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danielcoyle
01-12-2013, 12:34 AM
Hello, this is my first post here. Thanks for any advice.

I started a manufacturing and sales business 2 years ago as a sole prop. The product has some IP and I spent most of that time developing and testing it. This past summer I changed the business registration from sole prop to Manager Managed LLC in the state of Oregon. I did start some sales in the spring of 2012, mostly as a form of market testing, and have had positive results that encouraged me to continue on and source additional investment.

I have been a one man show and, in spite of 7 day work weeks for most of the past couple years, I fall behind on the project more and more each month. It just isn't a one man kind of pursuit. I don't have the means to hire a highly competent employee and agreed to a trial period working with a friend for two months. The goal was to determine if bringing him on as an equity for service member would work for us. He worked hard and was reliable, as I had expected from my past experiences with him. I have 10.5K invested in patents, 60K in loans from family members (including 15K i loaned the business myself) and about 15 K in equipment (soon to be 30K). He would like 20 % of the company (which feels like a lot to me but i need the help and, on a personal level, i trust him.) My plan is to do a reverse vesting of his 20% over 2 years with a very moderate compensation rate deferred (payments triggered by revenue benchmarks).

Nonetheless, if things go sour between us and we separate or if we separate on good terms and then I were to be approached by an investor (I worry that some investors might balk at investing in a company with a large uninvolved interest holder) I feel I would want to be able to buy him out. Of course I would want the price of the buyout to be fair to him (the clause would allow him to demand I pay for a valuation if we couldn't agree on price) so I would have to be pretty motivated. He is concerned about scenarios where he is forced to sell to me and then, 3 months/years etc later, the company has huge growth. I proposed granting him phantom stock (so that he could benefit from any large sale in the future) as part of any forced buyout but he was counseled against this for capital gains tax reasons. Of course, I can imagine scenarios that are directly the opposite in fortune as the one he brought up but that kind of negotiation only goes so far. Any thoughts on this situation would be useful even if they are that I am asking for too much control.

Dan

kcounsel
01-12-2013, 03:54 PM
danielcoyle, congratulations on your business venture.

It is always important to be on the same page as the person making the inquiry, especially with respect to complex legal and financing terms. You mention phantom stock. Are you using the term phantom stock as a way to define an alternative right that is not equity, or are you using this term to define the 20% equity? Just trying to clarify the relevance of phantom stock to the options remaining on the table. Additionally, he was counseled against acquiring phantom stock, but have you sought out the advice of your own tax expert on this very issue? Professionals sometimes have varying opinions. Is it possible that the friend's tax adviser was wrong with respect to phantom stock? With regard to reverse vesting, I presume you mean that the company is permitted to purchase any percentages that have not yet vested in the friend pursuant to your vesting schedule.

Looking at the situation practically, both you and your friend are investing sweat equity. I presume that you are handling 100% of the expenses and carrying costs associated with this business venture. Have you considered whether your friend will assume any responsibilities and/or liability with respect to these debts, expenses, and carrying costs, in exchange for X% equity? As to the investments, debts, and assets of the company, how does your equity affect ownership and responsibility for the items you mentioned (patents, loans, equipment)?

Additionally, equity percentages are not necessarily indicative of control and voting rights. Although your LLC is manager managed, have you considered whether it would be beneficial in your jurisdiction to discuss control and voting rights in your operating agreement?

There are many contingencies that should be considered, and perhaps explicitly provided for in the buyout provision, including, but not limited to: divorce, bankruptcy, death, disability, and so on - depending on the jurisdiction. When you want to ensure that a member of the LLC is pulling his/her weight, performance related contingencies may be used, including, but not limited to: acquiring similar or related employment with a competitor, failure to report to work for X days, insubordination of reasonable management directives of X member, failing to appear at X consecutive meetings, failure to abide by X rules and bylaws, failure to meet X production deadlines, failure to meet X quality standards, and so on.

