Equity Compensation for LLCs

TL;DR: LLC equity compensation is more complex to manage than C-Corp equity. For scaling companies, profits interests and unit appreciation rights are the most common, but each has its tradeoffs.

Granting equity to employees / contractors of a C-Corp startup has become a fairly standard process, and you can read all about it on tech startup blogs.  But as we’ve written before, C-Corps are much less dominant in the CPG world than they are in tech. We see CPG LLCs at least as often as we see C-Corps, and unfortunately granting equity under an LLC is much more complicated. The three most common forms of LLC equity compensation that we see are as follows:

Units / Membership Interests – the LLC equivalent of common stock. It’s a ‘straight’ ownership interest in the company, just like founders. Much like restricted stock grants in C-Corps, the tendency to grants LLC units/membership interests (sometimes called ‘capital interests’) generally tracks the value of the Company.

Broadly speaking, companies do not want to force their employees (or contractors) to have to pay something in exchange for an equity package. They highly favor “tax free” receipt of equity. C-Corp options, when properly structured, are tax-free to receive. To receive LLC units or membership interests ‘tax free,’ you have to pay their “fair market value” (the same is true of common stock).  That is very easy to do when, from an IRS perspective, the equity is worth almost nothing. It is much harder to do when it’s worth tens of thousands, or hundreds of thousands, of dollars. This is why very young companies might grant straight units / membership interests to recipients happy to pay a few dollars for them.  But larger CPG companies opt for other alternatives.

Profits Interests – Profits interests are the form of equity compensation that we most often see for CPG companies who are LLCs. Without getting too into the complexities, the idea of a profits interest is that the recipient is generally entitled only to the appreciation of the Company’s value above the value of the company on the date of grant.  It’s easier to explain by contrasting it with a straight membership interest.

If the Company is worth $100 on Day 1, and I receive a 5% membership interest in the Company; that membership interest is worth $5.  I’m getting full 5% ownership of the entire pie.

But if I receive a 5% profits interest on Day 1, from a tax perspective my profits interest is worth $0 at grant. I’m only entitled to 5% of the value that is created above the starting $100, which means a 5% profits interest is worth less than a 5% simple membership interest.

Profits interests, when granted in this way (with proper tax advice), should be tax-free on grant. That is great for the recipients, and is why it’s a very common form of equity compensation when company’s have some real value in their equity.

Profits Interests have a downside that they share with Membership Interests, however. If you own a profits interest or membership interest in an LLC, you can’t be an employee of that same LLC for federal tax purposes. Even if from an employment law perspective they are ’employees,’ they have to pay self-employment taxes just like a contractor. This can be a very material downside for certain companies.

Unit Appreciation Rights – These are the LLC equivalent of a “phantom equity” right, or stock appreciation right. Effectively, they are right to receive a certain amount of cash equivalent to holding a certain membership interest in the company, without actually being an equity-holder. They are easier for recipients than Profits Interests because employees are able to hold them while staying as W-2 employees for federal tax purposes. The big downside, relative to Profits Interests or Membership Interests, is that they are taxed as ordinary income; no ability to get long-term capital gains. Profits Interests and Membership Interests are able to qualify for capital gains tax rates.

An extra layer of complexity to all of these arrangements is that an LLC could choose to be taxed as a Corporation for IRS purposes, even though it stays as an LLC. That’s not very common in the CPG world, but when it happens, it changes some of the variables around equity compensation.

Aside from the above, there are a wide variety of alternatives for granting equity or equity-like interests in your company to employees and other service providers. As mentioned before, LLCs are generally a lot more flexible and less standardized than “cookie cutter” C-Corps, which allows for more creative structuring. A properly structured equity incentive plan for an LLC will allow the company’s Board of Managers flexibility in choosing the right type of equity incentive for each recipient.

Disclaimer: It should go without saying, but please do not base your company’s tax planning on a blog post. Hopefully you found this post educational, but absolutely consult personal advisors/counsel before committing your company to a specific path.

Does my CPG Company need to be organized in Delaware?

Background reading: How CPG Startups differ from Tech Startups

Short Answer: Long-term, possibly. Short-term, probably not.

Delaware by far dominates the tech startup world, for a number of reasons that you can read about extensively on other blogs/articles. Tech venture capitalists often require Delaware, as do many tech accelerators. Most of the standardized investment documents for tech startups assume a Delaware corporation.  But as we wrote about in the above-referenced post, the CPG world is very different from Tech.

First, there are no standardized investment documents for CPG Startups, so there’s no issue with needing to conform to any standardized, DE-based expectations.  There’s a lot more fluidity/flexibility in how CPG startup financings are structured, and that leaves more room for fitting into your particular state’s legal requirements.

Second, LLCs are far more dominant in the CPG world than in tech. LLCs governance is much more contractual in nature; as opposed to statutory. That, to a large extent, makes state law less significant for LLCs than Corporations. This too makes Delaware less of a requirement, certainly at early stage, for CPG startups.

