How To Incentivize Employees in a LLC context?

Question:  How would you financially incentivize key employees during the startup stage of a company? We’re an LLC so it’s hard to give units (but possible). The alternative is similar to “phantom shares”, but it’s expensive to setup.

Our Take:  First, I realize that “incentivize” isn’t a word (At least MS Word says it isn’t), but I can’t find a better substitute, so hold your grammar hammer comments. Your question is a tough one. While LLCs provide some tangible tax and operation benefits to a young company, the issues of employee equity ownership usually pull entrepreneurs to change their company to a corporate structure. (As an aside, most VCs can’t invest in LLCs per their fund documents – FYI).

Creating a phantom plan is an expensive pain. The two best ways are either granting / selling / giving units or setting up a “liquidation preference” for employees. One great thing about a well-setup LLC that it can be a very flexible document and one can normally amend the unit allocation table simply by amending that page and getting signatures from current unit holders. In other words, one doesn’t have to completely amend the document. The bad news is that you can’t very well impose vesting, so you end up amending the page often. The other bad news is that you are giving direct ownership of the company away.

One other technique that we’ve used is to not issue units, but in the allocation section of the LLC agreement, specifically say “in the event of a sale of the company, the payout will be X.” “X” can be most anything that you want. Perhaps it’s 50% to the founder, 30% to other co-founders and 20% to Jack, Jill and Mary, the company’s employees. Note that this “liquidation preference” is completely independent of unit ownership. If you want to get really creative, you could have the employee part of the allocation pay to an employee plan and then the plan pay out to the employees, so you only need to amend the plan and never mess with the LLC or feel the need to disclose this document to employees.

Bottom line, it’s a bit trickier than running a standard C-corp. Consult your attorney on this one.

  • Mike Tindell

    A note about incentivize: it is indeed a word. It may be used interchangably with incent. I think in this context incentivize is a better choice, since it sounds more buzzy; incent has connotations of incensed, which is not the desired effect.

  • Thank you for the suggestions. Your “in the event of a sale” option is much better than anything my lawyer came up with.
    BTW, you can right click on any misspelling in MS Word and just add it to the dictionary!

  • Yes, the “in the event of a sale” option is interesting, and one that we have contemplated as well. A question though, I have been told that in the event of a sale, any type of compensation arrangement such as this would be complicated by the IRS 409a code, which deals with deferred compensation. So for example, if a sale was executed and there was an earn-out, or some sort of additional payment based on performance, the subsequent consideration for an employee would be subject to the rules (and complications) of 409a. Has anyone given any thought to this? Any creative ways to to still provide an incentive based on a liquidity event, including deferred compensation?

  • One concern that I have with offering a liquidation preference (or allocation – I believe you are referring to the same thing in your post) is that the preference is not “dilutable”. (now is “dilutable” a word? )
    For example, let’s say you give a 10% interest in the proceeds of a sale to an employee, and let’s assume that this is a perfectly reasonable amount, given the financial picture of the company at the time. Anything less will leave you with an employee that feels unappreciated.
    What happens when someone invests $10,000,000 into the same company? At that point, 10% may seem far in excess of what the employee should be getting. Up the investment amount to $20 or $30 million if necessary to make this example work for you.
    If the employee had gotten units, then these units would have been diluted by the issuance of new units to the investor.
    So, it seems to me, this aspect could often make what I agree would be a wonderful method of compensating employees a problematic device.

  • Anonymous

    I realize this is an old post, but since I stumbled across it I figured I’d chime in.rnrnOur LLC issues Profits Interest Units to key employees, which we grant subject to a 4 year vesting schedule (1 yr cliff, 3 yr grad.). This was tricky for us to get legal and accounting advice on when we established it a number of years ago, but I believe this approach is more common now. rnrnThe primary downside is that the recipient becomes a K-1 member subject to self-employment taxes and loses eligibility for various employee fringe benefits. Still, it provides real upside and enables them to feel like a real entreprenuer!