depending. Wishy-washy guidance, maybe, but that's how to stay clean, for sure.
If you're a small business without much revenue, employees or any partners you might not even need to formally organize. LLCs and corporations are desirable entity forms principally because they protect you from exposure to personal liability for actions you take in the capacity of an agent for the business. If a partner or employee commits a tort in the course of providing services then the entity form prevents an injured party from suing you personally. Similarly, if the company takes a loan and can't pay it back then the creditor can't go maraud your personal bank account. FN3
The LLC then is the preferred entity form for company that has growth potential but is not anticipating seed or venture financing (the most obvious example here is a consulting business). The rationale is pretty basic: an LLC has limited liability protection but a) "partnership-style" pass through taxation (whereby taxes flow straight through to LLC members - rather than to the corporate form first and then to shareholders (creating the so-called "double taxation")); FN3 and b) partnership-style flexibility in terms of organizational form (e.g., no need to record every major decision or hold formal meetings, the capacity for special allocations of profits (not according to percentage ownership), etc.).
In addition, it can be mentioned that LLC's have lower statutory compliance costs (in terms of paperwork, corporate fees, etc. filed with the government) and that's technically true (regardless of the state in which the LLC was formed) but also somewhat misleading since the expense difference is probably just going to be a few hundred dollars here and there. Along these lines although it's said a corporation is more complex (bureaucratically) to initially create than an LLC, the difference is about the same as renewing a motorcycle license versus renewing a car license. Either way you have to go to the DMV and independent of the specifics that's the real hassle.
The core problems for an LLC are a) raising funds and b) hiring/managing employees. Once an LLC grows to a certain size and the partners seek to raise money through outside investment or delegate work to individuals it will start to shoe-horn corporation-like terms into its documents. The first problem is unavoidable and if you're a classic start up with big ambitions, it might make sense to incorporate as per FN1.
The second problem (employee management), however, is becoming increasingly manageable. Traditionally, incentivizing LLC employees was difficult because the portion of the IRS code which applies to employee stock option plans is solely relevant to corporations. Recent regulations, however, enable an LLC to efficiently grant "profits interests" to employees, which in effect act as stock appreciation rights (the logistics of such a grant are discussed here).
In addition, as far as the IRS is concerned, all LLC members are partners. Which means any employees of the LLC that receive equity won't be receiving W-2s and are subject to self-employment tax on income (at a rate of around 15% percent) rather than a share of FICA (at a rate of 7.65 percent) (as is the corporate case). This can vitiate the incentive of the equity (which is why LLCs commonly pay employees (who have equity in the LLC) a proportionally higher salary to compensate for the increased taxes).
Such are the high level variables that inform choice of entity. In the end, this is chiefly a question of tax strategy, so consult with your accountant.
FN1. A brief note here on the S Corp. An S Corp is (essentially, for the purposes of this discussion) like a C Corp except it has the benefit of flow through tax treatment (no double taxation). It's purpose is limited since it has limitations with respect to who can hold its stock (no entities and non non-U.S. citizens), among other things. An S Corp makes sense when the founders anticipate a future financing but also expect to personally fund the initial losses until that point in time and want to deduct those losses on their individual tax returns (i.e., pass through income tax treatment). Transitioning from an S Corp to a C Corp is relatively cheap and easy (for example, upon the event of funding from a VC, an S corporation will automatically convert to a C corporation). A very coherent and comprehensive comparison of the LLC and the S Corp is here.
FN2: There's plenty of commentary on on why this is the case in the blogosphere. A good summary is here. In short, an anticipated financing event (whereby the company is raising capital from outside investors) demands a corporate form because that's the way investors and lawyers are used to doing it. The LLC is a relatively new entity type (it wasn't really a tenable option until the late 1980s) and thus the investment community (and pretty much anyone involved in transacting financings (lawyers, accountants, etc.)) is not conditioned to working with anything but the corporate form (nor comfortable since there isn't a comparably established and uniform set of rules and regulations for LLCs). Thus, an LLC seeking to raise outside capital will, even if it finds investors interested in their business plan/product, almost inevitably a) be required to re-organize as a corporation (and this requires lawyers and if the company has any operational complexity at all can be expensive) as a condition to the financing, b) encounter significant documentation, legal and accounting costs (since all the standard templates for purchase agreements, investor rights agreements, term sheets, etc. are geared for the corporate form), and/or c) create more exposure to unanticipated costs (documentation mistakes, etc. that need to be corrected) and legal risks because of there's less guidance and standardization.
FN3. The limitation of liability that attaches to the corporate or LLC entity can be undone if it's shown, however, that a company owner provided a personal guarantee on the loan or commingled personal with company funds or otherwise did not adequately treat the company as separate from himself.
