How to Provide Equity Incentive Compensation To Employees of an LLC
The best-known form of employee equity compensation is the incentive stock option. The laws that permit employers to issue stock options to employees on a tax-friendly basis, however, apply only to corporations, so limited liability companies that wish to incentivize their employees must approach the issue differently. There are several types of securities that an LLC can issue for this purpose, but the most commonly used is the “profits interest.”
An LLC profits interest is a class of membership interest with specially defined rights. It entitles the holder (i.e., the employee) to share in an increase in the LLC’s value. On the date of issuance, the profits interest holder and the LLC enter into an agreement that sets forth the LLC’s “liquidation value” as of that date. The liquidation value is the amount that the LLC would distribute to its members if it were to sell its assets and pay off its creditors. It serves as the “profits hurdle” for the employee’s profits interest.
Once other members have received distributions in the amount of the profits hurdle, the profits interest holder shares in future distributions. In this way, the profits hurdle is analogous to a stock option’s exercise price. Unlike a typical stock option exercise, however, the employee need not pay any money to the company. The tax treatment of profits interests is complex, but if properly structured the employee recipient will recognize no income or gain upon issuance.
Like stock options, LLCs often issue profits interests subject to vesting based on the holder’s continued employment. In that case, distributions that the holder would receive if the profits interest were vested are either held in escrow or issued subject to rights to recover those distributions (“clawback”). Profits interests typically are not transferable and are subject to repurchase if the holder leaves the company for any reason. Holders can be given voting rights, but that is uncommon.
The issuance of a profits interest in exchange for services constitutes the sale of a security, but an exemption from the registration requirements of the federal Securities Act is available under Rule 701. California law provides a similar exemption but requires a notice filing with the state Department of Business Oversight.
Profits interests also require special provisions in the LLC operating agreement. For example, the agreement must provide for at least two classes of equity (common and incentive). It should also, as a practical matter, delegate to the LLC manager the authority to issue profits interests up to a stated maximum so that the members need not vote on every new issuance. In addition, the LLC will need to draft and adopt a profits interest plan, which is similar to a stock option plan. Finally, individual profits interests agreements must be prepared for each recipient employee.
If your business is an LLC and you need assistance on equity compensation matters, contact the experienced professionals at Capobianco Law Offices.
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