Membership Vesting and Limited Liability Companies

By Jennifer Reuting

One of the biggest causes of discord among partners is when one or more don’t live up to their ends of the bargain. When a partner agrees to provide certain value to the company (namely, in the form of services) in exchange for a certain percentage of the membership, he’s expected to make good on his promises.

Unfortunately, even the best-laid plans fizzle out; people can be lazy, or life can simply get in the way. Having a partner that doesn’t pull his weight usually dampens the enthusiasm of the other partners; after all, why should they work so hard when he’s off having fun and still getting the same ownership percentage? Resentment builds, and thus begins the slow, painful disintegration of a perfectly good business.

Luckily, you can prevent this all-too-common scenario through membership vesting.

The best way to protect your company in the event that one of the partners becomes dead weight is to make sure that he simply earns his membership as time passes and/or as he meets certain milestones. If a member departs as an employee/manager of the company (whether he leaves on his own or is kicked out), he takes with him only the membership interests that he’s already earned up to that point.

Deciding on a fair vesting schedule

The timeline in which members earn membership is called a vesting schedule. The most common arrangement for founding members of a new startup is a three-to-four-year vesting period, with membership vesting every quarter.

For example, if a founder only contributing services is placed on a four-year vesting schedule, then on the three-month anniversary of his starting “employment” with the company, he receives one-sixteenth of his membership. Then, every three months, he receives an additional one-sixteenth of his membership until, on his four-year anniversary, he receives the final increment and owns all his membership in full.

Vesting typically doesn’t apply to membership earned in exchange for a contribution of cash or property, only services.

If you have only one other partner and you each own 50 percent of the total membership interests, you may have a difficult time kicking out your ineffective partner. In this case, have an advisory board in which you issue a small interest (such as 1 percent) to a trusted third-party advisor and then require a simple majority vote. This person can serve as your tie-breaker.

An extra benefit to having an advisory board is that you can bring on additional advisors as needed. After all, it takes a village to raise a child. This applies to companies too!

Alternatively, have the membership vest based on specific milestones. That way, you may not be able to officially kick out your ineffective partner immediately, but at least he won’t keep receiving more membership he isn’t earning. When you’ve vested enough membership to have the majority of the interests, you can vote him out of there.

Understanding membership cliffs

You may have heard of the term membership cliff — when a company decides to make a partner wait an extra-long time upfront before her membership vests. For example, a one-year cliff on her vesting schedule means she doesn’t get any of her membership until the one year anniversary of the date she started employment (although the membership accrues during that time).

On that date (assuming a four-year vesting schedule), she receives the accrued one-quarter (four-sixteenths) of her membership and then continues vesting quarterly as normal.

Companies often use membership cliffs to incentivize a partner or employee to stay with the company for a certain amount of time (a year, for example). If the partner leaves early, she receives no ownership in the business. Membership cliffs should not last longer than six months. If a partner is only sticking around for the membership she was promised, do you really want her on board just biding her time?

However, cliffs are sometimes useful. If membership vests monthly (rather than quarterly), you should heavily consider implementing a three-month cliff. This way, if the new partner/employee doesn’t work out, you can quickly part ways without the hassle of having an extra member on board or, even worse, a bad hire who isn’t invested in your business.

Avoiding common tax pitfalls

When you agree to earn your share of a business over time, it’s generally because you believe that the company is going to increase in value. And if there’s one thing everyone knows about the startup world, it’s that when the big wins happen, they generally happen rapidly and gloriously, resulting in a huge increase in valuation.

If this jackpot happens to you, you’re on cloud nine. You may not see any of the cash for a while, but, gee, does your personal balance sheet look great! You’re living the dream, right? Well, yes — until you receive your tax bill. You see, the IRS will want to tax you on that new valuation even before you actually see any cash from the transaction.

And unless you have enough cash lying around to pay taxes on the millions of dollars that you’re now technically worth, you’re going to be hurting.

Luckily, the IRS gave the tax-savvy an out, and it comes in the form of an 83(b) election. When you make this election early on (generally right after you receive your membership grant), you lock in the valuation of the company at the time you joined.

This setup means that even though your membership interest may potentially be worth millions in six months, you’ll only pay taxes on the hundreds it’s worth now (or nothing, if your CPA structures it in a certain way).

Making 83(b) elections is pretty straightforward and definitely something that you want to get a jump on as soon as your membership is issued. However, if you’re going to implement vesting as a strategy, you really need to run everything by your qualified small-business CPA first.

This tax issue isn’t the only one that may affect you, and a good CPA can make sure that your butt is covered on all fronts. You may spend $100 now getting a consult, but that’s peanuts compared to the tax bill you may face later if you proceed unaware.