Jan 2 2007 by Jason

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.