

Ask HN: I'm Contractor 0, now being offered equity--in an LLC. Can this work? - equifused

= TL/DR Version =<p>Partners want to let me buy into an LLC in small, incremental, non-voting, non-LLC-member bits. To the extent I do, it'll slow the cash burn rate and give me a share in the potential upside, which partners and I would both like me to have. I trust them in the reliable business associate way, not the pick them as godparents way. Can stock options be simulated for an LLC by contract?<p>= Details =<p>(I'm a regular reader &#38; writer here--this is a new account for semi-anonymity.)<p>I've been contracting for a web startup for more than a year now, the first and longest-running of a small team of developers. There are two partners and no true employees.<p>The partners want to give me the opportunity to buy options at the company's current valuation (based on angel investment) with a 1.5 multiplier. E.g., $100 buys $150 of stock.<p>* The company is currently an LLC with the two partners as the main members and the two angels as minority members.<p>* So far, the partners are selling only their shares, so the second angel didn't dilute the first. My equity would come out of the partners' shares in the same way.<p>* The idea is that any time I bill them, I can say, "Pay this much in cash, put that much toward equity." I can do this under the current terms until the next funding/valuation.<p>The Big Complication:<p>There's not a really obvious way to assign small bits of equity in an LLC. [EDIT: We're actually trying to simulate stock <i>options</i>, not pure stock.] The proposed mechanism is to have a written agreement (and log of actual purchases) that my share in the company converts to stock options (to buy at $0.01/share, or whatever) whenever the company converts to a C corp (in preparation for sale or larger funding round).<p>Anyone have experience with such an arrangement? Is it possible/legal? I know, ask a lawyer--I'm trying to get a framework for asking before spending the $$.
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grellas
You can simulate the grant of options in an LLC but, for this to be readily
quantifiable, it requires that the membership interests be defined as "units"
rather than just a percent of the company.

Meaning that instead of saying: "Member x 33%, Member y 33%, Member z 33%,"
you say: Member x 333,333 units, Member y 333,333 units, Member z 333,333
units."

The operating agreement then sets forth an "authorized number of units," with
some held in treasury, and option grants are then made from those treasury
units. If and when the options are exercised, the units are granted, with the
effect of giving ownership to the erstwhile option holder and of diluting the
remaining members.

If the operating agreement is not set up to define the membership interests in
the form of units, it can be amended to provide for this. There normally are
no special filings associated with this - just everyone agreeing to the
changes and doing a re-draft to the document.

You cannot do incentive stock options (ISOs) with an LLC and so the options
would be non-qualified (NQOs). This means that, if they are not exercisable
until, say, the occurrence of a liquidation event, you would be required to
pay ordinary income tax on their value as of the date of such an event, i.e.,
the tax structure would not be particularly favorable to you.

You may also have tax complications arising from the way you are designating
your payments as being in exchange for the options. On this, you do need to
see an attorney. The way you guys are doing it is not ideal, as it lets the
IRS put a direct measure on the value of the equity (based on the value of
your billings being exchanged for it).

In general, then, it is legal to do what you are doing but it doesn't sound
like it is being done in the best manner, given the goals of the parties.

I don't think there are securities law concerns here, as only certain LLC
issues falls within the securities laws (remember, at its basis, an LLC is
basically nothing but a traditional partnership).

All in all, though, you need to get good advice based on your particulars from
an attorney who knows what he is doing. Though I am an attorney, I can't give
specific advice in this type of forum. But I think the general ideas I have
suggested should point you in the right general direction.

~~~
tptacek
This is an awesome comment and I am now reading everything else you've ever
written here. Thanks!

[ _edit_ now I'm done and must respectfully insist you write more.]

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tptacek
I don't understand your question. You can sell/assign membership interest in
an LLC (although a member of an LLC can't take W2 wages from it). You can even
call it stock.

The problem with this arrangement isn't going to be legal formalities. The
problem's going to be that your tiny minority investment in a private LLC is
going to have no protections against dilution or unfavorable buyout. It's
possible that the only recourse you'll have if something goes wrong is to be
such a pain in the ass that they'll buy you out.

Note well that you will not be able to sell or transfer your equity interest
in the LLC to anybody else.

~~~
equifused
Right, but what we really want is options, not proper stock. They don't want
to make me a proper LLC member, and I don't really want to be one anyway.

Part of the idea is the equity-holding stuff won't become a tax event for me
unless they do sell or buy me out, which is roughly how I understand options
to work.

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anamax
> The partners want to give me the opportunity to buy options at the company's
> current valuation (based on angel investment) with a 1.5 multiplier. E.g.,
> $100 buys $150 of stock.

You really need to consult a tax specialist before doing anything because that
looks like a transaction that will be taxable immediately to you even if you
never buy the stock and the options expire worthless.

~~~
equifused
> will be taxable immediately to you even if you never buy the stock and the
> options expire worthless.

That's the picture I'm getting, but your way of putting it certainly drives
the point home!

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russell
THEY ask a lawyer, because they are probably the ones violating securities
law. IANAL. A possible framework is for them to grant you x,000 options that
you accrue on some basis. You reduce your rate, because you are part of the
team. I am not sure you can buy stock or options at your leisure because you
probably are not a qualified investor.

~~~
tptacek
It is not a violation of securities law to include equity as part of an
employee's compensation. You're right to point out that his 1099 status might
muddy this up, but the spirit of the arrangement they are trying to come to is
certainly achievable under an LLC.

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jbr
What's the motivation to remain an LLC? (My co-founder did all of the legal
stuff and chose to go directly for a C-corp, so I don't know what the benefits
of an LLC are)

~~~
equifused
I think they mostly want to avoid the extra time and money and ongoing
maintenance that go into C-corp-ness. Also, a change at this point will
certainly have tax implications for the partners and the angels. Good or bad I
don't know--more complicated, almost certainly.

