Ask Inc.: Structuring Equity at an LLC - 1 Apr 2009

Ask Inc.: Structuring Equity at an LLC

  http://www.inc.com/magazine/20090401/ask-inc-structuring-equity-at-an-llc.html

Q: We've been running our business full
time for four years, and we're in talks to bring on a potential
partner. It's an LLC, and we want to structure compensation to include
equity. What are the best practices?

Michael Simmons
CEO and co-founder
Extreme Entrepreneurship Education
New York City

A: The structure of a limited liability
company, or LLC, makes it relatively easy to give new partners stakes.
But sharing equity works a bit differently than it does in a
corporation.

Now, for a definition of terms. In an LLC, there are two types of
equity compensation: a capital interest and a profit interest. A
capital interest entitles a partner to a share of the profits and an
interest in the underlying assets. A profit interest gives a partner
the former but not the latter. The difference becomes crucial when the
company is sold. At that point, a capital interest entitles the partner
to a share of the proceeds, but a profit interest gets him a cut only
of the company's increase in value. Capital interests are taxable upon
receipt, but profit interests typically aren't. If your partner wants
to avoid an immediate tax bill, a profit interest is usually the best
way to go, says Brian Snarr, a partner at New York law firm Morrison
Cohen.

Given the equivalence of time and money, if your new partner doesn't
invest in the business, then he should typically put in three to five
years before claiming full interest, says Greg Keshishian, managing
partner of GK Partners, an executive compensation consulting firm in
New York City. You can vest gradually or present the whole enchilada at
the end. If your partner parts early or can't meet performance goals,
he forfeits his unvested share. On the other hand, if he does invest
money, he should get a fully vested capital interest.

You will need the counsel of an attorney and a financial adviser,
says Snarr, but probably not an independent valuation. You should also
draw up a buy-sell agreement that specifies when your partner can sell
the stake, to whom, and at what price. After all, you don't want him
shopping his stake to a stranger or, worse, to a competitor.