Stock Option Alternatives for LLCs

If you’re wondering whether LLCs can issue stocks, you’re probably interested in equity compensation—a way for startups to compensate founders or employees without a lot of cash on hand.

LLC equity compensation is certainly possible, and it’s common for owners, employees, and service providers of LLCs and C-Corporations alike. However, it’s more complicated than issuing stocks and requires a more thorough discussion before choosing the right compensation structure for your venture.

These are some popular ways that LLCs offer alternatives to traditional stocks:

1. Corporate Member Stock Option Grants

A stock option gives the owner of the option the right, but not the obligation, to buy stock in a company at an agreed upon price prior to its expiration date. Since LLCs do not actually have stock to give, but rather membership interest, issuing stock options is tricky—but not impossible.

If an LLC’s management is dead set on providing traditional stock options that one would see in a C-Corporation, one solution is to form a separate C-Corporation, then grant or issue said C-Corporation a fixed profits interests in the LLC.

The corporation then adopts a stock option plan and those options can be granted as equity based compensation. This option presents some significant challenges and is not necessarily simple or cost effective, as there are several accounting and legal issues that must be managed carefully.

2. Profits Interests

A profits interest can be awarded to an individual for their service to the LLC, providing an equity right based on the future value of the business. The award consists of receiving a percentage of profits from a partnership without having to contribute capital. This is the most common form of equity compensation for LLCs.

The recipient of profits interests may also have a right to the increase in value of the business after the date of receipt of their profits interest. In other words, if the valuation of the business increases after the date of issuance, then the recipient of the profits interest will receive a proportionate share of the value of the company upon sale. Granting profits interests is remarkably similar to the issuance of stock options above. A profits interest may also be subject to vesting the same way founders’ stock or options are in a C-Corporation.

Holders of profits interest are considered members of an LLC, but they usually do not have all of the same rights (e.g., voting) as members who own an ordinary equity interest.

3. Phantom Stock/Synthetic Equity

A phantom stock plan is a plan that gives service providers—anyone who you may want to compensate through other means than cash—most of the benefits of owning equity in a venture without owning the underlying interest. Phantom equity is often referred to as synthetic or shadow equity.

Phantom equity grants service providers a right to a cash bonus that is equal to the amount that they would have received if they held a profits interest. Unlike a profits interest, the owner of phantom equity is not a member of the LLC and the owner’s rights terminate  with the completion of services.