Equity Education

Customizing multiple LLC equity types for different groups of employees

9 May 2023
Kevin Vela and Candace Groth

Kevin Vela is managing partner and Candace Groth is a senior attorney at Vela Wood.

Any opinions, analyses, and conclusions or recommendations expressed in this article are those of the authors alone and do not reflect the views of their employer or eShares, Inc. DBA Carta, Inc.

Growing businesses frequently have a need to incentivize different types and groups of employees. Two common groups are upper-level management or C-suite employees, and mid- to lower-level employees. Upper-level management will tend to want capital interests in the company or at least options; mid- to lower-level employees may be just as happy with an equity-like structure as long as they receive a large payment upon the sale of the company. 

Frequently the two or more groups of employees have different incentives, performance goals, and retention schemes that do not easily fit into one type of LLC equity plan.

Rather than pick an ill-fitting plan for one of the two groups of employees—or worse, no plan at all—a company can choose to implement more than one type of LLC equity plan, customized to each type of employee group.

How it works

This structure requires careful planning between the business and its legal counsel to design not just one, but two types of plans. 

  • Incentive Unit Plan (aka “profits interest” plan): for upper-level/C-suite management who expect to receive equity in the business as a performance incentive. 

  • Parallel Unit Plan (aka “synthetic equity” plan or “ phantom stock” plan): For mid- or lower-level employees whom the business wants to incentivize for the long term with a stake in the sale of the business. 

Typically the vesting schedules for each type of plan will be different. For example, the Parallel Unit Plan may incentivize longevity with the company by vesting over time, while the Incentive Unit Plan may be tied to company financial goals more readily obtained by a CEO, CFO, or other C-suite individual. Both types of plan can be set up with a variety of vesting schemes. The plans may be implemented side by side, or may be announced at different times, depending on business needs. 

LLC Blueprints

Determine the best LLC equity type for your company

Pros and cons of a dual equity structure

This overall structure works best for a company where there is a high degree of difference between the compensation structures for C-suite individuals, and those at a mid-level/lower-level of employment. Here are some advantages and disadvantages of this solution for each employee group below:

(‘Synthetic equity’ plan or ‘phantom stock’ plan)

Advantages

Disadvantages

Easy to administer and a non-qualified plan

Must comply with the Section 409A rules governing these types of plans

Flexible vesting schedules using time, performance criteria, or both

Have no value, and cannot be exchanged or swapped for actual equity or other value in most instances until a sale

Deductible as a salary expense to the company in the year of the sale

Ordinary income in the year of the sale to the participant

Normally forfeited upon termination of employment for any reason.

Can be used as consideration for a non-compete/non-solicit in most states.

Company is not required to buy back parallel units from a participant if they terminate employment. Parallel Units are not actual equity in the company

Plan is generally limited to a single-trigger event (sale of company) not other more complex conditions such as distributions to members

May be used with LLCs taxed as S-corporations

(‘Profits interest’ plan)

Advantages

Disadvantages

Provides equity incentives for employees who require/expect them

Company must repurchase vested Incentive Units upon termination of employment (or allow individual to continue to hold)

Flexible vesting schedules using time, performance criteria, or both

Complexity of administration because of Section 409A valuations annually and hurdle/threshold for each participant award

Similar to exercised stock options

Generally requires a 409A valuation annually or more frequently

Participants receive capital gain treatment after holding Incentive Units for one year or more.

Generally cannot be used with LLCs taxed as S-corporations

Other important factors

Companies should be aware that juggling two types of LLC equity plans adds complexity to overall compensation structures and is not for every company. Each type of plan, and its pros and cons, should be considered prior to implementation. 

In addition, here are some additional items to note for each type of plan:

Parallel Unit Plans

  • Full value of the company or appreciation value (above a threshold) can be used

  • Compliance with Section 409A is required, and permitted trigger events are very specific

  • Termination or changes to the plan are difficult due to Section 409A and its associated  regulations

  • A valuation (or 409A valuation) is generally only needed if non-sale trigger events or an appreciation (rather than full value) plan is used

Incentive Unit Plans

  • Participants are owners of the company, and generally cannot be employees of the LLC. Instead, participants must file quarterly tax filings with the IRS, and withhold/pay their own employment taxes.

  • Not generally deductible to the company when issued or paid 

  • Subject to capital gains treatment for the participant if held for more than one year

  • Although technically incentive units could receive distributions, most plans do not result in any distributions being issued to participants

  • 409A valuations are generally required every 12 months, or after a material change, to stay compliant

With both Parallel Unit Plans and Incentive Unit Plans, the value of the award is generally based on a set percentage or value of the company and its equity, and can therefore be calculated accordingly.

We hope that this article has been an informative introduction to the use of multiple LLC equity plans. We recommend you talk to a lawyer to create a plan or plans that work best for your particular situation and company. With employee equity and equity-like awards, the company is in the driver’s seat.