7 min read
Finding great employees is no easy task, and keeping them is even harder. This challenge is particularly difficult for newly formed companies, which are often already stretched thin financially. Many startups can't afford to offer high salaries to attract and retain the best talent. However, offering equity compensation can be an excellent alternative. In this guide, we'll explore the types of equity compensation available to LLCs, discuss their respective benefits and consequences, and provide practical examples to help you devise your own equity compensation plan.
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At the beginning, the flow of money is almost entirely out of the company. Startups often don’t have the funds to offer market-level salaries. This is especially true for LLCs, as their ability to take on investors is more limited compared to corporations. Offering equity compensation instead of fully cash-based packages allows LLCs to offer lower salaries while providing employees with ownership in the company.
Example: Imagine a small tech startup with two founders, each contributing their expertise but with limited cash to compensate employees. To attract a skilled software engineer, they offer a modest base salary along with a 2% equity interest in the LLC. This combination helps the startup secure the talent they need while managing cash flow effectively.
Equity compensation gives employees a stake in the company’s success. When employees know that their efforts directly impact their own financial rewards, it motivates them to work harder to achieve company goals, going beyond simply fulfilling their job duties. This aligns the incentives of the employees with the success of the business.
Example: Suppose your LLC develops a new mobile app. By granting equity, you can encourage the product manager to take ownership of the app’s success. If the app becomes a hit, the increased valuation directly benefits the product manager through their equity stake, incentivizing them to invest extra time and effort to ensure the app's success.
Equity compensation often includes vesting requirements, which can help retain key talent by imposing a minimum period of employment before the equity is fully vested. Even after vesting, an employee’s share of the profits acts as a continued incentive to stay and contribute to the company’s success.
Example: A marketing specialist receives 5% equity in your LLC, with a four-year vesting schedule and a one-year cliff. This means they must stay for at least one year to receive any equity, and the equity gradually vests over the next three years. This encourages them to stay with the company and be committed to its growth.
Equity compensation in corporations is similar to that in LLCs. In fact, some people argue that you could simply replace the word “stock” with “interest” and much of the concept remains the same. However, there are key differences between issuing equity in an LLC versus a corporation:
In an LLC, an employee who receives equity becomes a member of the LLC. This means that their compensation is no longer subject to traditional withholding taxes, and they must make their own tax payments, including self-employment tax on all income received from the company. In a corporation, an employee receiving equity can remain an employee for tax purposes, with taxes withheld from their salary.
Actionable Tip: Be sure to communicate the tax implications clearly to employees receiving equity. They should understand that they will be responsible for paying self-employment taxes on their share of the profits.
LLCs that issue equity must keep capital accounts updated for each member, reflecting any changes in value. When equity is issued, these capital accounts must be adjusted to account for any grants made to employees. Corporations, on the other hand, do not have the same capital accounting requirements.
Example: Let’s say an employee is granted a 5% capital interest in your LLC. You must adjust your company’s books to reflect this change, ensuring that the employee’s capital account is updated to show their share in the company’s assets.
When an LLC issues capital interest, the ownership granted to the employee comes directly from the other members’ existing ownership, reducing their share proportionally. In contrast, corporations can issue new shares that dilute ownership but don’t decrease existing shareholders’ stakes as directly.
Actionable Tip: Plan the equity grant carefully to ensure current members understand how their ownership will be affected. Use cap tables to visualize the impact of issuing new equity on existing ownership percentages.
Capital interest in an LLC gives the holder ownership of the company's capital assets. This means the employee gets a proportional share of the company’s value, including any future appreciation and proceeds if the company is sold. This type of equity is somewhat similar to restricted stock in corporations and can be issued as either restricted or unrestricted.
Unrestricted capital interest is fully vested, meaning that the employee has full ownership rights without any restrictions on transfer or risk of forfeiture.
Tax Implications: The employee is taxed upon receiving the capital interest, and the LLC can take a deduction equivalent to the value of the interest granted. If the value of the capital interest has appreciated since issuance, the employee may recognize additional income, impacting the LLC’s tax deduction.
Example: If an employee is granted an unrestricted capital interest valued at $10,000, they will be taxed on that value immediately. The LLC can also take a deduction for the same amount.
Restricted capital interest is subject to vesting, meaning the employee must meet certain conditions (e.g., continued employment) before gaining full ownership.
Vesting and 83(b) Election: Employees can make an 83(b) election to be taxed at the time of grant rather than waiting until the interest vests. This can help reduce the tax burden if the value of the interest is expected to increase significantly before vesting.
