What are options to acquire interests?
Most people are familiar with stock options as used by C-corporations: In that model, often associated with venture-capital-backed technology companies, owners grant employees the right to buy equity in the company after those options have vested. The price at which the employee can purchase the equity (“exercise their options”) is set at the time of the grant and is based on the Fair Market Value at that time.
For employees, the benefits are obvious—if the company’s valuation grows between the time of the grant and the time of the exercise, they can buy units at a price that is below the current market value. This can result in profit for the employee if the company has a liquidity event such as a company sale or an IPO (or a secondary transaction in which employees are allowed to sell their shares at a profit).
For employers, the advantage of this type of equity is that it can help attract and retain employees and align their interests with those of the company.
Options to acquire interests in LLCs operate similarly, with the company granting the contractual right to purchase shares at a price at the time of grant once certain conditions are met. However, LLC options to acquire interests have some important tax nuances compared to traditional C-corp stock options (see tax section below).
Employees can decide if they even want to pay the exercise price and become an equity holder (they don’t have to). They also decide when they want to exercise (and therefore become a member of the LLC and start receiving K-1s instead of W2s).
Upon purchasing the equity, LLC holders become actual equity owners and hold a capital interest in the company, so the holder has an economic right in the preexisting value of the LLC. As soon as holders decide to exercise and own the units, they are treated as partners/members of the issuer for tax purposes.
Actual equity ownership
You’re giving your employee the option to acquire an actual equity stake in the business: It is often easier to communicate the value of real equity ownership (as opposed to phantom or appreciation rights).
The administrative burden for the company
Granting options to acquire interests to multiple employees means the company must keep track of multiple dates of exercise even if all options were granted on the same date, because recipients can choose when or whether to exercise their options. Since each exercise must be accompanied by the company’s updated Fair Market Value, this plan’s administration can become burdensome.
If options to acquire interests can be exercised prior to a termination of employment, companies have to be able to address the human resources, finance, payroll, and legal issues of having an employee convert to non-employee status. To minimize this burden, companies often restrict exercise to after the termination of employment, conversion to a C-corp or other entity structure, or sale of the company.
Costs to acquire for employees
Unlike other forms of LLC equity, which are free to the recipient, options to acquire interests require cash payment by the recipient to acquire the equity. They also may have to pay tax on that transaction if there is a spread between the prearranged purchase price for the interests and the company’s valuation at the time of purchase. If the company’s value declines below the exercise price, the recipient could lose some or all of their investment.
For the company:
In certain cases, the LLC is entitled to a tax deduction upon the exercise of an employee option because the transfer of equity interests to the employee is considered income.
Not taxed at the time of grant: Employees don’t own any equity until they have exercised their option to acquire the interests—they have the contractual right to purchase the interests once they are vested. Therefore being granted the options does not trigger a tax event.
Not taxed at vesting: Vesting alone similarly does not trigger a tax event—if the employee does not purchase shares once vested, that means they still do not own the equity. Section 409A of the internal revenue code governs the issuance of equity; consult a tax attorney to make sure you are in compliance.
Taxed as ordinary income at exercise: The employee is finally taxed once they exercise their option to acquire interests by purchasing shares at the strike price, or the pre-arranged price pegged to the Fair Market Value at the time of the grant. The tax is based on the difference between the strike price at time of grant and the Fair Market Value of the company at time of exercise. This is also known as the “spread” or “delta.”
Companies that offer options to acquire units typically make them exercisable if one of three conditions are met: the employee terminates their employment, the LLC converts to a C-corp, or the company undergoes a change of control. This is because options to acquire units are not an ideal asset to hold while still employed at an LLC, since they require the holder to become a partner but without the tax advantages of other forms of equity such as PIUs, where the holder does not owe taxes on the interest until they receive a capital distribution.