LLC Trick # 258–Creating Employee Incentives through Profit Share Units
Because Limited liability companies (LLC’s) are a new creature in the alphabet zoo of business entities (which includes such varied species as the LP, LLP, C and S corps, etc.) there is a great deal of confusion regarding how to structure one to mimic some of the equity and incentive maneuvers made through corporations. First and foremost in many an entrepreneur’s mind is how to provide “stock options” when there is no “stock.” Remember an LLC is basically a turbocharged partnership, so there isn’t stock that one can issue. Owners aren’t owners because of stock, but rather because of the membership interest they carry. So no stock, no stock options, restricted stock, or actual shares.
Like many other legal “tricks” in the LLC world, your lawyer will have to come up with structures that approximate the outcomes in a corporation. Hence, the LLC does not offer options per se.
A potential approach to providing incentives to employees in an LLC is to share “profits interests.” by that I don’t mean a share in annual profits. Rather I am talking about a share in the profits resulting from the sale of the LLC altogether. While a share in annual profits is a relatively simple concept (I.E., the employee gets a piece of whatever monies are distributed by the LLC), the latter concept is not.
A profits interest in the vein I’m talking about is akin to a stock appreciation right. When one receives a share in profits upon sale, one is receiving a piece of the increase in the LLC’s value between the time the profit share was granted and the time the LLC is sold. So it’s not a piece of ongoing operational profits, but rather a share of the increase in the value of the LLC over a period of time. And unlike real stock options, there is potentially a more favorable tax treatment to this type of profit share grant.
Such a profit share is typically structured and provided through LLC units. Units are a way of parceling out an interest in the LLC. So rather than saying a member has fifty percent of a hypothetical LLC, if you were to represent the LLC as 100 units, then that member would have 50 units (or fifty percent of the total units). So you see in that respect units act like shares of stock.
Now it gets trickier. The founders who own all the units jointly can provide incentives to consultants and employees by not giving them the founders’ units, but rather by creating a new class of units altogether. So for example, the founders would all hold class A units and the employees and consultants would get class B units. Those class B units would be restricted to prevent sale and would only provide loss or gain on the sale of the LLC. And unlike a stock option there’s no capital outlay on the part of the grantee and no strike price (i.e., the price one has to pay to exercise the option.). Setting up a profit share plan such as this one can have positive tax treatments for the recipients as well.
So when thinking of what entity form you will go with for your venture, you should not dismiss the LLC, simply because as a traditional matter the corporation had the most tools to incentive-ize your people.
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