Startups often proceed through a variety of business entities throughout their lifecycle. This will almost always include existing as a limited liability company (LLC) for some period. When forming an LLC, the founds must determine the ownership percentage of each founders. This generally requires a number of considerations.
In this article, we discuss the types of LLC ownership and the considerations for how to distribute that interest.
What Are the Types of LLC Ownership Interest?
An LLC is owned by its members. Each member generally holds a given percentage of the LLC interest. In some states, there is no predefined share of ownership interest for an LLC. The percentage ownership of an LLC member is simply recorded in the LLC operating agreement. Most operating agreements have an appendix to record the ownership percentage. This allows for essay modification upon any changes in ownership. This is very common in pass-through tax entities. The ownership percentage may be affected if one party withdraws a disproportionate percentage of company profits compared to equally-situated members.
Other states authorize or requires LLCs to authorize a specific number of shares, known as “membership units.” It is important to note that LLCs do not have stock. The membership unit, however, functions very similarly to stock. The LLC can have multiple classes of membership unit as well. Special classes of membership unit generally provide advantages to the holder that are similar to those of preferred stock. It may allow for a distribution preference, superior voting rights, liquidation preference, redemption rights, etc.
Other forms of LLC interest might include profits interests and phantom ownership units. These are not true ownership interests, but they function similarly to equity.
Company Ownership Interest
How to distribute an LLC ownership interest to members depends upon the reason for distributing the interest. Founders of a company generally distribute ownership interests based upon the amount of value provided to the company at the time of formation. The company will distribute additional ownership interest to individuals who continue to provide resources (such as property or capital) to the company. Individuals who work for the company may acquire additional ownership interest as compensation for services performed for the company. Acquiring ownership interests in this manner is generally a taxable event.
Founders will continue to hold 100% of the company ownership interest until the company needs to distribute additional interests. Generally, the company will authorize additional membership units to accommodate this need. The two most common needs concerns the purchase of an equity interest by investors and compensation of employees with an ownership interest. Distributing additional interest percentage has the effect of diluting the current owner’s interests.
After seed-stage investments, an LLC generally must be reincorporated into a corporation. This is pursuant to the demand of investors. In a seed-stage investment, the investors will generally purchase between 5-25% of the company ownership. It is rare that seed rounds distribute greater amounts of equity, as it would leave too little founder ownership after future rounds of financing. Investors generally require the company to reserve up to 20% of company ownership to incentivize employees. This percentage will generally come from the ownership percentage of existing members. Awarding this ownership interest will cause a shift in total ownership percentages.
Deciding on how to employ LLC membership interests is a demanding undertaking. It requires an understanding of company valuation, distributions and tax obligations, and equity compensation plans. If you are seeking to distribute the equity of your LLC, consider speaking with a legal professional. The business formation lawyers at LawTrades are experts in matters of LLC equity distribution. We can provide advice and services you need to carry out your desired transactions.