LLC · Vesting

Downsides to not amending LLC agreement?

Omer Riaz Social Entrepreneur and Management Consultant (Strategy, M&A, Operations)

May 10th, 2016

I have an offer from a startup to join as a partner. Equity terms have been negotiated, and will be put into a legal agreement.

The CEO wants to put off amending the LLC agreement, because he says going from single-member to multi-member changes the whole structure of the LLC. 

As someone who is joining the (Delaware) company, and will be vesting over the next 4 years, are there any downsides to agreeing to this?


Christopher Payton Entrepreneurial Management Teaching Fellow at Harvard Business School

May 10th, 2016

Big caveat: I'm not a lawyer, and you absolutely should consult with one.

I'd be very concerned about missing key rights and responsibilities by not being included in the LLC agreement. Beyond that, as long as your partner is treating it as a single-member LLC (and assuming you'll have losses at the beginning) he'll be getting tax losses that should be accruing to you. Most importantly, why the reluctance to do this? If not now, when?

In short, I agree that it changes the structure of the LLC. But that's to be expected, can be dealt with easily, and is exactly what he's signed up for by bringing on a partner. If he's reluctant to make the company's legal documents reflect reality, I'd treat that as a pretty big red flag. 

Michael Barnathan Adaptable, efficient, and motivated

May 11th, 2016

He probably isn't looking forward to filing a K-1 or an 1120. But you need to be on the cap table earlier rather than later, to establish a membership interest at a low cost basis. If he decides that the company's common stock is valued at, say, $2m because he raised $500k of preferred shares for 25% (a common mistake I see founders make - the value of common should not be equal to the value of preferred!), then you can look forward to paying taxes on your percentage of that $2m right off the bat if you take it following the funding round.

If he doesn't want to make you a member, he could give you a profits interest in the LLC (read up on those). But I'd insist on being a member of the company if on the founding team; partnership taxes aren't *too* bad and you deserve a share of the control as well as an economic share.

Also, adding all promised equity holders formally to the cap table is the right thing to do.

W. Shanaberger Vice President, Business and Legal Affairs Driven Music Group

May 12th, 2016

Yes you can add a Member even though as of day 1 no legal title/ownership interest because the Membership Units are vesting over 4 years.  

However, know this:  For the existing Single Member LLC Owner to claim that "adding you now will change the whole makeup of the LLC; and be costly" as justification that no LLC change will be made until fully vested (4 years from now) would cause me (as a lawyer) to be very concerned about what is really going on with the current single member LLC.  You as the investor have absolutely no rights at all until and unless the LLC is amended to recognize your ownership.  Period. You have just purchased what is akin to "phantom stock."

Here is some perspective if in the public sector:  You call your stock broker and tell him you want to by 100,000 shares of Apple stock.  Cool he says; done deal. You authorize a significant withdrawal from your investment account for the 100,000 shares of Apple; he confirms the stock was purchased.  You ask for copies of the stock certificates.  He informs you that the CFO of Apple, doesn't want to take the time to put your ownership on the books and records yet b/c "it changes the existing shareholder make up; and is very costly; so he will do it 4 years from now."  You think you let Apple keep your $9.0 Million Dollars? (And, during that time--4 years--you watch the value of Apple Stock soar 1000 Percent.  Its month 48; you are put on the books (but the monies that would have bought 1000 times more stock 4 years ago buy 1,000 x less at month 48.  Then, imagine if in month 49, Apple sells the company for a boatload of money--you've been "kinda" an owner for 4 years but you aren't going to make the huge spread you would have if the purchase and ownership interest was done at DAY 1; and the interest gradually vested over 4 years).

An LLC is no different.  Rather than stock/shares there are Membership Units.  Rather than shareholders; Members. Rather than a Board of Directors, there is either a Sole Manager; or the LLC is "Member-Managed" (this is what you want as an investor).

 However, remember this; there are two key issues here--ownership/vesting (and protecting NOW your percentage share for a future exit; either through a buy-sell agreement with the other Members; or a CIC event (change in control); and operation/control/participation in the management of the company as your interest vests (i.e. you are protecting your investment).

