Comment by grellas | Hacker News Reader

Comment by grellas | Hacker News Reader

Parent Full thread

Mature LLCs do have tricky issues when it comes to option grants for employees. Among other things:

1. LLCs are partnership-like entities governed by an operating agreement and every owner (member) has to sign and agree to the terms of such agreement, meaning also that every owner (employee) gets to see in intimate detail who owns what within the company, who has what management authority, who has invested what, and the like. Bad for the company.

2. LLCs have no counterpart to ISO-like grants, meaning that everyone who exercises options can (normally) effectively do so only at the time of a liquidity event because he would otherwise have to pay an immediate tax on the "spread" (difference between exercise price and fair value of equity interest acquired) as of the date of exercise and would thereafter hold an illiquid investment for what could be many years. Bad for the employee.

3. Apart from the limitations of LLCs themselves, it becomes difficult to administer an option plan when the value of a company is already high because it costs too much for employees to buy into it. For example, if a company is already worth $10M, the exercise price of options needed to buy .001% of it would be $10K. How many employees want to part with real dollars for the hope of a speculative return way down the road, especially if the company itself says it has no plans to move toward a liquidity event any time soon?

Hence, the alternative plan adopted here makes sense. It does not represent any form of true equity interest but is an employee bonus plan. This means you lose the benefits if you leave employment. It also means you get, at best, employee compensation that is subject to tax at ordinary income tax rates as well as to all employment taxes (though no tax is due until the bonus is paid). It also means that the interest is not transferable. It is basically a special reward granted to those who stick it out over the years until the company gets to a liquidity event. It is not perfect but, given the problems noted above, it is actually a pretty good solution to the problem of how to afford special incentives to key employees whom you want to add value to a growing but mature company operating in LLC form.

Since we're on the subject: aren't there restrictions for LLCs about principles/members taking W2 wages? I know there's a way around this, but I'm curious about what the best practice is for issuing equity to employees at LLCs.

The members in an LLC can take W-2 compensation just as owners of any other entity can be employed by that entity and take salary, etc. There are no special restrictions on this, at least that I am aware of.

If early-stage LLCs want to adopt equity incentives, they can mimic what a corporation does with a little custom drafting to the operating agreement. Instead of defining ownership in terms of percentage ownership as set forth in a schedule (the typical LLC pattern), LLC owners who want to issue equity to employees can define the ownership in terms of "units" of ownership. They define a number of authorized units in an operating agreement (e.g., 10M units) and then reserve a grouping of them for an equity incentive pool. These can then be used to support unit option grants (like stock options, albeit always NQO and never ISO) or restricted unit grants (akin to restricted stock grants in a corporation). If this is all done in the early stage, the units can be priced at nominal pricing so as to avoid adverse tax consequences to the employees. There is still the problem of option holders being taxed on the spread on the date of exercise (as with NQO options in a corporation) but, otherwise, such grants may be made very much as they would be in a corporation (made subject to vesting, etc.).

The key to an effective plan is to do this early in the LLC's existence and, if done in that way, this is pretty comparable to what happens with a corporation (except for the absence of ISO-like options). As long as this is all done right, there are no special restrictions on issuing equity incentives to employees in an LLC.

LLCs are state-specific and it might be that there are special restrictions in Illinois or other states that don't exist in California where I practice. But the above sums up the essence of how it is done here.

I do not pretend for a moment to be the attorney here, but it is my understanding that members of LLC, unless that LLC has made an 8832 election, are mandatorily considered self-employed and must make quarterly SEP payments, and that they cannot be employed as W-2 because, as a creature of state statute, the LLC is not held at the federal level (for tax purposes) to be a distinct entity apart from its members.

This is false in at least the commonly understood case, you can elect to be treated like an S-Corp under an LLC and receive a salary and keep your SEP-IRA among other things.

The obligation to be 1099 is the default case for single-proprietor LLCs but can be overcome as I described above. It is not necessarily the case for multiple-member LLCs.

FYI:

I am not a lawyer, but I have done all this before.

you can elect to be treated like an S-Corp

Right, that's what an 8832 election I referred to in the original comment is.

You are correct; members of an LLC are considered self-employed, and since the entity is disregarded at the federal level for tax purposes, it's not really possible to pay them[selves] W-2 wages. You don't issue equity to employees in an LLC; you can issue shares of some sort of bonus pool like Jason describes, or you can make them members, but in that case, they have to pay SEP taxes and cannot be considered W-2 employees.

Generally speaking, LLCs are not appropriate entities for a highly fluid, ever-changing shareholder picture. If you want to be able to easily add or drop employees--and for that matter, institutional investors--as partners, don't choose a pass-through entity. Choose something that is structured as an appropriate vehicle for that kind of thing, i.e. a C-corp with a share pool.

There are ways to get around this, of course. The simplest idea I can think of if you are an LLC is to create a separate C-corp as a holding company, and have it own some (presumably non-trivial) percentage of the LLC. You can then issue shares in the Inc. holding company to your senior employees. The Inc. would of course be entitled to the highest liquidation preference, be dilution-proof to whatever extent desired, etc.

Edit: You can also do what grellas said above and make some sort of accommodation for an equity pool in an operating agreement. But if you want to actually write any employees in as partners, you'll have to amend your articles of organisation every time you do it. So, it's still by far not the most flexible entity type for that.

Reply on news.ycombinator.com