SWEAT EQUITY: BEST PRACTICES FOR VALUING EQUITY LABOR IN LLC S

Transcription

1 SWEAT EQUITY: BEST PRACTICES FOR VALUING EQUITY LABOR IN LLC S NOVEMBER 19, 2015 KATHLEEN A. SPERO, ESQ. KATIE@CRAFTBEERATTORNEY.COM

2 OVERVIEW 1) DEFINITIONS AND BASIC TERMS 2) QUALITIES OF SWEAT EQUITY PARTNERS 3) VALUATION OF CONTRIBUTION 4) OVERVIEW OF COMMON PROBLEMS AND SOLUTIONS TO ADDRESS a) CONFLICT b) TAXATION 5) QUESTION AND ANSWER PERIOD

3 DEFINITIONS AND BASIC TERMS WHAT IS SWEAT EQUITY? OWNERSHIP INTEREST OR INCREASE IN VALUE CREATED AS A DIRECT RESULT OF LABOR CONTRIBUTION TO A PROJECT IN THE FORM OF EFFORT, RATHER THAN MONEY TRADE OF HUMAN CAPITAL FOR OWNERSHIP I HAVE NOTHING TO OFFER BUT BLOOD, TOIL, TEARS, AND SWEAT. - WINSTON CHURCHILL

4 DEFINITIONS AND BASIC TERMS SWEAT EQUITY CONTRIBUTIONS ARE COMMON IN LLC FORMATIONS COMMON START-UP STRUCTURE LIMITED LIABILITY OF A CORPORATION FLEXIBILITY OF A PARTNERSHIP PASS THROUGH TAXATION OF S CORPORATION DO NOT REQUIRE FINANCIAL INVESTMENTS TO RECEIVE AN OWNERSHIP STAKE CAN ASSIGN DIFFERENT OWNERSHIP INTERESTS (CAPITAL INTEREST AND PROFIT INTEREST)

5 DEFINITIONS AND BASIC TERMS PROS OF SWEAT EQUITY PRACTICAL WAY TO COMBINE FORCES AND GROW A NEW BUSINESS PROVIDES ACCESS TO INFORMATION AND KNOWLEDGE THAT OTHERWISE WOULD BE EXPENSIVE OR UNAVAILABLE ALLOWS FOR CREATIVE CONTRIBUTIONS I VE GOT THE BRAINS, YOU VE GOT THE LOOKS. LET S MAKE LOTS OF MONEY. - PET SHOP BOYS

6 DEFINITIONS AND BASIC TERMS CONS OF SWEAT EQUITY POTENTIAL FOR CONFLICT TAX CONSEQUENCES TRADING OWNERSHIP INTEREST FOR PROSPECTIVE, NOT CERTAIN, CONTRIBUTION TRADING INTELLECTUAL PROPERTY EVERY CHOICE HAS ITS CONSEQUENCES. SOME MORE THAN OTHERS. - STEPHENIE MEYER

7 QUALITIES OF SWEAT EQUITY PARTNERS 1) IS HE OR SHE COMMITTED TO BEING A LONG-TERM PARTNER? 2) IS HE OR SHE PROVIDING A UNIQUE CONTRIBUTION TO THE BUSINESS? KNOWLEDGE AND SKILLS LEADERSHIP ABILITY EXPERIENCE INDUSTRY KNOW-HOW 3) IS HE OR SHE DRIVEN BY THE SAME MOTIVATIONS AND GOALS AS OTHER PARTNERS?

8 VALUATION OF SWEAT EQUITY LLC MEMBERS RECEIVE AN OWNERSHIP STAKE COMMENSURATE WITH THEIR INVESTMENT. HOW MUCH IS A SWEAT EQUITY INVESTMENT WORTH? ALL HAVE THEIR WORTH AND EACH CONTRIBUTES TO THE WORTH OF OTHERS. - J.R.R. TOLKIEN

9 VALUATION OF SWEAT EQUITY OPTION 1: FOREGONE OPPORTUNITY THE FULL-TIME SALARY THAT COULD HAVE BEEN REALISTICALLY EARNED AT ANOTHER LOCATION VALUE THE EXPERIENCE AND SKILL OF THE SWEAT EQUITY PARTNER REGIONAL VARIATIONS BUSINESS SIZE VARIATIONS

10 VALUATION OF SWEAT EQUITY OPTION 2: REPLACEMENT COST COST IT WOULD TAKE TO REPLACE THE CONTRIBUTIONS OF THE SWEAT EQUITY PARTNER MORE REALISTIC VIEW OF VALUE VALUATION INDEPENDENT OF PERSONAL CHARACTERISTICS OF SWEAT EQUITY PARTNER VALUATION BASED ON MARKET SUPPLY AND DEMAND

11 SOLUTIONS TO ADDRESS MEMBER 1: INVESTMENT PARTNER $50, MEMBER 2: SWEAT EQUITY PARTNER BREWER EQUAL OWNERSHIP SHARE (50/50)