The more relevant question is whether the LLC is the preferred entity form in all other scenarios, at least given extant tax law and related legal and business trends. The answer is: yeah, mostly, or at least, probably, depending. Wishy-washy guidance, maybe, but that's how to stay clean, for sure.
If you're a small business without much revenue, employees or any partners you might not even need to formally organize. LLCs and corporations are desirable entity forms principally because they protect you from exposure to personal liability for actions you take in the capacity of an agent for the business. If a partner or employee commits a tort in the course of providing services then the entity form prevents an injured party from suing you personally. Similarly, if the company takes a loan and can't pay it back then the creditor can't go maraud your personal bank account. FN3
The LLC then is the preferred entity form for company that has growth potential but is not anticipating seed or venture financing (the most obvious example here is a consulting business). The rationale is pretty basic: an LLC has limited liability protection but a) "partnership-style" pass through taxation (whereby taxes flow straight through to LLC members - rather than to the corporate form first and then to shareholders (creating the so-called "double taxation")); FN3 and b) partnership-style flexibility in terms of organizational form (e.g., no need to record every major decision or hold formal meetings, the capacity for special allocations of profits (not according to percentage ownership), etc.).
In addition, it can be mentioned that LLC's have lower statutory compliance costs (in terms of paperwork, corporate fees, etc. filed with the government) and that's technically true (regardless of the state in which the LLC was formed) but also somewhat misleading since the expense difference is probably just going to be a few hundred dollars here and there. Along these lines although it's said a corporation is more complex (bureaucratically) to initially create than an LLC, the difference is about the same as renewing a motorcycle license versus renewing a car license. Either way you have to go to the DMV and independent of the specifics that's the real hassle.
The core problems for an LLC are a) raising funds and b) hiring/managing employees. Once an LLC grows to a certain size and the partners seek to raise money through outside investment or delegate work to individuals it will start to shoe-horn corporation-like terms into its documents. The first problem is unavoidable and if you're a classic start up with big ambitions, it might make sense to incorporate as per FN1.
The second problem (employee management), however, is becoming increasingly manageable. Traditionally, incentivizing LLC employees was difficult because the portion of the IRS code which applies to employee stock option plans is solely relevant to corporations. Recent regulations, however, enable an LLC to efficiently grant "profits interests" to employees, which in effect act as stock appreciation rights (the logistics of such a grant are discussed here).
In addition, as far as the IRS is concerned, all LLC members are partners. Which means any employees of the LLC that receive equity won't be receiving W-2s and are subject to self-employment tax on income (at a rate of around 15% percent) rather than a share of FICA (at a rate of 7.65 percent) (as is the corporate case). This can vitiate the incentive of the equity (which is why LLCs commonly pay employees (who have equity in the LLC) a proportionally higher salary to compensate for the increased taxes).
Such are the high level variables that inform choice of entity. In the end, this is chiefly a question of tax strategy, so consult with your accountant.
FN1. A brief note here on the S Corp. An S Corp is (essentially, for the purposes of this discussion) like a C Corp except it has the benefit of flow through tax treatment (no double taxation). It's purpose is limited since it has limitations with respect to who can hold its stock (no entities and non non-U.S. citizens), among other things. An S Corp makes sense when the founders anticipate a future financing but also expect to personally fund the initial losses until that point in time and want to deduct those losses on their individual tax returns (i.e., pass through income tax treatment). Transitioning from an S Corp to a C Corp is relatively cheap and easy (for example, upon the event of funding from a VC, an S corporation will automatically convert to a C corporation). A very coherent and comprehensive comparison of the LLC and the S Corp is here.
FN2: There's plenty of commentary on on why this is the case in the blogosphere. A good summary is here. In short, an anticipated financing event (whereby the company is raising capital from outside investors) demands a corporate form because that's the way investors and lawyers are used to doing it. The LLC is a relatively new entity type (it wasn't really a tenable option until the late 1980s) and thus the investment community (and pretty much anyone involved in transacting financings (lawyers, accountants, etc.)) is not conditioned to working with anything but the corporate form (nor comfortable since there isn't a comparably established and uniform set of rules and regulations for LLCs). Thus, an LLC seeking to raise outside capital will, even if it finds investors interested in their business plan/product, almost inevitably a) be required to re-organize as a corporation (and this requires lawyers and if the company has any operational complexity at all can be expensive) as a condition to the financing, b) encounter significant documentation, legal and accounting costs (since all the standard templates for purchase agreements, investor rights agreements, term sheets, etc. are geared for the corporate form), and/or c) create more exposure to unanticipated costs (documentation mistakes, etc. that need to be corrected) and legal risks because of there's less guidance and standardization.
