Ask HN: I'm Contractor 0, now being offered equity--in an LLC. Can this work? | Hacker News Reader

Ask HN: I'm Contractor 0, now being offered equity--in an LLC. Can this work?

7 pointsequifused11 comments

= TL/DR Version =

Partners want to let me buy into an LLC in small, incremental, non-voting, non-LLC-member bits. To the extent I do, it'll slow the cash burn rate and give me a share in the potential upside, which partners and I would both like me to have. I trust them in the reliable business associate way, not the pick them as godparents way. Can stock options be simulated for an LLC by contract?

= Details =

(I'm a regular reader & writer here--this is a new account for semi-anonymity.)

I've been contracting for a web startup for more than a year now, the first and longest-running of a small team of developers. There are two partners and no true employees.

The partners want to give me the opportunity to buy options at the company's current valuation (based on angel investment) with a 1.5 multiplier. E.g., $100 buys $150 of stock.

* The company is currently an LLC with the two partners as the main members and the two angels as minority members.

* So far, the partners are selling only their shares, so the second angel didn't dilute the first. My equity would come out of the partners' shares in the same way.

* The idea is that any time I bill them, I can say, "Pay this much in cash, put that much toward equity." I can do this under the current terms until the next funding/valuation.

The Big Complication:

There's not a really obvious way to assign small bits of equity in an LLC. [EDIT: We're actually trying to simulate stock options, not pure stock.] The proposed mechanism is to have a written agreement (and log of actual purchases) that my share in the company converts to stock options (to buy at $0.01/share, or whatever) whenever the company converts to a C corp (in preparation for sale or larger funding round).

Anyone have experience with such an arrangement? Is it possible/legal? I know, ask a lawyer--I'm trying to get a framework for asking before spending the $$.

You can simulate the grant of options in an LLC but, for this to be readily quantifiable, it requires that the membership interests be defined as "units" rather than just a percent of the company.

Meaning that instead of saying: "Member x 33%, Member y 33%, Member z 33%," you say: Member x 333,333 units, Member y 333,333 units, Member z 333,333 units."

The operating agreement then sets forth an "authorized number of units," with some held in treasury, and option grants are then made from those treasury units. If and when the options are exercised, the units are granted, with the effect of giving ownership to the erstwhile option holder and of diluting the remaining members.

If the operating agreement is not set up to define the membership interests in the form of units, it can be amended to provide for this. There normally are no special filings associated with this - just everyone agreeing to the changes and doing a re-draft to the document.

You cannot do incentive stock options (ISOs) with an LLC and so the options would be non-qualified (NQOs). This means that, if they are not exercisable until, say, the occurrence of a liquidation event, you would be required to pay ordinary income tax on their value as of the date of such an event, i.e., the tax structure would not be particularly favorable to you.

You may also have tax complications arising from the way you are designating your payments as being in exchange for the options. On this, you do need to see an attorney. The way you guys are doing it is not ideal, as it lets the IRS put a direct measure on the value of the equity (based on the value of your billings being exchanged for it).

In general, then, it is legal to do what you are doing but it doesn't sound like it is being done in the best manner, given the goals of the parties.

I don't think there are securities law concerns here, as only certain LLC issues falls within the securities laws (remember, at its basis, an LLC is basically nothing but a traditional partnership).

All in all, though, you need to get good advice based on your particulars from an attorney who knows what he is doing. Though I am an attorney, I can't give specific advice in this type of forum. But I think the general ideas I have suggested should point you in the right general direction.

Thanks, grellas. Looks like the plan needs to be revised.

This is an awesome comment and I am now reading everything else you've ever written here. Thanks!

[edit now I'm done and must respectfully insist you write more.]

I don't understand your question. You can sell/assign membership interest in an LLC (although a member of an LLC can't take W2 wages from it). You can even call it stock.

The problem with this arrangement isn't going to be legal formalities. The problem's going to be that your tiny minority investment in a private LLC is going to have no protections against dilution or unfavorable buyout. It's possible that the only recourse you'll have if something goes wrong is to be such a pain in the ass that they'll buy you out.

Note well that you will not be able to sell or transfer your equity interest in the LLC to anybody else.

Right, but what we really want is options, not proper stock. They don't want to make me a proper LLC member, and I don't really want to be one anyway.

Part of the idea is the equity-holding stuff won't become a tax event for me unless they do sell or buy me out, which is roughly how I understand options to work.

> The partners want to give me the opportunity to buy options at the company's current valuation (based on angel investment) with a 1.5 multiplier. E.g., $100 buys $150 of stock.

You really need to consult a tax specialist before doing anything because that looks like a transaction that will be taxable immediately to you even if you never buy the stock and the options expire worthless.

> will be taxable immediately to you even if you never buy the stock and the options expire worthless.

That's the picture I'm getting, but your way of putting it certainly drives the point home!

THEY ask a lawyer, because they are probably the ones violating securities law. IANAL. A possible framework is for them to grant you x,000 options that you accrue on some basis. You reduce your rate, because you are part of the team. I am not sure you can buy stock or options at your leisure because you probably are not a qualified investor.

It is not a violation of securities law to include equity as part of an employee's compensation. You're right to point out that his 1099 status might muddy this up, but the spirit of the arrangement they are trying to come to is certainly achievable under an LLC.

What's the motivation to remain an LLC? (My co-founder did all of the legal stuff and chose to go directly for a C-corp, so I don't know what the benefits of an LLC are)

I think they mostly want to avoid the extra time and money and ongoing maintenance that go into C-corp-ness. Also, a change at this point will certainly have tax implications for the partners and the angels. Good or bad I don't know--more complicated, almost certainly.

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