12 SOLUTIONS TO ADDRESS: CONFLICT START-UP IS THE HONEYMOON PHASE DIFFICULT TO PERCEIVE CONFLICTS THAT CAN ARISE IN THE FUTURE DIFFICULT TO DISCUSS POSSIBILITY OF DISCORD AND DISSOLUTION DIFFICULT TO ACCOUNT FOR BUSINESS PROBLEMS IN CONTEXT OF LARGER RELATIONSHIPS LONG-TERM RELATIONSHIP: COLLEGE ROOMMATE, CHILDHOOD BEST FRIEND FAMILY

13 SOLUTIONS TO ADDRESS: CONFLICT PROBLEM 1: PAYDAY MEMBER 1 WANTS THE MONEY INVESTMENT TO BE PAID OFF BEFORE DISTRIBUTIONS OF PROFITS ARE MADE OTHERWISE, IF THE BUSINESS FALTERS IN THE SHORT-TERM, MEMBER 2 COULD WALK AWAY WITH AN EQUAL PERCENTAGE AT LIQUIDATION WHILE MEMBER 1 LOSES HIS OR HER$50, MEMBER 2 WANTS TO BE PAID AS SOON AS POSSIBLE AND RECEIVE AN EQUAL DISTRIBUTION AT LIQUIDATION OTHERWISE, HE OR SHE HAS LOST THE VALUE OF EARNING A SALARY, WHILE MEMBER 1 HAS LOST NOTHING

14 SOLUTIONS TO ADDRESS: CONFLICT PROBLEM 2: CONTRIBUTION LEVEL MEMBER 1 WANTS TO ENSURE THAT MEMBER 2 IS GOING TO BE PUTTING THE SWEAT IN SWEAT EQUITY OTHERWISE MEMBER 2 IS RECEIVING A 50% INTEREST IN THE BUSINESS WITHOUT GIVING A 50% EFFORT MEMBER 2 WANTS TO ENSURE THAT MEMBER 1 IS ALSO PROVIDING ONGOING BUSINESS CONTRIBUTIONS OTHERWISE, MEMBER 2 IS GIVING 100% OF THE EFFORT TO GROW THE BUSINESS WITH ONLY A 50% INTEREST

15 SOLUTIONS TO ADDRESS: CONFLICT PROBLEM 3: NEW BLOOD MEMBER 1 WANTS TO ENSURE THAT HIS OR HER OWNERSHIP INTEREST IS NOT DEVALUED WITH NEW INVESTORS OTHERWISE, HIS OR HER $50,000 INVESTMENT LOSES MONETARY VALUE WITH EACH NEW INVESTOR MEMBER 2 WANTS TO ENSURE THAT HIS OR HER TRUE VALUE IS NOT DIMINISHED SINCE IT IS NOT MONETARY IN NATURE OTHERWISE, HIS OR HER SKILLS, CONTACTS, ETC. ARE TREATED AS LESS THAN CRITICAL

16 SOLUTIONS TO ADDRESS: CONFLICT SOLUTION 1: CLEARLY DEFINE ROLES IN THE OPERATING AGREEMENT WHAT WILL HAPPEN IN A BUSINESS DIVORCE AND DISSOLUTION? OPTION 1: MEMBER 1 RECEIVES PORTION OF INVESTMENT, BASED ON LENGTH OF BUSINESS OPTION 2: MEMBER 2 RECEIVES HIGHER PERCENTAGE OF COMPANY S VALUE UPON DISSOLUTION HOW WILL NEW INVESTOR SHARES BE ISSUED OPTION 1: EQUAL DILUTION PERCENTAGES OPTION 2: PROVIDE GUARANTEED RETURNED ON INVESTMENT OR PROFIT INTEREST RATHER THAN CAPITAL INTEREST

17 SOLUTIONS TO ADDRESS: CONFLICT SOLUTION 1: CLEARLY DEFINE ROLES IN THE OPERATING AGREEMENT WHAT WILL VESTING SCHEDULE BE FOR EQUITY PARTNER? PROVIDE INCENTIVES FOR MEMBER 2 WHEN OWNERSHIP IS BASED ON TIME AND/OR BENCHMARKS PROVIDE FOR GREATER SECURITY OF INVESTMENT FOR MEMBER 1 HOW WILL INTELLECTUAL PROPERTY BE ASSIGNED? MEMBER 2 CAN PROTECT HIS OR HER CONTRIBUTIONS MEMBER 1 CAN ENSURE BUSINESS EXISTENCE CONTINUES IF MEMBER 2 LEAVES

18 SOLUTIONS TO ADDRESS: CONFLICT SOLUTION 2: CLEARLY DEFINE DUTIES AND ROLES WHAT WILL THE JOB DESCRIPTIONS BE? CLEAR LINES OF RESPONSIBILITY AND ACCOUNTABILITY CLEAR IDEA OF WHERE TO GO WITH PROBLEMS AND CHALLENGES WHO WILL BE THE MANAGING MEMBER WITH FINAL SAY IN DECISIONS? GIVE VALUE TO MEMBER 2 EXPERTISE AND EXPERIENCE AVOID DEADLOCK

