I recently did some fundraising and employee grants with an LLC and it was more complicated than you'd think...

You should make sure your grants have a "distribution hurdle." If you don't have a distribution hurdle, the options you're granting may be taxed as income immediately upon receipt. This would leave your employees with a big tax bill.

You should put everyone on a reasonable vesting schedule. With vesting, everyone is in it for the long-term and the shares given directly correlate to the work performed and the value provided to the company.

You should talk with your employees and agree in advance to the work being performed in exchange for shares granted during the vesting period. There is no clean way to include this in the operating agreement or grant notice, so communication is crucial. If either party is ever dissatisfied with their side of the arrangement, however, they can always leave. And if you've set up vesting appropriately, both sides should still be happy even if you don't reach the end of the vesting period.

Why would you want to prevent employee grants from diluting in the future? It breaks the alignment of incentives. If everyone dilutes equally, everyone has the same incentives regarding future investments. An investment would only be accepted if everyone thought the trade-off of money for equity was worth it based on the current valuation.

But if you DO want to prevent dilution, it's a fairly straight-forward clause you can add to the operating agreement. I'd suggest setting a ceiling or an expiry date for the dilution prevention clause. This ensures that if things change dramatically in the future, you won't be handicapped by your non-diluted employee grants.

Disclaimer: I'm not a lawyer. This is for entertainment purposes only. Don't sue me etc.

As Terretta mentions, you'll be offering "membership interests" and as far as I remember from our experience with an LLC, you don't offer shares but "units".

You'll have to detail unit interests in your operating agreements and set up unit subscription agreements with your employees. Most of it is akin to what you'd do with a C-corp but the terminology is a bit different.

One note: If you're contemplating raising outside investment in the future from angels or VCs, a C-corp may be preferable as it appears to be their preferred structure (not a hard and fast rule but a preference). I've heard LLC to C corp "conversions" can be less than pleasant.

Any of the VC names you read about on this site or others like it will not fund you without transitioning to a C-Corp.

As far as converting from an LLC is concerned, you just form a Delaware C-Corp, which acquires the LLC.

Investing in a C-corp keeps the personal taxes of the investors simple. LLC's are pass-through entities which means all income of the LLC must be mentioned on their personal tax returns via a K-1 schedule.

I would also suggest using an S-Corp instead of an LLC. It gives you the same benefits and flexibility as an LLC with pass thru profits and such but you can create shares more easily.

As far as paying your writers with equity, I like this approach defined in this article: http://www.readwriteweb.com/start/2009/05/building-your-team...

It talks about forming a contract where you will pay them double there hourly rate which they can then buy equity with it once the business gets it's first valuation.

Agreed - Granting or selling shares is much more straightforward than an LLC. Plus converting an LLC to an S or C-Corp takes a lot of billable hours.

So - find a lawyer local to you, and have him set up the S-Corp in your state. Don't worry about it being in Delaware. Making that change later, or even going to a C-corp is easy (for a lawyer)

Don't know about the LLC/S-Corp end of things, but on the 'how should I split it?' stuff I think Joel Spolsky's response here makes a lot of sense:

http://answers.onstartups.com/questions/6949/forming-a-new-s...

These percentages of ownership are called "membership interests", and they can be for operating or non-operating partners or investors. Both people and corporations can be members in an LLC.

Many of the biggest companies use LLCs for their advantages. Check the return label on your next package from Amazon.

Yeah, and you have to detail how all of that works in your operating agreement and spend thousands of dollars to do so. An S-corp takes care of everything for you due to the huge body of law around corporate share treatment, you get all of that free of charge with a corp.

That "body of law" is also a box. It significantly constrains your options.

The issue with LLC ownership is that it becomes much harder to kick out someone later on [or to transfer ownership interests], especially if you are onboarding some unsavory characters.

As far as ownership is concerned, with an LLC the payments do not have to be proportional to the ownership percentage. This is one way in which the LLC differs from the S-corp, because the S-corp requires that payouts are proportional to ownership stake. Hence, a small ownership stake in an LLC can mean diddly squat.

I would guess that the pass-through taxation of an LLC would complicate granting equity to employees.

LLC's are ripoffs. Use an S-Corp instead. They are far cheaper and easier, are FAR more flexible, and you get the same tax benefits.

LLC's are for people who don't know any better (and this includes myself, several times now in the past, having only been fully educated in this area fairly recently).

In Michigan you can form a LLC for $50. It's super simple.

EDIT: I am also an attorney, but have never practiced. In most cases a LLC is the best way to incorporate your startup. (Unless, you know you are getting funding ASAP)

Ok, how much is the yearly filing fee? How are profits taxed? How do you distribute ownership interest?

Super simple to set up, complex as hell to use.

This comment is almost exactly backwards for most startup purposes.

In particular, S Corp compliance is more tedious and costly, while ownership structure is less flexible.

Ok, let me respond a little more since I'm not on my iPad trying to peck out a response. Will try to get all of the questions answered in one shot here.

Why is it a ripoff? In my state (IL) it costs $250 annually to keep your LLC in good standing, while it costs $75 a year for an S-Corp.

Why is it a ripoff, reason number 2? When you form an LLC you have to spend lots of time with your lawyer hashing out things like what happens to the company when you die, if you have a partner the complexity of the operating agreement goes up exponentially. With a corp all of these things are already determined for you by a huge body of corporate law. With an LLC you are reinventing the wheel. Based on the original question this is a no-brainer for the poster, this alone is a big enough reason to scrap the LLC idea immediately.

