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.