19 SOLUTIONS TO ADDRESS: CONFLICT SOLUTION 3: SEEK OUTSIDE HELP BOARD OF DIRECTORS ALLOWS DECISIONS TO BE MADE IN BEST INTEREST OF BUSINESS, NOT PARTNERS THIRD-PARTY OBJECTIVENESS CONFLICT RESOLUTION STEPS WHAT IS A BREACH CONFLICT WAIVERS AND ROLE OF ATTORNEY

20 SOLUTIONS TO ADDRESS: CONFLICT HOPING FOR THE BEST, PREPARED FOR THE WORST, AND UNSURPRISED BY ANYTHING IN BETWEEN. - MAYA ANGELOU

21 SOLUTIONS TO ADDRESS: TAXES THE PROBLEM: TAXATION WITH REPRESENTATION AIN T SO GREAT EITHER IRS CONSIDERS SWEAT EQUITY TO BE TAXABLE! THE HARDEST THING IN THE WORLD TO UNDERSTAND IS THE INCOME TAX. - ALBERT EINSTEIN

22 SOLUTIONS TO ADDRESS: TAXES IRS TAXES INCOME, WHICH INCLUDES BOTH CASH AND NON-CASH COMPENSATION CIRCUMVENT INCOME TAX BY GIVING THINGS OF VALUE RATHER THAN CASH CAR, HOUSE, ETC. IRS VIEWS SWEAT EQUITY AS FOLLOWS: SWEAT EQUITY PARTNER PERFORMS SERVICES IN EXCHANGE FOR INTEREST IN AN LLC COMPENSATION INCOME IS EARNED EQUAL TO THE FAIR MARKET VALUE OF THE LLC INTEREST RECEIVED EQUIVALENT TO RECEIVING TAXABLE CASH COMPENSATION USED TO PURCHASE AN LLC INTEREST AT FAIR MARKET VALUE

23 SOLUTIONS TO ADDRESS: TAXES SOLUTION 1: PROMISSORY NOTE MEMBER 1 CONTRIBUTES $50,000 TO THE LLC MEMBER 2 CONTRIBUTES A PROMISSORY NOTE TO THE COMPANY FOR $50,000, PLUS INTEREST AS MEMBER 2 BEGINS TO EARN A SALARY, A PORTION OF CASH COMPENSATION IS PAID UNTIL NOTE PAID IN FULL NOTE PAYMENTS ARE TAXABLE EVENTS CANNOT ACCELERATE PAYMENTS IF MEMBER 2 LEAVES

24 SOLUTIONS TO ADDRESS: TAXES SOLUTION 2: EQUITY VESTS OVER TIME SWEAT EQUITY NOT TAXABLE IF IT IS SUBJECT TO A SUBSTANTIAL RISK OF FORFEITURE OWNERSHIP VESTS OVER TIME OR WITH CERTAIN MILESTONES MEMBER 1 CONTRIBUTES $50,000 MEMBER 2 IS GIVEN OPTIONS TO PURCHASE EQUITY OVER TIME AT A PRICE OF $1,000 FOR EACH 1 PERCENT PURCHASED, CAPPED AT 50% MEMBERSHIP INTEREST PURCHASE OF EQUITY IS TAXABLE EVENTS MEMBER 2 NO LONGER ABLE TO PURCHASE IF LEAVES COMPANY

25 SOLUTIONS TO ADDRESS: TAXES SOLUTION 3: COMPANY LOAN MEMBER 1 AND MEMBER 2 EACH CONTRIBUTE $10 FOR A 50/50 EQUITY STAKE MEMBER 1 LOANS THE LLC $50,000, PAYABLE WITH INTEREST OVER A 5 YEAR PERIOD OUT OF COMPANY PROFITS MEMBER 1 HAS GUARANTEED RETURN ON INVESTMENT MEMBER 2 HAS NO PHANTOM INCOME

26 SOLUTIONS TO ADDRESS: TAXES OTHER SOLUTIONS MEMBER 2 BORROWS MONEY FROM BANK OR FROM MEMBER 1 TO CONTRIBUTE TO LLC MEMBER 2 RECEIVES FUTURE PROFITS INTEREST BUT NO OWNERSHIP INTEREST MEMBER 2 BORROWS MONEY FOR TAX PAYMENTS

27 SOLUTIONS TO ADDRESS: TAXES IF YOU WORK AS AN ACCOUNTANT, YOU DON T HAVE PEOPLE COMING UP TO YOU IN THE STREETS SAYING, HEY, GREAT JOB ON TAX STATEMENTS!. - KEVIN NEALON

28 QUESTION AND ANSWER THANK YOU FOR PARTICIPATING TODAY. WE LOOK FORWARD TO SEEING YOU FOR OUR DECEMBER 2015 WEBINAR TOPIC: END-OF-THE-YEAR AUDITS AND IMPORTANT CHANGES FOR THE CRAFT BEER INDUSTRY FOR 2016