Frederic runs a $15 million a year e-commerce company that he has grown steadily for the last 10 years, pretty much by himself. Now he wants to bring on a highly experienced operational executive to focus on logistics, fulfillment and e-commerce, allowing him to focus on sales, marketing and product.
Because he wanted the COO to be a true partner in the business—not just working for a salary, but rewarded for 10x-ing the company from $15 to $150 million potentially—he wanted to offer an equity stake in the business. But he didn’t know where to start. “How do I set up a mutually beneficial equity plan for this new exec within my LLC?” he asked me.
Good question! As a flow-through entity, LLCs are unlike C-corps. There are important tax and control issues to consider when granting equity. There’s definitely advantages to granting equity. One is moving money out of salary expense (decreasing payroll taxes) into business owner income. Though it’s not a one-size-fits-all solution, equity is valuable when it works.
Let’s jump into the five main questions or steps I walked Frederic through.
Question 1: What Type of Compensation Is Ideal for this Hire?
Consider: Motivation and Longevity. My first question for Frederic was pretty basic. Is equity a better tool than salary-only or bonuses to accomplish his growth goal? Some hires aren’t in the mind-frame to stay in one place for the multiple years it might take to hit his big goal. They wouldn’t want or value an equity grant. Yet others do. I asked him if he wanted a hire that was in it for the long run, or someone with expertise to set things up and leave.
Consider: Disclosure. As an LLC owner, are you comfortable disclosing everything about your company? Transparency is very high in an LLC, especially compared to a private C-corp, where an equity holder may not know what percentage they own, what their stock is worth or how much they’re going to earn in a certain year. An LLC is truly a partnership for the business owner. Once somebody comes in as a partner with equity, they will get a K-1 tax form. That means all LLC equity owners get to see full financials, including what percentage of the business they own. Is that ok with you?
Question 2: What’s a “Good” Offer?
Frederic wanted to know how to make a good offer. Essentially: what’s normal for this type of position in my kind of company? How much should I grant this hire?
Consider: Benchmark. We looked at answering this in two ways. First, I had him look at executive benchmarking compensation studies to find out what a COO usually gets granted in a company for that role. The answer was a couple percentage points of the company.
Consider: Upside. The second issue was: if this person is super successful and does take the company into the future Frederic envisions, say, five or seven years out—at that future point, when you hit your goals, what do you want the hire’s upside to be? Do you want them to have an additional one times their annual salary? So if it’s a $200,000 employee, they make an extra $200,000 for working five years? Or do you want this person to make a million bucks? What is your target? If you know what your goal feels like, then you can work backwards to set it up, within the range of what’s normal.
Question 3: Use A Buy-In or Profit Interest Units?
In an LLC, there’s two main ways to grant equity. One is via an employee buy-in, where they buy the stock at its market value (either at hire or over a set time). The second method is through what’s called profit interest units, where you grant a share of the profit without their contributing anything. (In a C-corp, PIUs are like a stock option plan.) Many early-stage LLCs that I run into tend to move towards the PIUs, for many reasons, including these:
Consider: New Hire Relationship/Status. What did you decide in question #1 about transparency? If your new hire is buying in, this person instantly becomes a partner in the LLC and gets that K-1. How much information do you want to share with them right away? With PIUs, they can be a partner with an equity upside without being fully “open kimono” about the company’s financials.
Consider: Their Cash Ability to Pay. If someone is buying in, they need to write the company a large check for its stock. Certainly there are ways they can finance that purchase, or your company can finance them, but ultimately buying requires a large check to be written. Do they want to do this and can they? (This also means you’re going to get paid. You can take your chips off the table if you like and take the cash for you.) And note that “giving stock” to an individual also creates a taxable event for that individual, so they’ll still need to come up with cash to pay the tax implications of the “gift.”
Consider: Participation from Now or from the Start? Profit interest units are a little unique in the way they are granted. The hire joins the company as though today is “day zero.” If the company is worth $5 million today, they join at this point and participate going forward. If you sell the company for $20 million, they get part of the $15 million growth or profits since their start date, from the point they joined to the point they exit or you sell.
Buying into the company, however, essentially means participating from value zero to the exit value. You can see that PIUs creates different economics.
Consider: Yes or No on Voting Rights? When someone buys in, they’re (typically) buying the same class of stock that you own, the normal units of the company. That stock has voting and other rights. With profit interest units, you can specify whether they have voting rights or not.
From a control perspective, the question becomes this: is this someone you want to have a say in the governance of your company? Or do you prefer they be on the management team with the rewards of equity participation, but without a direction-setting vote? Think about big decisions and how your operating agreement is written.
How you answer this question could play out when it comes time to sell your company and you get an offer you like. Do you want to enable your new hire to block a sale, saying, “Nope, let’s keep running it.” Or do you want to issue PIUs and maintain complete control over those big decisions?
Consider: What If They Don’t Work Out? What if this person doesn’t do a good job or wants to go in a direction you don’t like, and 10 months later you want them out? As you’re kicking off this relationship, it’s important to think about how you want things to work if they leave.
If they bought stock and are now a part owner, they own the percent you set on day one. It’s harder to unwind that over time and they may not feel particularly invested to stay a longer time. You can put in repurchase rights and rules along those lines to be able to get your stock back.
Buybacks can be contentious and should be done carefully. If your attorney forgets to include that clause, it can very hard to buy the stock back. If anything happens to this hire, the equity may even pass to their heirs, which is a whole other kettle of fish. A good attorney will include a repurchase right, but even a new employee might refuse to sign that. They might say, “Hey, if I create a bunch of value and the company goes from $15 to $30 million and will hit $150 million based on what I did, and I choose to leave the company at $30 million to do something else, I don’t want you be able to repurchase.”
PIUs are easier in that you can create vesting schedules. Your new COO can earn equity over time, for instance earning 25% of a grant annually over four years. As you might have guessed, I often encourage LLC owners to look at PIUs because they offer flexibility. And they can be easy from a tax perspective. Your program can be designed with many contingencies to address your goals. You can even have your employee only participate in income upon a sale, not during the year.
Next: Valuation and Vesting
In Part 2 of this article, I’ll go into the last two key questions and tell you what Frederic decided. Question 4 is about getting a company valuation for an equity granting program (different from a tax valuation). And question 5 is about setting up ideal vesting schedules.
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