In the US, limited liability corporations (LLCs) are a recent phenomenon — Wyoming pioneered them in 1977, the IRS issued comprehensive rules around their taxation in 1988, and by 1996 all 50 states had LLC statutes. LLCs are almost by definition a hybrid of corporations and partnerships, which comes with advantages (e.g., taxation) but also disadvantages (e.g., no way to issue options). And that’s where “synthetic equity” comes into play, as an increasingly common way for LLCs to compensate their employees. But before we can focus on that this article will start with some basic definitions.
1) Basic Definitions
There are many ways to structure your business, below is a very very simplified table:
|Corporation (Inc)||Partnership (often limited liability partnership aka LLP)||Limited Liability Corporation (LLC)|
|Overview||People working together in an entity that is separate from those who create it or own it||People working together to advance mutual interests.||Combines elements of corporation and partnership|
|Ownership||Shareholders, which could include employees||The people working for it||Shareholders, which could include employees|
|Taxation||Legal entity is taxed separately.||Pass-through i.e., profits and losses go straight to the owners||Pass-through i.e., profits and losses go straight to the owners|
Again, there are *many* intricacies to the high-level summary above. For instance, the description above applies most specifically to the most common variant known as C corp. If you meet certain (strict) criteria you can be a S Corp, which is actually taxed as pass-through. There is also a B Corp which is a certification around social and environmental performance.
2) Why Would A Startup Be An LLC?
While most startups are Inc there are good reasons to be an LLC because it basically saves you money and time. On the first topic, if you have an Inc that entity and you will both be taxed by the IRS but if you have an LLC it will be taxed more like a sole proprietorship. You can also protect your assets against lawsuits on the company, which is especially useful at the early stages of a company. On the second topic, LLCs are just easy to set up, make changes, and also allowing you to choose a location. It usually makes sense to set up your entity in your primary state of business but there are cases where you may want to do otherwise or additionally. For instance, Delaware is known for very friendly business laws and if you are running a healthcare company you may need to have an entity in each state you are operating in.
3) Incentive Plans
LLCs don’t have employee stock ownership plans (ESOPs) — so all that talk about options and shares is out of the door. So how can LLCs still give a stake to its employees? The most common way is to give them profit-sharing. It is not a share per se but a portion of the increase in value of the LLC over a period of time, vesting schedule potentially included. Along the same lines, instead of offering profit interest the LLC can offer the right to increase its membership. Finally, probably the simplest way is to issue phantom shares. It is not legally a share but modeled as one, the employee pays income tax at the time of payout, essentially treating it as a bonus.
4) Synthetic Equity — Pros and Cons
The benefits for employees should be self-evident — stock is often more motivating than cash. The benefits for the LLC is there are no additional owners because even if you treat the employees as such they don’t get to vote, don’t get to keep the stock if they leave, and there is no hassle around doing secondary sales. The challenges though are the LLC needs to cover the costs of eventual transactions, which is not feasible for a company not doing as well. Also in balance sheets they are accounted as liability, not equity. Finally, given that most startups are still Inc, explaining all of this to current and future hires is non-trivial.
Originally published on “Data Driven Investor,” am happy to syndicate on other platforms. I am the Managing Partner and Cofounder of Tau Ventures with 20 years in Silicon Valley across corporates, own startup, and VC funds. These are purposely short articles focused on practical insights (I call it gl;dr — good length; did read). Many of my writings are at https://www.linkedin.com/in/amgarg/detail/recent-activity/posts and I would be stoked if they get people interested enough in a topic to explore in further depth. If this article had useful insights for you comment away and/or give a like on the article and on the Tau Ventures’ LinkedIn page, with due thanks for supporting our work. All opinions expressed here are my own.