Due to the popularity of limited liability companies (LLCs) as a form of business entity, we have been approached lately more than ever to structure equity and “phantom” equity based compensation for LLC businesses, including private equity firms and other businesses that embrace an employee ownership culture. Phrases such as “restricted stock”, “stock options” and “stock appreciation rights”, all applicable to corporations, are commonly known. There are, however, equivalent terms applicable to LLCs.
LLCs do not issue stock. Rather, they issue membership “units” as equity. If an LLC has “checked the box” to be taxed as a corporation for Federal tax purposes, it generally can sponsor the equivalent of an employee stock ownership plan, and can issue the equivalent of incentive stock options. Most LLCs, however, are not taxed as corporations, but rather are taxed as partnerships (if they have more than one member). For these LLCs, the equivalent of an employee stock ownership plan and incentive stock options are not available. However, these LLCs have a host of other equity and phantom equity based compensation tools available to them, which are briefly described below.
LLCs taxed as partnerships can issue:
- “Restricted or Performance Units”, equivalent to restricted stock in a corporation. These are typically earned over a period of three to five years or as performance targets are met. The underlying units will generally determine whether the holder as any voting rights or interests in the annual profits of the LLC.
- “Capital Interests” that provide the holder with a direct interest in a percentage of the LLC value at a liquidity event (commonly the sale or other change of control of the business, and sometimes upon termination of employment). Capital Interests typically do not confer any voting rights or interests in the annual profits of the LLC. They are also commonly used to create the equivalent of stock options, which are exercisable at a strike price equal to fair market value at the time of issuance after any stated vesting or performance requirements are met.
- “Profits Interests”, which are typically designed to give the holder an interest in the annual profits of the LLC (based on a percentage of LLC value of a number of units), PLUS a capital appreciation right (equivalent to a stock appreciation right in a corporation) measured from the date of issuance to a liquidity event. “Carried Interests”, which are commonly issued by private equity firms, are different than Capital Interests, in that a Carried Interest is a phrase commonly used to describe a transferable interest in the annual profits of the LLC, without any capital appreciation rights attached. Profits Interests are also commonly used to create the equivalent of stock options, which are exercisable at a strike price equal to the value at the time of issuance after any stated vesting or performance requirements are met.
- “Phantom Unit Rights” or “Unit Rights”, which are the equivalent of phantom stock in a corporation. These entitle the holder only to a payment at a liquidity event equal to the value of a unit at the time of the liquidity event times the number of Phantom Unit Rights awarded. Phantom Unit Rights do not confer to the holder any of the other benefits, rights and privileges of being an actual unit holder in the LLC, which minimizes issues in the governance of the business of the LLC. For this reason, they have become popular. Phantom Unit Rights confer past and future value of an LLC unit, measured from the time of the award.
- “Phantom Unit Appreciation Rights”, which are the equivalent of phantom stock appreciation rights in a corporation. These entitle the holder only to a payment at a liquidity event equal to the increase in value of the LLC (based on a number of units) measured from date of the award to the date of the liquidity event. These also do not confer to the holder any of the benefits, rights and privileges of being an actual unit holder in the LLC (hence the reference to being “phantom”), which minimizes LLC governance issues. These have become even more popular compared to Phantom Unit Rights because Phantom Unit Appreciation Rights confer only future value of an LLC unit measured from the time of the award.
These forms of equity and phantom equity based compensation provide great flexibility to LLCs in structuring compensation packages and providing incentives to employees and other service providers who assist in creating value in their businesses.