Option Plans for LLCs: Incentivizing Key Employees
This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Cara Stone, LLP and the author expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.
As a company grows, many business owners want to reward their key employees with equity in the business or rewards tied to the business’s performance. We’ve discussed several equity incentive plans for LLCs in prior posts, and today, we’re focusing on one strategy in particular – option plans for LLCs.
What is an option plan (and what it is not)?
There are certain scenarios where an option plan can be a great tool for employers. An option plan, generally speaking, is designed to incentivize employees and contractors to work over a period of four to five years to see the company grow in value or achieve some milestone. The idea behind an option is most of the time that people want to incentivize people to share in the exit proceeds down the road, but not necessarily get any cash flow from the business.
An option in a company, just like an option on real estate, is the right to buy equity. However, the option is not actual equity. An equity interest is what gives an employee or contractor the right to receive profits or dividends. The profits or dividends can be from the operations of the company or some distribution at exit. The option does not make an employee an owner of the corporation or the LLC, but it allows them to exercise or buy the equity at some later date when they think that they might want to share in the upside.
Typically, options are subject to a four-year vesting schedule which means if an employee leaves or is fired before the four-year period ends, that some amount of those options go away. Check out this post to learn more about vesting.
Option Plan Considerations for LLCs
Options and option plans are common among high growth tech companies (which are often corporations rather than LLCs). While the general concept of an option plan is similar, there are certain considerations an LLC should take into consideration. Unlike a corporation, LLCs cannot issue incentive stock options. Instead, LLCs issue non-statutory options. With non-statutory options, the employee is taxed on any gains from the option at his/her ordinary income rates at the time he/she exercises the option.
Another factor for employers to consider is once an employee exercises his/her option, they become an owner of the LLC. Employers should take how this could impact the business into consideration. For example, employers may want to set up different voting rights for different types of stock if they do not want employees voting in key management decisions.
Employers should also consider an employee’s ability to exercise their option. In most cases, employees must buy their options. This means employees will need to pay an out-of-pocket cost to own stock in the company. Factoring payments into the economic incentive of the option is key to understanding the value of the option for employees.
Finally, option plans and option grants generally expire 10 years after the grant date. If the company does not plan to exit within that 10-year period, the option may end up null and void. Thinking through the trajectory of the company will help employers determine whether an option plan is appropriate for their employees.
Option plans can be very flexible and come with a lot of benefits for employers and employees. However, there are a lot of components, especially if the company is an LLC. Thinking through the high-level issues early will set employers up for the best outcomes down the road.
If you have any questions or need help setting up an equity incentive plan, get in touch. We would love to help!
This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Cara Stone, LLP and the author expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.
As a company grows, many business owners want to reward their key employees with equity in the business or rewards tied to the business’s performance. We’ve discussed several equity incentive plans for LLCs in prior posts, and today, we’re focusing on one strategy in particular – option plans for LLCs.
What is an option plan (and what it is not)?
There are certain scenarios where an option plan can be a great tool for employers. An option plan, generally speaking, is designed to incentivize employees and contractors to work over a period of four to five years to see the company grow in value or achieve some milestone. The idea behind an option is most of the time that people want to incentivize people to share in the exit proceeds down the road, but not necessarily get any cash flow from the business.
An option in a company, just like an option on real estate, is the right to buy equity. However, the option is not actual equity. An equity interest is what gives an employee or contractor the right to receive profits or dividends. The profits or dividends can be from the operations of the company or some distribution at exit. The option does not make an employee an owner of the corporation or the LLC, but it allows them to exercise or buy the equity at some later date when they think that they might want to share in the upside.
Typically, options are subject to a four-year vesting schedule which means if an employee leaves or is fired before the four-year period ends, that some amount of those options go away. Check out this post to learn more about vesting.
Option Plan Considerations for LLCs
Options and option plans are common among high growth tech companies (which are often corporations rather than LLCs). While the general concept of an option plan is similar, there are certain considerations an LLC should take into consideration. Unlike a corporation, LLCs cannot issue incentive stock options. Instead, LLCs issue non-statutory options. With non-statutory options, the employee is taxed on any gains from the option at his/her ordinary income rates at the time he/she exercises the option.
Another factor for employers to consider is once an employee exercises his/her option, they become an owner of the LLC. Employers should take how this could impact the business into consideration. For example, employers may want to set up different voting rights for different types of stock if they do not want employees voting in key management decisions.
Employers should also consider an employee’s ability to exercise their option. In most cases, employees must buy their options. This means employees will need to pay an out-of-pocket cost to own stock in the company. Factoring payments into the economic incentive of the option is key to understanding the value of the option for employees.
Finally, option plans and option grants generally expire 10 years after the grant date. If the company does not plan to exit within that 10-year period, the option may end up null and void. Thinking through the trajectory of the company will help employers determine whether an option plan is appropriate for their employees.
Option plans can be very flexible and come with a lot of benefits for employers and employees. However, there are a lot of components, especially if the company is an LLC. Thinking through the high-level issues early will set employers up for the best outcomes down the road.
If you have any questions or need help setting up an equity incentive plan, get in touch. We would love to help!
