One ever-present challenge with LLC’s is that forcibly grafting corporate concepts and structures into the LLC format is counterproductive at best. Simply, pass-through membership interests are very different from corporate stock. As a result, several options and best practices have arisen to expressly leverage the best aspects of LLC’s to achieve similar goals to the traditional stock option plan. However, these approaches operate in very different fashions from the venerable stock option as further detailed below.
I. Capital Interest vs. Profits Interests
The first and most important concept to grasp is that most incentive awards in the LLC context are driven by actual equity ownership in the company, or actual ownership of LLC membership interests. Contrast that with a stock option which is merely a contractual right to purchase stock and hold equity at some later date, meaning a stock option holder does not hold actual equity. That said, LLC membership interests can be broadly split into two categories: a “Capital Interest” or a “Profits Interest.”
The basic capital interest is more or less tantamount to so called “common stock” in the corporate context. Capital interest holders enjoy the right to a proportionate share of the capital, profits, and residual value of the LLC. On the other hand, the basic profits interest is exactly like its capital interest cousin. The fundamental difference, however, is that a profits interest holder, on the date of the grant, gets no interest in the present day value of the company or its capital account balances. Hence, since that is the only difference, like capital interests, profits interests share in the profits and residual value of the LLC. Put another way, a profits interest begins with a zero dollar value and eventually increases in value as the LLC valuation increases. Bear in mind that a profits interest recipient actually becomes a “member” of the LLC, complete with a Schedule K-1 for accounting purposes.
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