Why is it a ripoff, reason number 3? The reason your tax guy is telling you it's a good deal is because of the pass through loss/profit which falls through to you. If you dig deep enough you will discover that an LLC really IS you for most purposes, especially if you own 100% of the shares. It is not a separate legal entity unless you have more than one shareholder (go look it up).

As far as complexity, that's bullshit. I would venture that 100% of the people who say this nonsense have no idea what you actually need to do in order to keep a corp in good standing. Yes, you need to have minutes of your annual meeting, even if it's something as simple as "the annual meeting was held over lunch and nothing of note was discussed". It is not rocket science, it's just scary when you're not familiar with it.

Now for the really big reason: if you make a profit with an LLC, you will pay self-employment tax. If you take profits with an S-corp it is dividend income (or share buybacks, etc). You WILL pay more taxes using an LLC than an S-corp simply because you have far less flexibility owing to the fact that the corp is a separate legal entity while that is an extreme grey area for an LLC. I strongly suspect this is why people are generally herded towards LLC's, simply because they are easier to track and tax than corps.

Your average CPA is useless when talking about these topics, they are used to talking about real estate tax deductions and dependents, not the intricacies of setting up a legal entity with the flexibility to deal with other legal entities, distribute shares, etc.

Let's go into a few points:

Costs. My state has the opposite (corps more expensive than LLCs), So this is a YMMV thing.

>Why is it a ripoff, reason number 2? When you form an LLC you have to spend lots of time with your lawyer hashing out things like what happens to the company when you die

It is almost trivial to change the LLC operating agreement. Sure, once you start to get into it, you can get more complex, but this again, is something you can do easily again later once you're sure you are sticking with this thing.

>Why is it a ripoff, reason number 3? The reason your tax guy is telling you it's a good deal is because of the pass through loss/profit which falls through to you

Only for 1 of the three ways to do LLCs. You can do LLCs as a disregarded entity (what you're talking about, which is simple as hell, but has a generally higher tax burden). You can elect to treat your LLC as a C-Corp for federal tax purposes (and state). This, for tax purposes, is basically a C corp, with all that matters under the tax law. You can elect to treat your LLC as a S-Corp (what I do). This allows you to do damn near everything you can as an actual S-Corp with oodles more flexibility, generally smaller filing fees, and a much faster setup with no annual meeting, etc, requirements.

>Now for the really big reason: if you make a profit with an LLC, you will pay self-employment tax. If you take profits with an S-corp it is dividend income (or share buybacks, etc).

Only if it's a disregarded entity. You do not pay self employment tax with a LLC taking a S-Corp election, you pay active owners a salary(on which you pay SS and medicare) and any other income is reported on schedule K (which does not trigger self employment tax; self employment tax is a stand in for SS and Medicare taxes).

> You WILL pay more taxes using an LLC than an S-corp simply because you have far less flexibility owing to the fact that the corp is a separate legal entity while that is an extreme grey area for an LLC.

No it's not. LLCs are better statutorily defined than corporations actually. They are quite clearly defined. Generally speaking, disregarded entities (what you apparently had) are considerably closer to a sole proprietorship than S-Corp and C-Corp elected LLCs. This is why I say "You should probably be doing a S or C corp LLC".

>Your average CPA is useless when talking about these topics,

You need to find a small business CPA. They know tons about this. If you go to an estate planning expert, don't expect tons of tricks in the small business department. CPAs have specialties just like coders do. You wouldn't have your ruby guru write your C microcontroller code. Same deal with accountants. I've been to two small business CPAs who both sung "S-Corp election of a LCC" from the top of the highest mountains.

> In my state (IL) it costs $250 annually to keep your LLC in good standing, while it costs $75 a year for an S-Corp.

The other reply to yours is detailed and refutes each of your points, so I'll just address this. If you're thinking this $175 difference is relevant, you should probably just stick with a sole proprietorship.

On seven figures of revenue, my main LLC's tax bill (company + members, the same CPA handling it all) is some $7500 a year, but would run twice that as an S corp, and about four times that as a C corp.

Before this company, the last LLC I was a member of grew to 8 figures a year in revenue as an LLC, and changed to C corp only when we took $27M in funding. Prior to those, and before receiving genuinely good advice on the flexibility afforded by LLCs when pursuing high growth and investment, I used S corps. By comparison, LLCs are fantastic.

PS. "Go look it up" seems a little snide.

Can you elaborate on how an LLC is a rip-off? (It may also be useful to mention your state). So far, in Pennsylvania, I've had a different experience.

It depends on what you are doing. If you are losing money and not trying to transfer ownership interests you will have no problem. Once you start making money or want to do anything a tiny bit more complex you have created a hornet's nest for yourself.

Again, my last LLC earned 8 figures a year in revenue with several accredited investor bridges under our belts, before taking $27M in funding and converting to C. My current LLC earns 7 figures a year. In both, we did things that were quite complex, and being an LLC made them easy compared to being an S.

In my experience, your comments are exactly backwards.

Why is an LLC filing as an S-Corp a ripoff compared to an actual LLC? I was advised to that particular form of business by tax professionals and would like to hear why you think they are deficient.

Now if you're just talking as compared to a disregarded entity LLC, I would agree with you

Please see my other answer, I went into pretty good detail.