Generally speaking, CPG startups in states with reasonably sophisticated business environments (CA, CO, TX, NY, WA, MA) shouldn’t feel pressured to organize in (or convert to) a Delaware entity unless there are investors requiring them to. Larger institutional CPG investors will still often prefer Delaware, but are less likely than tech investors to set it as a condition to investment.

Our usual approach is that if we’re already going through a significant corporate event, like a conversion from an LLC to a Corp, we might favor moving to Delaware just for long-term planning purposes, but more often than not local state law works just fine for CPG companies.

How CPG Startups Differ from Tech Startups

There is an entire ecosystem available online for tech startup entrepreneurs to learn about the intricacies of forming their companies, fundraising, exiting, and everything in-between. Unfortunately, the CPG world has only a tiny fraction in comparison. We regularly see CPG entrepreneurs relying on online resources meant for tech companies, but it’s often not a good fit. The purpose of this blog, and specifically of this post, is to highlight a few key differences that CPG entrepreneurs need to keep in mind regarding legal issues faced by CPG companies.

1. LLCs are a lot more common for CPG.

Without getting too into the weeds, the most material difference between C-Corporations and LLCs is that C-Corps have an entity-level tax that LLCs do not have. Profits from LLCs “pass through” and are taxed at the individual level of the LLCs members (1 tax layer), whereas C-Corps have a corporate level tax that must be cleared first and then distributions are again taxed at the individual level (2 tax layers).

C-Corps are by far the dominant legal structure for tech startups, for a number of reasons, largely revolving around (i) norms and institutional structures of venture capitalists, and (ii) the very high-growth nature of tech companies that often leads them to operate at a loss for long periods of time; rendering the corporate tax on profits a non-issue.

In the world of CPG startups, however, LLCs are far more common. We typically see an even split between C-Corps and LLCs in CPG. Individualized circumstances around how the company plans to be funded and scale, the expectations of investors, and tax nuances all play a role in which structure a particular CPG company will implement. But the most important point to understand up-front is that, as a CPG entrepreneur, you should not take the advice of all the tech startups blogs out there and automatically assume a C-Corp is the right path. CPG companies grow and run very differently from tech companies, and LLCs should be strongly considered before a decision is made.

2. Equity compensation for employees is less common.

Virtually every tech startup has an “option plan.” Employees who join tech startups expect an equity-related component to be a significant part of their compensation package. For this reason, it is not uncommon at all for a typical technology company to have hundreds of stockholder-employees. CPG companies, however, usually don’t use equity as a standard part of service compensation in this way.

The degree to which CPG startups issue equity to employees varies with the culture of the company. For some, they act more like tech companies and give everyone a small piece of the pie. For others, equity is held more tightly by key executives and founders; with cash-based compensation dominating for everyone else.

Whether or not a CPG company is an LLC or C-Corp can also play a role in determining the degree to which equity gets issued. Generally speaking, managing a large number of equity-holders is much more complicated under an LLC than it is for a Corporation. We do have many LLC CPG clients with equity incentive plans that utilize profits interests in much the same way that a C-Corp startup would utilize options, but it is not a universal norm, and it is not as simple to implement.

3. Investment / Financing structures are far less standardized.

There are deep cultural norms in the tech startup world around what a financing round should look like. There are even templates available widely online for financing a tech startup. This significantly narrows the variation in fundraising structures, which also has the benefit of keeping legal fees in check.

The CPG world has far less standardization in financings. There is no such thing as a “standard” seed financing in CPG. Working with counsel/advisors to understand the pluses and minuses of different structures, and also understanding what your investors expectations are, is key.

4. Valuations are less lofty.

Determining the appropriate valuation for a tech startup is often, certainly at early stage, far more art than science. Pre-revenue or companies with barely any revenue will receive valuations in the 8 figures because of the team, the size of the market, and investors’ belief that they will execute properly. This would all be considered absurd in the CPG world.

Physical products take much longer to scale, and are lower margin, than technology products. Valuations are therefore far more conservative, and are far more likely to be based off of a revenue multiple. For this reason, CPG startups bootstrap for far longer than typical tech companies, and will also rely more heavily on conventional business lending (enabled by hard assets) for growth.

Unit economics (clear path to profitability) also play a significantly more prominent role in diligence than they would in tech. A CPG company therefore often needs to be much larger, in terms of revenue, than a tech startup before the numbers start to make sense for outside equity investment.

5. Branding / Trademark law are taken much more seriously. 

In the tech startup world, logos, branding, and even the name of the company are generally considered secondary concerns relative to the more practical features/value delivery of the product. In CPG, where you’re competing for scarce consumer attention in a crowded market, branding is core “IP”, and companies will go to much greater lengths to develop, protect and enforce it.

In short, utilizing the web for building knowledge about how to handle your CPG company’s legal needs is great. But good advice is usually highly specialized. Be mindful of the industry that a particular blog post or article is targeting, because it may be talking to entrepreneurs with very different circumstances/needs from your own.