By: Tyler Mills
March 2018
Timing Restrictions on Ownership and Why They Are Complicated in the LLC Context
Timing restrictions on stock ownership are commonly used by entrepreneurs in corporations. Start-Up Toolkit indicates that a four-year vesting schedule with a one-year cliff is a typical agreement that business founders and co-founders use to incentivize employees to stay invested in their work. This agreement means two things: First, to capture any equity in the company, the individual subject to the one-year cliff must work for at least one year; and second, the individual will begin capturing one-fourth of his or her promised equity at the end of each of the subsequent four years. Founders and co-founders that organize as corporations use vesting restrictions to ensure that other co-founders and employees remain actively involved in the company’s operations for a period of time before they can collect any equity. This should be familiar to those with experience in founders’ agreements and employee restricted stock agreements in corporations. However, an interesting question arises in the context of limited liability companies (“LLCs”) with regard to how founders and co-founders can restrict membership units for a period of time, thereby capturing the desirable effects of stock vesting.
First, it is important to understand some principles of LLC law. There are relatively strict restrictions on the addition of new members to LLCs, pursuant either to the LLC’s operating agreement or the default state law rules governing LLCs, which are generally based on the Revised Uniform Limited Liability Company Act (“RULLCA”), with slight variations. Typical provisions found in operating agreements, and most, if not all, default state LLC statutes, include that after the formation of an LLC, a person becomes a member as provided in the operating agreement or with the consent of all members and an LLC is not formed until and unless at least one person becomes a member. As a result of these commonly applicable provisions, it is best practice to structure arrangements, in this case Restricted Unit Agreements (“RUAs”) or unit rights plans, with the above-mentioned in mind.
The Easy Case: One Founder with Diluted Membership as Employees’ Units “Vest”
According to the National Center for Employee Ownership (“NCEO”), likely the easiest way to incentivize employees in the LLC context is through a RUA. In the easy case, there is one founder who owns 100% of the LLC’s membership interests. This satisfies the requirement that there be at least one LLC member upon formation. Then, the founder of the LLC will put in place a unit rights plan, which will grant an employee a hypothetical number of LLC membership interests—sometimes referred to as “phantom shares”—which will be subject to vesting over time. Please note that the terms “shares” and “vesting” are used only by analogy to ownership timing restrictions in corporations because, according to the NCEO, “There is no agreed-upon legal definition for what these would be called in an LLC.” Similar to corporate vesting, as a percentage of membership units begin to “vest,” the original founder’s 100% membership interest will be diluted to make way for additional members. Structuring a RUA in this way will adhere to the principles of LLCs set forth above; specifically, that there be at least one member at the moment of formation and that all existing members will have agreed to add this new member.
The Intermediate Case: Timing Restrictions on Co-Founders’ Ownership with Some, But Not All, Membership Initially Accounted For
The intermediate case may arise when there are two or more co-founders, each who wishes to incentivize the other co-founder to stay on board. In this scenario, the structure of the RUA may look something like this. First, the two co-founders grant each other a percentage ownership of the LLC at the moment of formation, say 25% each. This satisfies the RULLCA requirement that there be at least one LLC member upon formation (and distinguishes the “messy” case below). Then, the remaining 50% ownership may be subject to timing restrictions. For example, each co-founder will capture one-fifth of the remaining membership over five years. Put differently, each co-founder’s membership interest will increase by 5% in each of the subsequent five years until all 100% is accounted for. By structuring a RUA in this way will similarly adhere to the principles of LLCs set forth above; specifically, that there be at least one member at the moment of formation and that all existing members will have agreed to add this new member.
The “Messy” Case: Timing Restrictions on Co-Founders’ Ownership with No Membership Initially Accounted For
The “messy” case results when entrepreneurs put a RUA in place, without fully understanding the implications of LLC law. Take the following example. There are two co-founders and each desire membership in the LLC. The LLCs operating agreement lists both as members, each with a 50% membership interest in the LLC. There is nothing wrong with this arrangement so far, as this is a very typical LLC ownership structure. However, suppose each co-founder would like the other co-founder’s membership interest to be subject to a unit rights plan or RUA. To accomplish this, the two co-founders agree that each of their 50% ownership will be subject to timing restrictions, for example a one-year “cliff.” As a result, technically, at the moment of formation there are no LLC members, therefore not satisfying typical LLC principles explained above, and in the RULLCA. Put differently, in this scenario, no co-founder owns any membership interest yet and as such the LLC technically has no members.
In the messy case, the question becomes: What would happen if the company dissolved before the “vesting” of any membership interests. Recall that in the easy case the only member prior to the employees’ membership vesting was the company’s founder. As such, in the event of dissolution before vesting, the founder would collect all of the company’s assets. Similarly, in the intermediate case, where each co-founder owns 25%, and the remaining 50% is subject to timing restrictions, there is a clear membership breakdown. As a result, in the event of dissolution before vesting, the co-founders would each collect 50% of the assets. However, because in the “messy” case there are technically no members until the co-founders’ units vest, what would happen to the company’s assets if it were to dissolve is unclear. This question is best answered by using doctrines governing contract interpretation. According to Vincent R. Martorana, to accurately interpret a contract, one must “determine the intent of the parties with respect to the provision at issue at the time the contract was made.” Therefore, a court would presumably defer to the agreement underlying the RUA. Specifically, although no membership had vested, each co-founder entered into the agreement under the assumption that at some point in the future they would each own 50%. In light of this understanding, a court would likely find that, although the LLC technically had no membership at the time of dissolution, each co-founder is a 50% member to whom 50% of the assets would distribute upon liquidation.
A Recommendation for Entrepreneurs
Although the overall recommendation of this post is to structure employee membership subject to timing restrictions in accordance with the easy case—the unit rights plan laid out by the NCEO—or the intermediate case, it was also important to address the “messy” scenario in case an entrepreneur finds him or herself in that situation. To implement the best ownership structure to incentivize other co-founders and/or employees via RUAs, entrepreneurs should ensure that they understand the general provisions of the LLC’s operating agreement, the default state laws with respect to LLCs, and the RULLCA. Only after understanding the requirements for LLCs with respect to membership can an entrepreneur-founder structure the LLCs ownership to avoid the “messy” case.