Startup Equity Compensation for LLCs

Background Reading:

As I’ve written before, with more entrepreneurs realizing that the “standard” (whatever that means) corporate trajectory for startups may not be what’s best for their specific company, we are seeing more tech companies explore the possibility of operating as LLCs (limited liability companies). By all accounts, C-Corps are still the market norm, especially for companies with no near-term plans to achieve profitability (everything is reinvested for growth) and with plans to raise conventional institutional venture capital.

But nevertheless, the “LLC Startup” market is real, and there’s far less info ‘out there’ for entrepreneurs to understand core concepts.  Here we’re going to cover the basics of how LLC startups typically issue equity, and how it differs from what C-Corp startups do.

The primary driver behind why LLC equity comp is very different from C-Corp equity comp is that W-2 employees of an LLC can’t hold equity in that LLC, under IRS rules. For C-Corps, both contractors and employees can hold equity, which simplifies equity compensation. But for LLCs, holding *true* equity requires the LLC to issue you a K-1 on an annual basis (you’re a “partner” for tax purposes), and the Company doesn’t cover employment taxes the way it does for W-2 employees.

Units/Membership Interests and Profits Interests (True Equity)

High-level executives (including founders) in an LLC startup are usually OK with this issue, and will hold direct equity in the LLC. They’ll receive K-1s annually.

That equity usually takes one of two forms: Units (sometimes called membership interests), which are the LLC equivalent of stock. Units can be voted (usually) on Day 1, and they are taxable on receipt if their “fair market value” is not paid for, which is why they’re typically issued only in the very early days of the company, like founder/early employee common stock in C-Corps. They can be expensive to receive if they are very valuable (in the IRS’ judgment) on the issue date.

As the value (for tax purposes) of units increases, companies will switch to Profits Interests, which are kind-of a LLC corollary to options, because (i) they only entitle you to the appreciation in value of your equity after the grant date, and (ii) when issued properly, they are tax-free to receive. When profits interests are granted, the Company has to obtain or decide on a valuation that pegs the “threshold value” of the company on the grant date, and the recipient of the PI is then entitled to the increase in value of the equity above that threshold value.

Returns on both units and profits interests receive capital gains treatment, like stock in a corporation. While units usually have voting rights, profits interests can have voting rights, but companies often times structure them to not vote.

Unit Appreciation Rights (Phantom Equity)

While founders and senior executives of LLCs will often be OK with K-1 status and holding true equity, it can become problematic for a number of reasons (tax oriented, benefits oriented, etc.) to have everyone be a K-1 recipient as the business scales. When LLCs want to issue equity-like compensation to lower-level employees, while continuing to treat them as true W-2s, they will usually switch to Unit Appreciation Rights, which are the LLC equivalent of phantom equity.

UARs don’t vote, and aren’t really equity at all. Instead, they entitle the recipient to a cash payment (like a bonus) upon some future milestone (typically an acquisition/exit) that is pegged to the value of equity. Much like profits interests, on the grant date a valuation is determined, and then as the LLC’s equity appreciates in value after the grant date, the UAR holder’s future bonus increases proportionately. When granted properly, UARs are also (like PIs) tax free on the grant date.

While the upside of UARs is that they significantly simplify tax filings/treatment for recipients (no annual K-1s, can stay W-2), the downside is that returns on the UARs are treated as ordinary income by the IRS; no capital gains treatment.

LLCs require Tax Specialists

The main reason startups choose to be LLCs is taxes: given the nature of their business, they want to avoid the corporate-level tax applied to C-Corps, even if that means deviating from the C-Corp norms of typical venture-backed startups.

But the cost of those tax savings is significant ongoing tax complexity in issuing and managing equity, and making annual tax filings. That requires not just good accountants, but good tax lawyers; who are very different from classic “startup lawyers.” If you’re planning to be an LLC that will use equity as compensation, make sure you’re using lawyers with access to solid tax counsel.

Tax Disclaimer: I’m not your tax lawyer or advisor. I don’t want to be your tax lawyer or advisor. The above is just a summary of what we typically see in the market for LLC startup equity. LLCs are highly flexible, and circumstances vary. Do NOT try to rely on any of the above advice without engaging your own personal tax advisors, including tax lawyers. 