FN3. The limitation of liability that attaches to the corporate or LLC entity can be undone if it's shown, however, that a company owner provided a personal guarantee on the loan or commingled personal with company funds or otherwise did not adequately treat the company as separate from himself.
Tuesday, December 21, 2010
Think Evil, and Early
The movie The Social Network takes place in a conference room, presumably at a law firm. Mark Zuckerberg and his lawyers sit across from Zuckerberg's former business partner and his lawyers and through flashbacks we learn how they ended up there. It's a clever narrative device and a post-worthy lesson for founders: in the best case scenario, maybe especially in the best case scenario - the company wildly succeeds - there may be disputes between the founders as to the distribution of that success.
Co-founders sue in bad case scenarios too. And medium case scenarios, I suppose. This is America. And, frankly, they might even have an understandable argument and claim. It might not even be them. It might be their son or widower or soon to be ex-spouse.
There's an obvious enough strategy to eschew the worst of this: document partner rights, responsibilities and distribution rules (in the event of a break-up) at the outset. This is frequently not done, or done with enough care, for all the reasons you'd suspect. Timing wise, the outset is an unlikely and also awkward moment to consider the dissolution of the partnership.
Ironically, doing the necessary documentation here is not a particularly onerous exercise. It probably does not even necessarily require a lawyer. It is simply a matter of drafting provisions into some operative agreement (usually the Bylaws (if you're a corporation) or the Operating Agreement (if you're an LLC) or otherwise some kind of partnership agreement if the partnership is some other form).
The provisions in that operative agreement (even if your attorney does the drafting, make sure these issues are addressed) should memorialize in detail: a) the time or capital (as is relevant) each founder is expected to contribute, b) what percentage of the business each founder is expected to receive and in what form (profits, capital, assets, etc.) and if any vesting provisions apply, c) what happens in the event the business needs more capital, d) whether a partner can be removed for cause or without cause and how is that transacted (majority vote? unanimous vote?) FN1 and e) what happens when a person leaves the business (or dies) (i.e., how much does that person get and in what form (cash, equity, etc.).
These precautions can't prevent disputes. However, they can make any dispute considerably less problematic (monetarily and psychologically) for the on-going concerns of the business.
FN1
The removal issue in particular can be tricky. For example, it might seem strategic to include a provision in an operating agreement that prohibits any founder from being non-voluntarily removed from a management position since that would protect the founders from losing control of the company at some later date to subsequent investors. When you're starting a company it's natural to think that enemies will come from without not within. But business conflicts are a lot like the other conflicts in life. The bad guy is typically someone you already know.
Co-founders sue in bad case scenarios too. And medium case scenarios, I suppose. This is America. And, frankly, they might even have an understandable argument and claim. It might not even be them. It might be their son or widower or soon to be ex-spouse.
There's an obvious enough strategy to eschew the worst of this: document partner rights, responsibilities and distribution rules (in the event of a break-up) at the outset. This is frequently not done, or done with enough care, for all the reasons you'd suspect. Timing wise, the outset is an unlikely and also awkward moment to consider the dissolution of the partnership.
Ironically, doing the necessary documentation here is not a particularly onerous exercise. It probably does not even necessarily require a lawyer. It is simply a matter of drafting provisions into some operative agreement (usually the Bylaws (if you're a corporation) or the Operating Agreement (if you're an LLC) or otherwise some kind of partnership agreement if the partnership is some other form).
The provisions in that operative agreement (even if your attorney does the drafting, make sure these issues are addressed) should memorialize in detail: a) the time or capital (as is relevant) each founder is expected to contribute, b) what percentage of the business each founder is expected to receive and in what form (profits, capital, assets, etc.) and if any vesting provisions apply, c) what happens in the event the business needs more capital, d) whether a partner can be removed for cause or without cause and how is that transacted (majority vote? unanimous vote?) FN1 and e) what happens when a person leaves the business (or dies) (i.e., how much does that person get and in what form (cash, equity, etc.).
These precautions can't prevent disputes. However, they can make any dispute considerably less problematic (monetarily and psychologically) for the on-going concerns of the business.
FN1
The removal issue in particular can be tricky. For example, it might seem strategic to include a provision in an operating agreement that prohibits any founder from being non-voluntarily removed from a management position since that would protect the founders from losing control of the company at some later date to subsequent investors. When you're starting a company it's natural to think that enemies will come from without not within. But business conflicts are a lot like the other conflicts in life. The bad guy is typically someone you already know.
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