Example: Techy LLC grants Elon a restricted equity interest valued at $10, subject to a five-year vesting period. If Elon makes an 83(b) election, he will be taxed on the $10 value immediately, and Techy LLC will get a corresponding tax deduction. If Elon does not make the election and the value of the interest grows to $25 at vesting, he will be taxed on the $25 value.
Actionable Tip: Provide employees with guidance on whether making an 83(b) election might be beneficial, and ensure they understand the risks involved, such as the possibility of paying taxes on equity that may eventually be forfeited.
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Profits interest represents an interest in the future profits and appreciation of the company, but not in the existing capital at the time of grant. Unlike capital interest, profits interest only gives the employee a share in the value added after the grant.
Example: Techy LLC is valued at $100 when Elon receives a 5% profits interest. If the company is later sold for $200, Elon will receive $5 (5% of the $100 increase in value). If the company is sold immediately after the grant for $100, Elon receives nothing because there was no profit or appreciation.
Actionable Tip: Use profits interest for employees who join after the initial formation of the company to reward them for future growth without diluting the initial members' capital.
Unrestricted profits interest may fall under the safe harbor rule and is often not taxable when granted if provided for services rendered.
Restricted profits interest is unvested and subject to certain conditions, similar to restricted capital interest. It generally is not taxable at grant unless specific conditions are met (e.g., certain exceptions in IRS revenue procedures).
Actionable Tip: When granting restricted profits interest, consider the conditions under which the equity will vest to align them with company growth goals, such as reaching revenue targets or project milestones.
An option to acquire gives employees the right to buy a certain amount of equity at a future date, usually at a predetermined price. This allows employees to benefit from appreciation in the company’s value without making an immediate investment.
Exercise and Taxation: The grant of an option is not taxable. However, when the option is exercised, the equity granted is taxed based on its fair market value, subject to the rules discussed earlier for capital or profits interest.
Example: If an employee is granted an option to acquire 5% equity at today’s value of $10,000, they can choose to exercise that option in the future, even if the company’s value has increased to $100,000, thereby benefiting from the growth.
Actionable Tip: Clearly communicate the terms of the option grant, including the exercise price, expiration date, and the conditions for exercising the option. This ensures employees understand their potential benefits and risks.
Phantom equity isn’t actually equity—it’s more of a cash bonus structured to mimic equity. Phantom equity can be tied to the value of the company’s actual equity, rewarding employees based on changes in value.
Tax Treatment: Phantom equity is treated as ordinary compensation income and is typically subject to 409A regulations governing deferred compensation.
Example: Phantom units may provide the employee with a cash bonus equivalent to the appreciation in company value, similar to how profits interest works.
Actionable Tip: Use phantom equity if you want to offer the benefits of equity without adding new members to the LLC. This allows employees to benefit from company growth without affecting ownership structure.
Equity compensation may trigger securities laws that require registration of securities offered by the company. However, Rule 701 provides an exemption for securities offered to employees under compensatory agreements, provided certain conditions are met.
Rule 701 Conditions: The offer must be part of a written compensation agreement, the recipient must be a current employee, and the total value of the equity offered must stay within specified limits (e.g., $1,000,000 or 15% of company assets).
Actionable Tip: Always consult with legal counsel to ensure compliance with both federal and state securities laws when offering equity compensation.
The amount of equity to issue may vary based on the development stage of the company. Common practice is to issue between 10-20% of the company’s equity for employee compensation. It’s important to plan well so that you don’t run out of equity to issue.
Actionable Tip: Create a detailed equity plan that accounts for current and future hires. This will help you determine how much equity to allocate for employee compensation without over-diluting existing members.
You should also consider restrictions on the transferability of equity. If an employee leaves the company or wants to sell their equity, restrictions can help prevent ownership from ending up with someone outside the company.
Buyback Clauses: Include buyback provisions or right of first refusal clauses to maintain control over who holds ownership in the company.
Example: If an employee leaves the company, the LLC has the right to buy back their equity at the fair market value to prevent outside influence.
Actionable Tip: Draft clear buyback or right of first refusal clauses in equity agreements to avoid future disputes and ensure the company's stability.
Equity compensation is a powerful tool for attracting and retaining talented employees, especially when cash flow is tight. By understanding the different types of equity compensation available to LLCs, you can design a plan that fits your company’s needs while balancing tax implications, compliance requirements, and ownership considerations.
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