Early Startup Employee Compensation

Background reading:

Given how deeply involved we are with early-stage startups hiring their first key employees, I figured it would be helpful to outline a few key principles to help entrepreneurs navigate the topic.

Make sure they are actually employees, and if they are, at least minimum wage.

States vary in how strict they enforce the line between contractors and employees. California is way harsher than elsewhere in the country.

In general, employees are under your control as to how they work and when they work. Contractors, on the other hand, are required to deliver a service/end-product, but have more control over how it gets done, and they usually are working less than full-time hours and have multiple ‘clients.’ Those are very rough guidelines, and you should work with lawyers to ensure you stay on the right side of your state’s (and federal) specific rules.

The employee v. contractor classification is very important, because contractors can be engaged for free from a cash perspective (equity only). Employees, however, need to be paid at least minimum wage, and may be entitled to benefits. The legal and tax requirements for engaging (and terminating) contractors v. employees are also very different.

Every startup lawyer knows stories of startups that treated someone as a contractor in order to keep costs low, then the relationship went south, and the person ended up filing complaints and getting the startup into hot water. On top of following the rules, your best protection is to be careful with whom you hire, and be respectful/thoughtful if you have to terminate them.

All else being equal, more equity means less cash, and visa versa.

Generally speaking, if someone is getting paid significantly less than what’s “market” for their position, they will expect to receive more equity in order to make up for the difference. Very early employees are generally working at below-market (often substantially below market) cash compensation, and therefore receive much larger portions of equity than someone hired post-Series A or Series B.

And the converse is true as well. If someone, for whatever reason, needs to make $X, even if it’s a serious stretch at the startup’s current budget, then their equity should be proportionately lower. And it should go without saying, all employee equity should have a vesting schedule. 

All of that being said, the early employees will of course expect their compensation to move closer to market as the startup raises funds and hits revenue milestones.

In the very early days, employees are often paid more than founders / senior executives.

The further you move away from the founder team, the greater the dilution of a person’s commitment to the “mission” of the startup; and that means more cash to keep them committed.  For that reason, at pre-seed and seed stage, it is not uncommon for *true* employee hires to actually be earning more, from a cash perspective, than the founder CEO; obviously with substantially lower equity ownership.

After a decent-sized seed round (and certainly Series A), it becomes a lot rarer for the CEO to not be the highest cash earner on the roster.

For more info on what founders are typically able to pay themselves at the various stages, see: Founder Compensation: Cash, Equity, Liquidity.

Don’t over-optimize for market data.

When you reach post-Series A or Series B, it can be helpful when hiring people to obtain hard data on what’s “market” for a certain position, and use that data in negotiations. There are some good services to help with that.

But at very early stages, everything is highly contextual. I’ve seen teams where everyone is making almost nothing. I’ve seen situations where the founder CEO is making nothing, and their lead developer is making six figures. I also see everything in-between. It all depends on the relationships and context. Maybe ask around if you need to, or do some AngelList Jobs perusing, but don’t put too much faith in the value of broad market data for your pre-seed or seed stage startup’s hiring needs.

Employment laws and taxes are not a place to move fast and break things.

Finally, as much as I appreciate keeping things lean, moving fast, and skirting the rules where the costs are low, realize that violating laws around employee compensation and hiring/firing can burn you, badly.

In some contexts, unpaid employee compensation is even recoverable against the Board or executives, outside of the Company. Did you catch that? Let me repeat it for you: failing to pay employees compensation you promise them, or taxes for that compensation, can in some contexts result in personal liability for you, even if the company itself files for bankruptcy.

Take. This. Sh**. Seriously. While I’ve seen more than my fair share of nuclear wars between founders – see: How Founders (Should) Break Up – the deep relationships among founders often allow for more leeway in terms of following/not following the letter of the law. Employees are usually different, and will hesitate significantly less to use every weapon against you if you cross them. Make sure you’re well-advised from the moment you bring on your first *true* hire. 

When a Startup Lawyer can’t scale.

