Negotiating Favorable Executive Equity Terms in an LLC – Capital vs. Profit Interests
Despite the pandemic, executive recruiters face one of the strongest candidate markets in the past twenty years. You have more negotiating power than ever for executive compensation.
When it comes to executive equity compensation, do you know that there are differences between employee equity from a corporation and an LLC? This article explains two types of employee equity you can receive from an LLC, how they compare to equity in corporations, and what favorable terms to negotiate for your executive equity compensation package.
Equity Compensation for Executives in an LLC vs a Corporation
Corporations and limited liability companies (LLCs) offer equity compensation to reward and motivate employees. The forms of compensation they offer are different, though. These differences are related to the tax regulations that apply to the two types of business structures.
LLCs can choose to be taxed as a corporation, partnership, or a trust. Most LLCs choose the partnership tax designation because their members get certain tax benefits.
Partnership designation means that an LLC falls under different tax regulations than a corporation. Understanding how different types of equity compensation can affect your tax situation is critical before accepting an equity grant.
Choices for LLC Equity Compensation
An LLC can offer four types of equity compensation: profits interests, capital interests, equity options, and phantom equity. These forms of compensation are based on membership units in the LLC. Units of membership are similar to shares of stock in a corporation.
- Profits Interest – A profits interest lets you share in the future earnings and appreciation in value of the LLC.
- Capital Interest – A capital interest gives you a right to the existing capital of the LLC and any future income of the business.
- Equity Options – An LLC can grant an option to acquire a capital interest. When you exercise the option, and pay the strike price you get your interest in the assets and future revenue of the LLC.
- Phantom Equity – Phantom equity is the promise to pay a cash bonus equal to the value of a unit of capital or profits interest at a future point in time.
Earlier articles of mine have discussed options and phantom equity in the case of stock issued by corporations. Their characteristics are similar with LLCs, so this article will focus on equity unique to LLCs, i.e., capital and profits interests.
Vesting of Your LLC Interests
Like stock, both profits and capital interests, when issued, are typically subject to vesting, which means you forfeit all or part of the benefit of the equity if you leave employment before you are fully vested. The time frame is typically over 3 or 4 years. Often there is a one year “cliff”, so you vest nothing unless you stay a year. Sometimes there is a holdback even after the 3 or 4 year vesting period.
To further align the executive with company goals, vesting terms can also include a partial or full acceleration for a “success event”. This is often a liquidity event, acquisition or IPO, but it can be another milestone as well, e.g., favorable FDA or other regulatory approval.
Profits vs Capital Interests: Different Rights to Company Assets
The main difference between profits interests and capital interests is how the assets of the LLC are treated and the rights of the holder of such interest to assets of the LLC.
A profits interest is an interest in the future profits of the LLC and future distributions as a result of the appreciation of its assets. If the partnership liquidates immediately after granting the profits interest, you wouldn’t receive any distribution. If the LLC liquidates later, you’re entitled to a distribution of your profits interest percentage of that portion of the value as had increased since granting the interests.
A capital interest gives you an immediate interest in the assets of the LLC to the extent of your LLC capital interest as well as your percentage of future profits.
Profits vs. Capital Interests: Different Taxation and Uses of 83(b) Election
The different rights of these interests result in different tax treatment.
Because the profits interest has no immediate value, there is no taxation when the grant occurs, even if a portion is vested on grant.
However, for profits interests, it is important to make a section 83(b) tax election within 30 days of grant, to be taxed on all present value, taking into income unvested profits interests. Since all of the value is zero, this is a painless tax election. It costs you nothing. If you fail to make that timely tax election, then at each stage of vesting, if there has been appreciation so that your interest has value, you will face ordinary taxation, including payroll taxes, on that value at the time of each vesting. However, if the 83(b) election was timely made, taxation will only occur with the distributions you receive. If distributions occur from profits more than a year later, those would be taxed at lower long term capital gains rate.
For capital interests, your interest does have value from day one, and you will be taxed if and when you are vested. So, if you do get a capital interest, which is attractive because it has immediate value, you have to determine if you expect significant appreciation and also expect to remain long enough to vest. If the answer is yes to both, then you should consider also filing an 83(b) election. For the capital interest, you will have to pay ordinary tax on the present value you take into income. If that tax is high, you might consider doing a partial election, taking into income perhaps the first two years of vesting if you are confident you will remain two years, knowing you will face ordinary taxation on later vesting.
Threshold Amount and Its Determination
As said, LLC profits interests can be very attractive to the executive by combining the desirable features of two different forms of corporation equity. Like a restricted stock grant, there is no cost, and like an options grant, there is no current value, so you can make a painless 83(b) election.
But what is different about LLC profits interests from those corporate forms is that here, you take your value on appreciation over a specific threshold amount. In your LLC grant, you want that threshold amount clearly identified. You should also inquire as to its determination. You want a determination that would stand up to later IRS scrutiny. You also do not want a threshold amount that is so unrealistically high that it is unlikely your LLC interest will ever be “in the money.”
Additionally, the threshold amount, as all terms in your LLC, will be governed by the company’s LLC Operating Agreement. You want to check the terms of future modifications of your threshold amount.
Other Key Terms of LLC Operating Agreement
You also want to first receive a copy of the company’s LLC Operating Agreement and then review terms of that agreement relevant to LLC interests. LLC Operating Agreements are quite flexible in what they state and are often 30 or more pages long and quite complex but it is important to review the terms relevant to you.
The first thing to check, if you do have profits interests, is that those are covered and authorized by the LLC Operating Agreement. The next thing to check is how distributions are to be made, as well as terms relating to the threshold amount. You want to assure yourself you are being fairly treated.
Among the other important terms to check for are the company’s right to buy back or cancel your equity interest. Companies very often seek to cancel your interest once you leave the employment. I strongly resist that and would argue that if you have stayed long enough to vest, there should be a buyback only if it is mutually agreed. This way, if you want, you can hang on to your interests in hopes of a further liquidity event or other distributions.
It is exceedingly rare that an executive, even a CEO recruit, will secure any change in the LLC Operating Agreement already approved and well established among the investors. However, how those fixed LLC Operating Agreement terms are to be applied to the equity offered to the CEO, C-level or senior executive recruit, is quite another matter. You want to be sure your executive employment counsel fully understands how those LLC Operating Agreement terms will apply to you and your executive equity package of LLC capital or profits interests. Your counsel can, and certainly should, seek and negotiate for you provisions specially put into your own LLC equity grant or your offer letter, that assure that key terms of the LLC Operating Agreement will be applied by the company or the LLC managers in a manner attuned to your reasonable needs and protections.
As indicated above, LLC profits or capital interests can offer a great executive equity compensation opportunity for C-level and senior executives. However, the interests themselves, their taxation and the operating agreement can be quite complex. So it is wise to have a well tax-trained and knowledgeable executive compensation attorney review these terms to ensure that you will get the benefits you seek if you are successful at your job.
Written by Robert A. Adelson.
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