Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.

Although the vast majority of start up companies looking to raise angel and venture capital start off with a C-Corporation structure, companies and investors alike are increasingly becoming more comfortable with the LLC structure. Almost all start-up and emerging growth companies, however, need some type of equity incentive plan for founders, employees, consultants and other service providers.

Unfortunately, few practitioners have the experience necessary to craft these plans, and many founders, employees and other service providers are really only familiar with incentive stock options (“ISOs”), which are not available to LLCs. Many LLCs are not aware of the types of equity incentive plans that might be available to them. Below are some equity incentive plans LLCs might consider implementing:

a. Option plan. LLCs can adopt an option plan, which may be the easiest type of equity incentive plan to implement and administer. To adopt an option plan, your LLC operating agreement should generally be a “unit-based” LLC in which individuals are issued units of membership interest in the LLC. Options are relatively widely understood by companies and by employees. Option plans also push off having to create a new class of equity (perhaps) because people with options are not members and have no voting rights or other rights of members until they exercise their option on the unit of membership interest. As mentioned above, LLCs can only issue “nonstatutory options” (“NSOs”) as opposed to “incentive stock options (“ISOs”). ISOs are treated more favorably than NSOs from a tax point of view. ISOs are generally not taxable at the time of grant or exercise. Instead, an employee is taxed at the time that the stock underlying the option is sold after exercise. Assuming an employee waits the requisite period, such a disposition of the stock after exercise of the option generally would be subject to capital gains treatment. NSOs are taxed at the time of exercise and generally subject to ordinary income tax rates (on the difference between value of the membership interest at the time of exercise and the exercise price). Option grants are usually effective when the manager(s) formally approves the issuance of an option and enters into an option grant agreement with the employee or service provider.

One issue in granting options is that the company should not issue discounted stock options. Your company should be issuing options at an exercise price equal to fair market value under the internal revenue code. Your company should also not backdate the options to a time when the fair market value of the underlying membership interest was lower. The Internal Revenue Service has issued some safe harbors for a company to be able to do this, and I would recommend that you follow them. Section 409A provides certain safe harbor rules, but the breadth and depth of Section 409A is beyond the scope of this post and will be subject to future posts. Employees have to actually pay the exercise price to get the underlying interest in this plan. Most plans have provisions for cashless exercises, however.

b. Profits interests: your company could issue a profits interest to people working for the company. This would immediately make them members, but you could make holders of the profits interests non-voting members of the company if you would like. Profits interests are a bit more complex than the options, and the company may have to make cash payments depending on how you structure them (you could make them only payable upon a liquidation or after a cash reserve above a certain available cash threshold). Also, if any future investor requires you to switch to a C-Corp, it is not as straightforward to convert these to a stock option as it is a unit option to option on common stock. I have used profits interests with companies frequently. Another issue is that you will start having to issue K-1s to these employees, as they will technically be partners for tax purposes. Consider whether this would cause you to switch from current W-2 reporting.

c. SARs, Phantom Equity, Omnibus Equity Incentive Plan: Your company could adopt a broad-based equity incentive plan that allows you to use a variety of the above and additional equity incentive plans.

i. SARs (or, in this case Unit Appreciation Rights, rather than Stock Appreciation Rights) are rights of a participant to be paid an amount equal to the difference between the value of the employer’s underlying stock on the date of exercise and the value on the date of grant. You can make SARs payable in units of membership interest in the company (roughly called a “stock settled SAR”, or in the case of an LLC, a “unit-settled UAR”) rather than in cash. SARs can be designed to be compliant with 409A of the Internal Revenue Code or exempt from 409A of the Internal Revenue Code (those are the deferred compensation rules we discussed briefly above).

ii. Phantom equity is generally an award of hypothetical shares of company stock (or, units in an LLC), and participants are entitled to payment at a specified date for the full value of the underlying units (including any appreciation after the date of grant). Participants do not need to pay an exercise price, and they have hypothetical units credited to their phantom equity accounts. A payout on the phantom unit accounts may be paid only upon a permissible distribution event (can be a specified date, separation from service, death, disability, change of control (as defined in Section 409A of the Internal Revenue Code).

iii. An omnibus incentive plan would allow you to issue any of the above types of interests for maximum flexibility. This may be a good option where the company wants to use Unit Appreciation Rights and Phantom Equity for some key employees (these are not usually ideal for a broad-based employee plan), while being able to issue options and other types of interests to other employees.

d. Capital interest: of course, your company could determine to grant a straight capital interest, but the individual will likely have a tax liability on the date of grant. This would entitle the member of the LLC to a capital account on the date of grant, and the individual would begin to be allocated items of gain and losses immediately.

No matter what plan your company ends up choosing, it is important that the LLC administer the plan in accordance with state and federal laws, and you should also give some thought the appropriate vesting schedule and hiring needs of the company.

A copy of this post may be found at Silicon Bayou News, http://siliconbayounews.com/2011/11/30/equity-incentives-for-llcs/