TL;DR: If you’re building a scalable business, your main lawyer(s) need scalable infrastructure to ensure projects/deals can get handled correctly, promptly, and cost-effectively. Hire a startup lawyer who can’t scale, and when you need them most, they’ll be unavailable.

Background reading:

When I talk to seasoned founders about what they really want out of their company counsel, their responses largely boil down to 3 things: quality, responsiveness, and cost-effectiveness. Any good, single lawyer can at some point in time deliver all 3 of those, but not consistently, and not at scale. To do that it takes what I call, broadly, “infrastructure.” If you hire a lawyer who doesn’t have infrastructure — no matter how good they may be — you can expect a world of pain at the very moment that you need him/her most.

Law firm infrastructure includes:

  • Paralegals / Professional staff (like word processing) to handle necessary tasks that you don’t want a lawyer billing hundreds of dollars an hour for (like signature collection, option grants, state filings, etc.);
  • Technology and institutional knowledge, like automated templates, form libraries, etc. to streamline standardized processes to ensure lawyer time is spent on higher-value work;
  • Junior attorneys and appropriate training/compensation infrastructure for them, to keep work moving that is too complex for paralegals/staff, but not cost-effective for Partners to manage;
  • Other partners/senior attorneys to keep work moving when the main partner isn’t available (on another deal, on vacation, sick, etc.);
  • Access to niche specialists (IP, Tax, Employment, Commercial, etc.) to ensure answers on complex issues get the right subject matter expertise, though they don’t need to be within the same firm;
  • Experienced M&A (Mergers & Acquisitions) attorneys who specialize in high-stakes exit transactions, which require different expertise from venture capital/angel financing experts.

The clearest symptom of a startup lawyer who can’t scale is slowness, and as anyone with experience in the startup game knows, time kills deals. To a lawyer who’s seen hundreds of deals, your $500,000 seed financing may seem like just another small deal.  But to you it’ll feel like life and death, and you can’t wait weeks for your lawyer to get on it because he’s on vacation, out sick, or stuck in another deal without the right support infrastructure to ensure yours gets handled as well. 

I’ve known lawyers who dramatically underestimate how time consuming and expensive it can be to build and maintain legal infrastructure. They think they’ll just wait until they get busy enough and “just find someone.” It always blows up in their faces. Hiring specialized, highly qualified staff and attorneys is hard in any specialty area. Building a compensation structure that works mathematically but will attract and retain the people you need is even harder. Many lawyers can’t actually afford it. There is a world of difference between a single lawyer handling his own little portfolio of clients v. building a real firm that can handle hundreds of clients, day in and day out, with minimal hiccups. 

Even within very large firms, you might run into lawyers who are, effectively, solos. By this I mean that they lack the relationships/connections within their large firm to really ensure their clients will get served properly. Again, the clearest symptom is slowness. If clients are regularly having to follow up with a lawyer, solo or within a firm, because stuff is not getting done, that is a clear sign that you have a startup lawyer who can’t scale.

An easy way to vet a startup lawyer for whether she/he can scale is: 

  • Analyze their website: are there other lawyers/professionals with similar experience on their roster? Some solo lawyers, sensing that smart clients know they can’t scale, will brand themselves as a firm, when really their “firm” is nothing more than… a website.
  • Ask them: when you’re not available, who else do you have quick access to for ensuring my work gets done? Ask for names, and diligence.
  • Talk to their clients: find out what companies in your network already work with them, and ping them for feedback (on your own).

Small businesses who may need their lawyer for one non-urgent thing every year or so don’t need to worry about their lawyer’s scalability. But tech startups are, by nature, high-growth and need regular, consistent, and sometimes urgent legal bandwidth. And changing lawyers/firms can be a serious pain, and lead to mistakes.

Hire a startup lawyer that can scale to the level you expect your company to be within the next 5 years, or you’ll regret it.

Non-Competes

TL;DR: Post-employment non-competes are generally not enforceable in California. Given how much content around tech entrepreneurship originates from California, you might get the impression that not having non-competes in startup employment agreements is the norm across the country. You’d be wrong.