On the ownership end of things the Vesting Schedule establishes when you acquire LEGAL TITLE to the Membership Units, so take a look and see if it vests only on each of the anniversary dates of the initial subscription at months 12, 24, 36 and 48; or pro rata 365 days per year.  If the latter, then, although no legal title ownership interest when you sign; 24 hours later you have 1/365 % of the first annual vesting amount--LEGAL TITLE.

Notwithstanding legal title; if you are purchasing equity, via Membership Unit Purchase, even if vesting over 4 years; 10 years; 20 years; you IMMEDIATELY have "equitable title" and with that, under the law comes certain rights and obligations  generally FROM the majority holder TO the minority holder.

Aside from the legal/equitable title concern (and yes, get on the CAP table ASAP), the other equally important goal if you are a significant investor is a say/control in how the funds are used and how the company is run.  The only way to ensure this is (a) establish your Membership Interest on the books and records NOW; and (b), depending upon the level of investment demand what is tantamount to a seat on the board; by ensuring that the management of the LLC is "Member Managed" rather than by a "Sole Manager" so you have some say in protecting your investment as it matures.  You can't be a "Member-Manager" unless your Membership Interest is on the books.  Many, many other issues that need to be examined for the best protection of your interest but too involved for a brief reply (ie. what happens if there is a CIC before you fully vest; do you get paid on the as vested interest; or do you require that a CIC is a "triggering event" that will cause your interest to vest 100% just prior to closing on the CIC so you enjoy the benefits; Can you force another Member to sell you their interest? Can they force you to sell yours to them? You successfully become a "Member Manager" but forget to look at the Amended Operating Agreement which establish a quorum required for management action and whether a simple or super majority (or some other percentage) is required to cause a company action; and learn, when it is too late; that your Member Manager position is without effective power b/c you can simply be outvoted by simple majority--rather than insisting on something greater, for example; and various other issues (classes of Membership Units; Preferred Membership Units; Voting Trust Agreements, etc.).

Brett Gardner Serial Entrepreneur

May 10th, 2016

I am actually curious about this as well. I just so happen to be in the opposite seat. I started a LLC, brought on a equity partner. We have a legal contract but it is not a LP, LLP yet. We started thinking we would only be building 1 app but now we have ideas upon ideas and want to change the name to reflect the app development firm by means of starting a new company (the partnership) and acquiring the first. company, shutting it down, but keeping the same services/apps available.

Any downsides? Things to look out for?

Omer Riaz Social Entrepreneur and Management Consultant (Strategy, M&A, Operations)

May 10th, 2016

Thank you for your feedback, Christopher. In answer to your questions:
- why the reluctance to do this?
He claims this will be a costly procedure for the company.

- If not now, when?
At the time we raise $500K in funding. His logic is that since I have no vested stock in the beginning anyway, it doesn't really matter.

Omer Riaz Social Entrepreneur and Management Consultant (Strategy, M&A, Operations)

May 12th, 2016

Ok, so apparently the issue is I currently do not have any ownership (my ownership vests over 4 years). Has anyone come across this issue? Is there a way to add someone as a member, given their ownership on day 1 of joining the company is zero?

Omer Riaz Social Entrepreneur and Management Consultant (Strategy, M&A, Operations)

May 12th, 2016

W. Gregory Shanaberger, thank you so much for your guidance. Very helpful. I'd like to make two clarifications:

- I am not investing any cash up-front in the business, so the equity I am receiving is for the work I am putting in. The vesting occurs in 6 month increments, and the offer is to change the operating agreement 6 months down the road.

- The CEO is offering to include in my employment contract that I am being given stock/units in the company with a particular vesting period. He is also offering to make some sort of amendment in the current operating agreement to reflect this, and the fact that the OO will be changed in 6 months, when the first 1/8th of my equity vests.

Michael Barnathan Adaptable, efficient, and motivated

May 14th, 2016

Unvested stock still counts as a restricted stock grant, and would appear in the cap table (also importantly, it would establish a cost basis for tax purposes if you take an 83(b) election within 30 days of receiving the grant, otherwise the cost basis will be established as the restricted stock grant vests). The company can't promise the shares it already promised you to someone else as well, after all.