There are many subjects and tidbits to consider. Best of luck to you!

nealrm
01-12-2013, 06:17 PM
Bring him in as an employee with his compensation tied to company profits. You would most likely need to pay him a min amount to satisfy min wage laws. There is no need to worry about buying him out or other partnership issues.

kcounsel
01-12-2013, 06:40 PM
Bring him in as an employee with his compensation tied to company profits. You would most likely need to pay him a min amount to satisfy min wage laws. There is no need to worry about buying him out or other partnership issues. Seems like a potential option. However, with respect to hiring the friend as a straight employee, I suspect that federal payroll taxes would come into issue. Would there even be an ability to take on the added expense of paying at least minimum wage, as well as any other state based or federal unemployment insurance? As compensation is tied to company profits, the issue as to appropriate percentages, and the issue of outstanding interests concerning potential investors remains. Additionally, I suspect that the friend would want guarantees with respect to employment, so that the compensation is not unilaterally terminated at the whim of the LLC owner - perhaps a provision against at-will employment.

nealrm
01-12-2013, 10:15 PM
The amounts on the taxes will change some, but not as much as you might think. The employer will pay half the SS and Med. Profits will be reduced by that same amount, which in turn would reduce his profit based compensation. Unemployment insurance here is not a huge amount, not sure what Oregon charges. I also don't see much different between employment at will and a forced buyout, from his standpoint. Either way he would be out of a job.

There are some advantages of having him as an employee. Think of the three Ds, Death, Divorce, Drugs. If he dies do you want to be in business with his wife, his kids or worse some family member you don't even know. What if his portion is tied up in probate for years? What if he gets divorced and the wife gets the business or 5 years down the road he decides that he doesn't want to work. It is a lot easier to handle these if he is an employee. Also, there are command structure advantages for you. There would not be any confusion about who was in charge. Since this person is you friend, setting that up at the beginning may help you to keep that friendship. Business partnership have ended more friendships than women, so watch out.

kcounsel
01-12-2013, 11:34 PM
The amounts on the taxes will change some, but not as much as you might think. The employer will pay half the SS and Med. Profits will be reduced by that same amount, which in turn would reduce his profit based compensation. Unemployment insurance here is not a huge amount, not sure what Oregon charges. I also don't see much different between employment at will and a forced buyout, from his standpoint. Either way he would be out of a job.

There are some advantages of having him as an employee. Think of the three Ds, Death, Divorce, Drugs. If he dies do you want to be in business with his wife, his kids or worse some family member you don't even know. What if his portion is tied up in probate for years? What if he gets divorced and the wife gets the business or 5 years down the road he decides that he doesn't want to work. It is a lot easier to handle these if he is an employee. Also, there are command structure advantages for you. There would not be any confusion about who was in charge. Since this person is you friend, setting that up at the beginning may help you to keep that friendship. Business partnership have ended more friendships than women, so watch out.

Under such a scenario, danielcoyle should confer with a local accountant and determine the company's expected liability for the payroll taxes, at least on the minimum wage. My understanding is this: it does not matter that the company is profitable or losing money, the company continues to be responsible for paying out the applicable minimum wage to its employees. What if the business continues to be unprofitable for many years to come? According to the original post, the danielcoyle said "I don't have the means to hire a highly competent employee."

However, I agree with the sentiment that partnerships can be very troublesome. As this friendship is entering a business relationship, it would not matter whether this will proceed as employment or partnership, both may lead to much animosity -- it's the nature of business. An operating agreement drafted by a competent attorney should be able to alleviate the concerns you mentioned with respect to "death, divorce, drugs," with provisions such as: a right of first refusal, equity returning to surviving partners upon death of member based on agreed valuation, and performance related contingencies, and drug testing. As the friend is demanding significant equity, I would venture a guess that an employment relationship is not in the cards, especially one that is at-will.

danielcoyle
01-13-2013, 09:45 PM
Thanks so much. Tried to answer your questions below

You mention phantom stock. Are you using the term phantom stock as a way to define an alternative right that is not equity, or are you using this term to define the 20% equity?

He would be getting traditional ownership equity. 20% in this case (but probably in units rather than in promised % so that the company could issue additional ownership units in the future if an advantageous investment situation came up, thereby diluting the value of existing units without break promises about %). The phantom stock would be granted (and this is just an idea to make him feel better about a forced buyout) if his shares were bought back from him against his wishes (because it would be in the Operating Agreement). The phantom stock would entitle him to financial gains from distributions or a company sale but he would not have membership as an owner in the llc.

