I’m walking you through five main steps to setting up an equity-granting program in an LLC. Frederic, the owner of a $15 million e-commerce firm, asked me how to compensate a new COO he wanted to hire to 10x his company. At the end, I’ll tell you what he decided.
In part 1, I went through the first three questions: 1. What is the ideal comp for this executive? 2. How do you know what makes a “good” offer? And 3. Should you use a straight equity buy-in, or offer a profit interest unit program? Here are the last two steps, plus the resources you need to put your new plan into action.
Question 4. What’s Your Company Valuation?
Whether you use a buy-in or a profit interest unit, the next step is determining what your company is worth, its valuation. If someone is going to own part of the company, you need to put a defendable price on that, one that can be agreed upon.
With profit interest units, you’re substantiating to the IRS that when Frederic gives those units to this new executive, he provided them at an appropriate valuation. Not undervalued, not overvalued. Obviously, the IRS wants to stop people from transferring value in a way that cheats or avoids taxes. If I have a $10 million company, I can’t say, “Well, I really think my company’s only worth $1 million.” It undervalues the equity transfer.
So Frederic needs a substantive valuation (or 409A) performed, and there’s a couple ways to do that. One is to use a valuation firm. That’s the most iron-clad and traditional answer. (At my company, AVL, we often use a company called Carta. They maintain a capitalization table for you and do options expense for C-corps, but they also do the 409A valuation work as well). Other financial advisors, like CPA firms, offer this service as well. The more complex the company, the more sophisticated the professional should be…
For simpler companies, there are ways to do this less expensively. Suppose you own a fairly small, privately held company, where there’s few external investors. Then having a professional like a CFO, a CPA or a tax person create an internal valuation report is probably a good estimate. Based on the industry and the market you’re in, or based on your revenue and profitability, they can come up with a solid estimated value. It may be a little more risky if you were ever sued or the IRS had questions, but it’s a perfectly acceptable course of action so long as the valuation is done by a qualified person. So ask yourself: how much risk do you want to take as an entrepreneur setting a valuation?
Question 5. What Vesting Schedule Is Ideal?
Setting up the vesting schedule is a critical final step. You need to understand how you want vesting to impact your new hire. Will you grant all the equity up front, or do you want a bit of a “handcuff” where they earn it over a period of a couple years?
The preponderance of evidence out there is that three- or four-year vesting schedules are most common. Many companies today are granting options annually; every year they grant the employee more options with four-year vesting. Your hire would only get it all if they stayed four years, and then five years, and then six years. It’s an ongoing employee incentive.
Getting Support to Put It All Together
Now you know your structure, its role, how many units, company valuation, and the vesting schedule. The last step is putting this together. Now you hire a corporate securities attorney to create your profit interest units agreement or stock purchase agreement and make it all work with your current operating agreement. You also need a tax CPA to help manage your capital accounts going forward and to figure out, from the tax perspective each year, the K-1s and your capital accounts. That’s a critical component from the go-ahead.
Your CFO should review this deal structure and your risk exposure. Even for a buy-in, there are other key items you need to have in place. For instance: buy-sell agreements with life insurance! If your new partner gets divorced or dies, you can set up insurance to help you or the company buy back that person’s equity. That’s a very common eventuality even in two-person partnerships!
A new AVL client is going through this right now, where two partners owned a multi-million software company and one of them sadly passed away. Now the company’s value is owed to that founder’s estate. The company is trying to determine their valuation to pay off the estate. Unfortunately, there was no insurance in place on the founder, to buy out the estate. So they have to negotiate how it’s paid, and finance it. It’s complicated because the company’s CFO didn’t prepare the company for this unfortunate possibility.
A CFO can also work on tax distributions, equity distributions, and updated valuation reports. You need to keep these and other things happening now that you have multiple members in an LLC.
Those are the key steps for setting up an LLC equity program.
Frederic’s Final Decision
Following these steps for the $15 million e-commerce company, we first figured out the COO’s base salary. Frederic decided this hire was not going to write a check to buy in, so he chose profit interest units. We set up a vesting schedule based on whether certain objectives were met. Specifically, he figured out an upside based on a five-year goal of taking the company to $50 million in revenue. So this new hire is creating $35 million in value, and Frederic wanted his executive to have at least a million dollars in value, about three percent of the company when they hit the $35 million revenue growth goal.
He wanted to grant three to five percent, a little higher than industry, but his company is a bit more mature. It’s still a growth company, so he felt good about that and it gave him an amount. For vesting he chose a three-year vesting with a one-year cliff, so the COO had to stay for one year before vesting the first 33% of the grant. The valuation is set on the date of grant, not as it vests, so this executive would see all upside from the date of hire. For Frederic, that structure gave him 12 months to figure out if this guy was going to be the right fit.
For a valuation, they hired their CPA firm for about $4,000. He said it was worth it to get a clean valuation and minimize that risk. Then they moved into paperwork.
Frederic had come a long way from his starting point, which was, “Why don’t I just give him 5%?” I had pointed out that 5% of a $15 million company is giving away $750,000 (estimating the company’s value at 1x revenue) like a signing bonus. That means the COO would be taxed on that. He’s going to have to write a check to the IRS for $300K. Furthermore, that size signing bonus is not market; it’s just not what you do. And what if he doesn’t work out after you’ve transferred ownership? Buy him out? He had a lot to think about.
Frederic saw the rationale of other options and eventually went with the profit interest units.
Without a COO, Frederic had grown his company to $15 million. With a COO, he wanted to 10x it and keep dreaming. With this equity plan, the COO could make a big difference and participate in that value creation from this point forward.
What are your questions about creating equity in an LLC? Let me know in the comments below. (In the future, I will address this issue in C-corps as well.)