A reader asks, What are the best practices for structuring equity as part of the compensation package at a limited liability partnership, or LLC?
Q: We've been running our business full time for four years, and we're in talks to bring on a potential partner. It's an LLC, and we want to structure compensation to include equity. What are the best practices?
Michael Simmons CEO and co-founder Extreme Entrepreneurship Education New York City
A: The structure of a limited liability company, or LLC, makes it relatively easy to give new partners stakes. But sharing equity works a bit differently than it does in a corporation.
Now, for a definition of terms. In an LLC, there are two types of equity compensation: a capital interest and a profit interest. A capital interest entitles a partner to a share of the profits and an interest in the underlying assets. A profit interest gives a partner the former but not the latter. The difference becomes crucial when the company is sold. At that point, a capital interest entitles the partner to a share of the proceeds, but a profit interest gets him a cut only of the company's increase in value. Capital interests are taxable upon receipt, but profit interests typically aren't. If your partner wants to avoid an immediate tax bill, a profit interest is usually the best way to go, says Brian Snarr, a partner at New York law firm Morrison Cohen.
Given the equivalence of time and money, if your new partner doesn't invest in the business, then he should typically put in three to five years before claiming full interest, says Greg Keshishian, managing partner of GK Partners, an executive compensation consulting firm in New York City. You can vest gradually or present the whole enchilada at the end. If your partner parts early or can't meet performance goals, he forfeits his unvested share. On the other hand, if he does invest money, he should get a fully vested capital interest.
You will need the counsel of an attorney and a financial adviser, says Snarr, but probably not an independent valuation. You should also draw up a buy-sell agreement that specifies when your partner can sell the stake, to whom, and at what price. After all, you don't want him shopping his stake to a stranger or, worse, to a competitor.