The whole non-compete debate in tech circles is fun to watch. Certain people try to paint it in simplistic “good v. bad” terms. The champions of innovation who believe “talent should move freely,” v. the traditionalist ogres representing entrenched BigCo’s. But as you’ll hear me repeatedly say on this blog: watch incentives. Where you stand depends on where you sit. 

Imagine for a second that we’re sitting in a God-like seat, where we can push the population of a country in one of two directions.

Option A: People will have more babies, but die sooner.

Option B: People will have fewer babies, but live longer.

Now imagine there’s a debate among two sets of constituents as to which option should be pushed forward. The first group are the people currently living in that country. The second group are foreign shareholders in a conglomerate that sells (i) baby clothes, and (ii) coffins. Think there’s disagreement?

Get my point? Maybe a “Hunger Games” metaphor would’ve worked better. I’ll elaborate.

Ecosystem v. Individual Incentives

The debate over non-competes has a few core elements to it. First, it pits ecosystem v. individual incentives, which I’ve discussed in a few places on this blog. I’m fairly confident that if you remove the ability for employers and employees to agree (voluntarily) to have non-competes in their employment docs, the end-result is more companies and more bargaining power for employees (obviously); which is to say, it probably does net-out to faster ecosystem growth.

But if I’m an entrepreneur who has already started a company, I give far far more shits about the specific company I’ve sunk my sweat and tears into than about your “ecosystem.” Your ecosystem is not going to produce an ROI on my “one shot” investment.

However, if I’m a venture capitalist, angel investor, or run an accelerator, my ROI is tied to the ecosystem; I have portfolio, not “one shot” incentives. I benefit from incentivizing hyper-competition and the creation of new companies, even if it threatens the existence of those who are currently working on their “one shot.”

ps, it also increases the need for capital to fund talent wars. Watch incentives.

From an evolutionary perspective, you better believe it would help the human species if people died sooner and reproduced more. You also better believe the people currently alive might have a slightly different perspective on the matter.

So putting aside moralizing judgments, everyone discussing the non-compete issue needs to first acknowledge the reality of their misaligned incentives.

Grandstanding

Secondly, because so many people on the entrepreneurial/employer side, particularly in Silicon Valley (where there is an extremely^2 competitive labor market), are so concerned about being seen as “that awesome person/company that just LOVES employees and you really really really should want to work for,” there is very much a reluctance to speak honestly on this issue. You’ve got companies offering doggy daycare and daily massages to try to hold onto their roster. They sure as hell aren’t going to go on the record saying “yeah, it would be nice if we could have non-competes.”

So it doesn’t surprise me that most of the public content on the issue involves people grandstanding about the values of innovation, disruption, free talent flow, etc., and how they support outright bans on non-competes. The law (in California) is already there – they can’t have non-competes, and that’s not changing – so why on earth would I counter its logic publicly, when deviating from the script will hurt my recruiting efforts?

There’s a very similar dynamic going on here with the 90-day exercise period on employee options. Putting aside the legal and tax nuances around it, so much of the public content coming out of SV on it paints it as total BS and just a way for employers to “screw” employees.

Summary:

  1. Asking employees to commit to a 1-year non-compete is just employers “screwing” employees. Nothing more.
  2. Asking employees to exercise their options within 90 days of leaving the company, or forgo the equity, is also employers “screwing” employees. Nothing more.

Is not offering doggy day care “screwing” employees as well? Asking for a friend, in California.

“Non-competes and employee option expiration are outrageous! We’d NEVER do that to employees!”

Translation: “We’re hiring! Chef-prepared veganic meals daily. All you can drink Soylent.”

Employers (including current entrepreneurs) have wants and needs. Employees have wants and needs. Startup investors have wants and needs. And many of them conflict. Acknowledging it, instead of finger-pointing and grandstanding, makes debate possible.

Humanize the Issue

I’m very much a fan of humanizing complex business issues; which to me means distilling them down to basic norms and ethics of human interaction. It’s easy to get caught up in cold business calculus when you talk about “employers” and “employees,” instead of reducing the issue down to people simply bargaining with each other.

