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Equity Compensation for Limited Liability Companies (LLCs)
by Teresa Y. Huang, David R. Johanson, Samuel W. Krause, Rachel J. Markun, Alan Nadel, Monica R. Patel, and Corey Rosen
This is provided as a zip file containing both the book PDF and the contents of the CD accompanying the print version of the book, with no shipping charges. It also is available in a print version (for which shipping charges apply).
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This book finally makes detailed material available on equity compensation in LLCs. It not only explains all the issues around LLC equity compensation but also includes a set of sample plan documents in Microsoft Word format.
In the second edition, the book has been substantially revised and expanded. The chapter on equity interests in LLCs was completely rewritten and expanded by a team of experienced attorneys. The same team replaced the single plan document in the first edition of the book with a new, complete set of plan documents. Additionally, chapter 6 has been added, discussing communicating with employees about equity. Finally, the chapter on accounting has been updated.
Format: Zip file containing book PDF and CD contents, 98 pages
Dimensions: 6 x 9 inches
Edition: 2nd (April 2013)
Status: Available for electronic delivery
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1. A Primer on Limited Liability Companies
2. Designing an Equity Incentive Plan
3. Equity Interests in Limited Liability Companies
4. Accounting for Equity Compensation in an LLC
5. A Primer on Sharing Equity with Employees in Non-LLC Companies
6. Communicating with Employees About Equity
Appendix: Using the Sample Plan Documents
About the Authors
About the NCEO
Sample plan documents (in Microsoft Word format) included on the print book's CD and in the digital book's zipped file:
Equity Incentive Plan
Capital Interests or Profits Interests Award Agreement
Action by Unanimous Written Consent of the Voting Members
Units Appreciation Rights Plan
Unit Appreciation Rights Agreement
From Chapter 3, "Equity Interests in Limited Liability Companies"Either type of interest may be subject to restrictions, such as a vesting requirement that is satisfied by the employee's service for a specified period of time or by satisfaction of certain performance standards. Either type of interest may be forfeited if the employee engages in criminal activity that results in direct harm to the company, such as embezzlement. Many companies also will want employees to forfeit their capital and/or profits interests if they go to work for competitors. While these anti-competition agreements can be written into equity grant agreements, they may be difficult to enforce. Many companies choose to take a middle ground, writing into their equity grant agreements repurchase rights and rights of first refusal that allow the LLC to buy back the employee's interest in the event that they leave the LLC, coupled with more limited "forfeiture" rights with respect to an employee that has been terminated by the LLC for "cause" as defined in the LLC's operating agreement. There can be variations as well in which the purchase price of the equity is modified based upon the circumstances and timing of the termination of the LLC employee who previously received a grant of equity. Whereas repurchase rights and rights of first refusal generally provide for a selling employee to receive the fair market value or book value of their capital interest, the "forfeiture" provisions often provide for the "bad actor" terminated employee to receive the lesser of fair market value or what he or she paid, if anything, to acquire the equity interest in the LLC. Either way, when structuring such arrangements, it is important to consider how the valuation and purchase price will be established (such as by a fixed formula, an independent appraisal, or otherwise). The use of an independent appraiser (albeit fairly expensive) adds some significant credibility to an equity incentive plan as employee participants now know that an independent third-party establishes the fair market value of their equity. Furthermore, it is not uncommon to couple such arrangements with noncompetition, nondisclosure, nonsolicitation, and nondisparagement arrangements.
The grant of either a capital or profits equity interest in an LLC is a contractual matter. LLCs need to have a written plan under which grants, awards, or purchases can be provided, as well as individual agreements with employees detailing each party's rights and obligations, and these agreements need to comport not only with state and federal law but also with the LLC's formation and operating agreements. Because of the myriad of considerations involved, it is essential that these documents be developed by qualified legal counsel and that they define all terms and requirements unambiguously. Furthermore, as a general matter, the grant of a capital equity interest typically requires a valuation of the LLC as of the date of grant, award, or purchase to establish a benchmark against which the future increase in the fair market value of the LLC may be measured.
From Chapter 5, "Accounting for Equity Compensation in an LLC"Unlike the capital interest in an LLC, a profits interest provides only for a share of future net income of the LLC. Although the terms of the profits interest may allow the employee to sell his or her interest in the LLC, it does not represent any ownership of the underlying capital or equity of the company. It is merely a right to a future cash payment based on company profits. ASC 718 addresses situations in which employee awards are settled in cash rather than an ownership interest in the business. It specifically provides for "liability" accounting in such cases.
The accounting rules allow the private company to make a "policy decision" about how to account for liability awards. The company may use either fair value or intrinsic value for award valuation purposes. Regardless of which approach is used, the profits interest is valued at the grant date (similar to the treatment of capital interests). Furthermore, in each subsequent accounting period the profits interest is subject to mark-to-market treatment until the award is settled. The result is that the company recognizes an expense for all cash payments made to the employee while the employee holds the profits interest rather than fixing the expense at the initial date of grant.
From Chapter 6, "Communicating with Employees About Equity"One of the best ways to build trust is open-book management. Companies using open-book management make a regular practice of keeping employees informed about how the company is doing. Employees feel a lot more like owners when this information is shared. While it is useful to share income statement basics and stock price changes, it is even more useful to share "critical numbers." These are the measures company leaders use to gauge just how they are doing week to week, month to month, and year to year. They are what drives company success, what leaders worry about if they are not being met. Critical numbers at the corporate level may be profits, but they might also be new customers, new patents, customer service, repeat buyers, overhead absorption, sales growth, and so on. At the operational level, each unit of a company also has critical numbers that measure its contribution.
Sharing these numbers helps employees focus on what matters. It is also very motivating. People will happily play slot machines for hours, even though they usually lose, because there is a game attached. But if they were paid, say, $50 for five hours of pushing the buttons, with no rewards for winning or costs for losing, casinos would go out of business. Business is also a game and is much more fun to play if you know the numbers. Jack Stack, the CEO of SRC, the leading thinker about these issues, says that not keeping employees informed about the score in business is like not telling basketball players who is winning.
In entrepreneurial companies that are looking to be sold or do an IPO, it is especially important to discuss the expected timing of that event, what the company needs to do to prepare for it, what milestones need to be met along the way to reach the company's goals, and what employees can specifically do to help reach them. Too often, company leaders occasionally say that their goal is one of these two events, but employees are left in the dark about management's vision of how to reach them.