With regard to reverse vesting, I presume you mean that the company is permitted to purchase any percentages that have not yet vested in the friend pursuant to your vesting schedule.

I think so, if I understand you correctly. He would be granted 20% ownership to start with. This is to accomplish establishing him as an owner/member with enough equity to save us from being required to pay him as an employee or acquire worker's comp. If he left before the vesting schedule was up the company would buy back the unvested shares ( for their original value ) and, if the forced buyout clause was established, buy back his vested shares as well for their value at the time of the separation.

Looking at the situation practically, both you and your friend are investing sweat equity. I presume that you are handling 100% of the expenses and carrying costs associated with this business venture.

Yes, so far.

Have you considered whether your friend will assume any responsibilities and/or liability with respect to these debts, expenses, and carrying costs, in exchange for X% equity?

I have considered creating a clause in the OA that would allow the manager to demand contributions to the company from members in the case of a critical event. Beyond that, really, he and I are both expecting that he will contribute work/service, not capital.

As to the investments, debts, and assets of the company, how does your equity affect ownership and responsibility for the items you mentioned (patents, loans, equipment)?

Hmmm. Trying to figure that out right now. In an ideal world I would claim that patents and equipment were mine or, at least, the property of the old sole proprietorship. Then I would lease/license them to the company for a minimum rate and the value of the company could reasonably be called close to 0. This would allow my buddy to buy his 20% (in units) at a next to nothing price and establish his ownership. The bank account that I use is the original one I set up while a sole proprietor. I have not changed that since registering as a manager managed llc. most of the assets have been bought with revenue from past sales or from cash recieved as loans to the sole prop (40K) and loans to the llc (20K). there are no other members but me

Additionally, equity percentages are not necessarily indicative of control and voting rights. Although your LLC is manager managed, have you considered whether it would be beneficial in your jurisdiction to discuss control and voting rights in your operating agreement?

I have written up the OA draft as one that can act like a member managed llc. Since I am calling myself the sole manager AND will have majority ownership it won't matter too much currently (???) but I want the agreement to recognize that while my buddy won't be able to outvote me he will be involved in the decision making process as a voting member.

There are many contingencies that should be considered, and perhaps explicitly provided for in the buyout provision, including, but not limited to: divorce, bankruptcy, death, disability, and so on - depending on the jurisdiction. When you want to ensure that a member of the LLC is pulling his/her weight, performance related contingencies may be used, including, but not limited to: acquiring similar or related employment with a competitor, failure to report to work for X days, insubordination of reasonable management directives of X member, failing to appear at X consecutive meetings, failure to abide by X rules and bylaws, failure to meet X production deadlines, failure to meet X quality standards, and so on.

Yes. Good stuff to think about. My buddy is unmarried with no kids currently (for what its worth). I have made some effort to include some of the contigencies you mention including, specifically, death, resignation, termination. The others seem important to look into as well. As for the performance contingencies, i considered creating that for the vesting schedule (so it is specific to him and what i want him to accomplish) and then writing up the OA so that it recognizes such contracts. Would it be important to do this kind of description in the OA itself?

There are many subjects and tidbits to consider. Best of luck to you![/QUOTE]

danielcoyle
01-13-2013, 09:48 PM
the hope is to avoid the requirements of min wage laws by issuing him such % that the state recognizes him as an owner not requiring pay.

danielcoyle
01-13-2013, 09:50 PM
Seems like a potential option. However, with respect to hiring the friend as a straight employee, I suspect that federal payroll taxes would come into issue. Would there even be an ability to take on the added expense of paying at least minimum wage, as well as any other state based or federal unemployment insurance? As compensation is tied to company profits, the issue as to appropriate percentages, and the issue of outstanding interests concerning potential investors remains. Additionally, I suspect that the friend would want guarantees with respect to employment, so that the compensation is not unilaterally terminated at the whim of the LLC owner - perhaps a provision against at-will employment.

here this idea is to defer a minimum payment until the company can both pay the wage AND pay back the deferment. the deferment would go on the books as a debt that would be paid off as a priority (along with other loan debts) in the event of the company folding.