Say I’ve spent years building up a family restaurant, with all of my special recipes, business contacts, processes, etc., and I invite you to come work with me. I’m going to teach you everything about the business; all of my secrets. But to ensure I can trust that you aren’t just going to take everything I teach you and use it somewhere else, I ask you to agree not to compete with us for a year if you leave.

Am I an asshole? Or am I simply protecting myself somewhat from betrayal. I can think of lots of human scenarios in which this kind of bargain is perfectly acceptable and reasonable. And with my libertarian tendencies, I don’t feel comfortable with the government dictating that me and my prospective employee can’t simply agree among ourselves what the right bargain is.

And now we’ll have the necessary rebuttals.

But this isn’t about family restaurants, Jose. This is about Google and Apple trying to keep powerless employees from choosing where they want to work.

Is it really? You think the Pre-Series A entrepreneur with 10 employees isn’t exposed to a key employee walking with everything she’s learned and taking it somewhere else?  There are valid arguments for why non-competes need to be right-sized for the circumstances, and why perhaps very large corporations shouldn’t get the same benefits from them as smaller businesses. And also that lower-level staff should get more freedom than employees closer to core IP/trade secrets. Courts already think about them this way.

And let’s also stop playing the violins for a second. Are today’s tech employees, especially in startup ecosystems, really powerless?

But confidentiality provisions and other IP protections still protect companies, even without non-competes.

Trust me, it is 100x as expensive to prove in court that someone stole your trade secrets than it is to point to a paragraph in an employment agreement and be done with it. Google and Apple have the resources to fully enforce their IP confidentiality. Most small companies / startups do not. Today, total banning of non-competes may help Goliaths more than Davids.

But removing non-competes requires employers to hold onto their employees in other ways.

I get it. Government reduces the power of an employer, so the employee now has more leverage. Employee therefore gets better treatment. Wonderful. But the point of this post is that employees aren’t the only people in the business ecosystem that matter, and there are valid arguments on the other side that are worth hearing.

Non-Competes are the Norm. 

Outside of California, non-competes are the norm, and they can be valuable, among the many other bargaining mechanisms, between employers and employees. They can help provide a foundation of trust, which allows employers to invest in their employees for the long-term.

Maybe you’re so gung-ho on the total free flow of talent and “ecosystems” that you absolutely want to forgo non-competes. That’s perfectly fine. Every company is different, and has its own culture. But at least understand why your counterparts at other companies may think differently about the situation, and offer alternatives. That’s how healthy labor markets are built.

The right answer on non-competes probably lies somewhere in the middle of the two polarized sides. On the one hand, it is definitely unfair for a powerful 20,000 employee behemoth to be able to restrict even a secretary from working at a competitor. I think we can all agree on that, and the courts already do. But that doesn’t mean the same rules should be applied to the key employee at a 10-employee startup.

On the other hand, there is a valid argument that the level of hyper competition in Silicon Valley is not something other ecosystems should try to totally replicate. It may lead to talent wars, which waste resources on frivolous perks, and require larger rounds of capital. It may also hurt the ability of companies to invest in their talent for the long-term, because they’re constantly worried about that talent being bought out by a better capitalized competitor.

We should all agree that there are valid points to be made on both sides, and valid disagreement as to what a “healthy” startup ecosystem really looks like. The grandstanding and obfuscation of misaligned incentives is the problem.

Transparency, Risk, and Failure

TL;DR: In the very uncertain, high risk environment of an early-stage startup, the most successful founders are extremely good at practical risk mitigation. One of the most important forms of risk mitigation is to build a culture of transparency and honesty at all levels of the company; meaning people say what they’re thinking/feeling, and do what they say they’re going to do. No politics. No surprises.

Background Reading:

One of the biggest myths, in my experience, about successful entrepreneurs is that they are generally risk-seeking, risk-loving, uber-optimists who fearlessly run right into unknown unknowns, expecting things to turn out for the best. It’s just false. My word for the person I just described is “idiot.”

Yes, they are optimists, but what they’re often optimistic about is their risk mitigation skills. To an outsider, they may look fearless and indifferent toward risk. But in their mind they’re constantly analyzing risks, including seeing risks that others don’t see (the paranoid survive), and actively taking steps to address them.

