I have formed a LLC in Sate of Nebraska in order to pursue a small business idea. My challenge is that they I require certain skills/knowledge that I don’t have. Because my business has $0 value, I cannot yet afford to hire individuals with these skills. I want to form business relationships with individuals with these skills in order to start a business together (“entrepreneurial partners”). Can I offer some sort of limited private stock options to these “entrepreneurial partners” which would increase in value as the company grew, and potentially be sold on the open market years later, if the company goes public? What is this called, and what does it look like?
by Ethan Stone, Stone Business Law
First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish a lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site. The information below is general in nature and should not be understood as a substitute for personal legal advice.
I should add that I’m not a Nebraska lawyer and don’t know anything about Nebraska LLC, securities or employment law, all of which are highly relevant. If you are going to proceed with or even seriously consider what you are proposing, you absolutely need experienced Nebraska counsel to help you think through these and other legal issues.
All of that said, I’ll lay out a few pointers on the main issues you have to resolve.
First, an LLC is not generally a good vehicle to compensate people with options. It is possible to grant options in LLC membership interests, but it isn’t easy. So if you really want to compensate people with stock options, you’ll probably want to convert your LLC into a C corporation.
An LLC is a good vehicle if you want to unbundle equity, for example by splitting interests in profits from interests in capital and governance rights. But you need very sophisticated corporate and tax counsel to make those creative variations on equity work properly. If you try to do it yourself, you’re almost guaranteed to create an unholy mess that, you, your employees, the courts and the IRS will spend many miserable years trying to sort out.
The second issue is securities law. On the federal side, there are fairly standard ways to deal with this, but you need legal counsel to make sure you get it right (getting it wrong has very serious consequences). On the state side, the securities rules vary a lot on paying people with equity interests. So if you’re in Nebraska, you absolutely must go to Nebraska counsel. For more information on this, take a look at my post here: http://www.foundersspace.com/company-formation/are-there-any-laws-i-need-to-follow-when-issuing-stock-to-founders-in-different-states/.
Finally, there’s the pesky question of state and federal employment laws. Again, if you’re operating in Nebraska, there is no alternative to going to local counsel who understands Nebraska’s laws. That’s not me and I won’t hazard a guess at what they say. On the federal level, you’ll have to comply with federal wage and hour laws, as well as the tax laws (in particular Section 409A of the Internal Revenue Code and the regulations under it). Depending on who is involved, how much equity they have and what the service arrangements are, it is possible that they might be considered owners or independent contractors, rather than employees (i.e. exempt from most wage and hours laws). That is simply not a judgment you can make on your own. 409A compliance also requires expertise. Again, if you try to wing it here, you are almost guaranteed to run afoul of reams of complex regulations and unwritten or partially written policies of the IRS and federal Department of Labor. The results can be extremely painful.
Those are the main legal issues involved. It’s worth stepping back and noting that well-advised entrepreneurs rarely try to do this. That’s partially because of the legal complications discussed above. It’s also because of the business complications that arise if you try to get people to work on the basis of equity alone. As a rule, good, skilled people won’t work on that basis. Most of them need cash to feed their families and pay their mortgages. So before you go that route, it’s worth thinking hard about who is going to remain in your applicant pool. Another problem is disappointment. People can develop very unrealistic notions of how much equity compensation is worth. In fact, if that’s all you’re offering, you’re effectively selecting for people who are exaggerating the probable value of your equity. Extreme disappointment often leads to fights, unhappy departures and, whether justified or not, lawsuits. That kind of disappointment is rarely a problem with people who get paid mainly in cash. Finally, if everything goes well, you’re likely to end up with a lot of small, unsophisticated people holding your equity. That is, in itself, a problematic situation, as I have discussed in this post: http://www.foundersspace.com/news-announcements/considering-the-alternatives-to-angel-and-venture-funding/.
I’m sorry if this isn’t very encouraging. I don’t want to rain on your parade, but I do want you to understand the difficulties you’re facing. Depending on your specific circumstances and goals, it’s possible that your plan (or some variation on it) could be legally feasible and make a lot of sense. To get to that conclusion, however, I’m sorry to say that you will really need a Nebraska lawyer who can give you sophisticated, personalized legal advice.
Good luck with the venture!