In the early days of a company, without a doubt one of the largest sources of risk is, to put it simply, people. Co-founders, employees, consultants, commercial partners, investors, advisors, etc. Before your company has become a fully greased and well-running machine with an established brand, market presence, and gravitational pull, it is, in large part, a highly fragile vision of the future; dependent, to the extreme, on a handful of people and their ability to execute toward a common goal. It takes just one “bad” person, or decision, or accident, in that group to bring it all crashing down. 

Each person carries around risks; either risks that originate from them, or risks they know more about than others. Examples:

Co-founders: Are they truly satisfied with their equity stake/position at the company, and committed to the cause? Do they feel like the CEO is the right person for that position, and making the right decisions, with the right input?

Employees: Are they happy with their compensation/position, given the resources and stage of the company, or are they already planning an exit? Do they feel like the company is moving in the right direction? Are there behaviors/activities going on at the company that the C-suite should know about, but maybe aren’t aware of?

Commercial partners: Are their intentions the ones they’ve actually stated at the negotiation table? If circumstances or incentives change, will they try to preserve the relationship or at least reasonably negotiate a fair break, or will they try to maximize one-sided gains?

Investors: Do they truly believe the current executive team can execute effectively at the current stage of the company, and if not, have they communicated their thoughts to the team? If they are planning for changes, are they letting the team know, so the process can be open and balanced?

By working with people with a heavy bias toward transparency and honesty, you maximize your visibility into risks, which maximizes your ability to proactively address them. Risks that take you by surprise are 100x more deadly than those you can see coming. But what does transparency mean, and how do you find it?

Transparency means:

  • Saying what you’re truly thinking, feeling, and planning to do, instead of what may be optimal for you to convey in a short-term self-interested sense;
  • Even if you’re not the best at verbalizing your thoughts/feelings, conveying them in other non-verbal ways – transparent people tend to show more emotion. The perpetually sterile, calculated, always careful not to speak off-script demeanor that all of us encounter in business is the opposite of what you should look for.

It does not mean blurting out your thoughts at random without proper self-awareness or sense of propriety, or conveying more information than specific people really need to know. The “radical transparency” I’ve read about in some circles – for example, the idea that everyone needs to know everyone’s compensation – in my mind is asking for trouble. There is always information that the CEO has that should be heavily filtered before it gets to employee #200, and visa versa. But a thoughtful, respectful, durable culture of transparency ensures that the right information flows to the right people who truly need it and can benefit from it. 

It also does not mean always being the nicest, most agreeable person in the room.  Sycophants and glad handers may keep the peace, but at a cost of smothering you with so much bullshit that you can’t hear the things you really should be hearing. There is an art to conveying uncomfortable information, and people can be trained/coached for it, but it will always still be somewhat uncomfortable.

I’ve been very happily married for almost 10 years (this December!), but I’ll be damned if I ever tell you that hasn’t come with conflict. If anyone ever tells me that they’re in a serious, complex relationship that is completely conflict free, I hear one word in my mind, and one word only: divorce. Small conflicts prevent massive ones. If there is honesty and transparency, there will be some conflict, and it will make you stronger. 

And of course, if you’ve struggled to find, attract, and retain people who are honest and trustworthy, a very good place to analyze the problem is a mirror. Company culture is very much a reflection of the people who started it. Be the person you expect others to be.  And if you want transparency, don’t penalize people when they act accordingly.

At the end of the day, transparency is the foundation of trust in relationships, and the data is universally clear that virtually nothing helps teams, businesses, and broader networks thrive (and minimize serious conflict) better than trust. In the world of startups, there are hundreds of sources of potential failure that you are constantly battling against, and that you can’t do a lot about. Very very few risk mitigation tools are in as much of the founders’ control as the culture they implement in their team from Day 1.

Do the intentional, hard work up-front to recruit/engage people who say what they’re thinking, and do what they say they’re going to do, and you’ll maximize your chances of survival. You’ll also keep your legal fees way lower in the process.