Corporate Structure for Start-Ups

Is there an Investor, Founder AND Employee friendly corporate structure for early stage start-ups?  

YES!

The much maligned Limited Liability Company (LLC) structure can be used to satisfy all the needs of the various constituents and do so fairly.

The Concept

The Founder(s) of a company originate the idea and want to develop it, but at some point they need help both financially and operationally. They approach Investors who are looking for great ideas that can leverage their cash and contacts at a rate higher than that available in the stock markets, and together they implement the opportunity through recruiting talented people who are willing to take a career risk on an uncertain future, but one that they can materially and visibly affect. All need a structure that will deliver appropriate returns fairly.

Typically investment in any start-up, whether LLC, S-Corp or C-Corp requires negotiating the value of the company from the day of the first investment, a time when most often the value is a wild guess (and/or toughly negotiated). The reason for negotiation is simple: allocation of future financial returns is based directly on the percentage ownership negotiated. Thus investors want a low value and resulting high percentage ownership while founders want a high value. If the value is set fairly then everyone will win, however that cannot be known for years, and rarely happens.

The LLC in its basic form apportions ownership, in all its senses, on a percentage basis to partners, effectively no different from an S-Corp or C-Corp share structure (other than tax treatment). Unique to the LLC, however, are provisions for other forms. For example, ownership interest can be established separately from financial interest. This means that financial interest can be allocated independently of ownership, and can vary depending on any criteria the company sets up for its members. Thus different member groups or classes can be established to reflect the interests of Investors, Founders and Workers. This then is the basis for a structure that fairly responds to the needs and contributions of each Member segment.

Principles

The interested parties really divide into two groups, those that put in cash or assets, and those that put in expertise and time (the groups are not mutually exclusive, of course). So we'll call them Investor Members and Working Members. What is desired is a mechanism that gives Investors a predictable and to some extent preferential financial return, while also recognizing the input of the founders and other advisors and staff. While contributions are made in various ways and times, returns are made simultaneously to all, and generally in the form of money.

Mechanics:

Investor Members

These individuals or companies primarily contribute cash and assets. Any specific, performance based, contribution by an Investor will be recognized as a Working Member interest described in the next section. Investors contribute at some risk of loss, typically, but not necessarily, at higher risk earlier, and lower risk later, so they should earn a commensurate return. Both the timing and relative risk are recognized by establishing, at the time of each investment, an annual percentage Minimum Required Rate of Return. The MRRR is used any time there is a financial distribution to Members to compute, on a pro rata basis, the total amount Investor Members should have received to date. That amount is reduced by the total of any previous distributions to determine the Minimum Required Return (MRR). Investor Members receive the first 80% of the distribution, up to the total amount of the MRR. Following satisfaction of the MRR, Investor Members receive a 20% pro rata share of the remaining amount.

Working Members

Founders receive an initial award of Points, and Working Members are awarded Points which may vest over time. At the time of a distribution the total number of vested Points is used to establish the pro rata share each Working Member receives. Working Members receive 20% of the distribution amount up to the amount that satisfies 100% of the Investor Members' MRR (or put another way, an amount equal to 25% of the MRR). If there remains any amount to be distributed, it is allocated 80% to the Working Members and 20% to the Investor Members.

Sample LLC Agreement

Sample Allocation Spreadsheet

Implementation

Consulting services are available should you want assistance with implementation for your specific needs. Contact Mark Gluck.

Credits and Caveats

Credit for the original idea goes to L. Pierre de Rochemont, whom I thank for providing the fruits of his work. Following his generousity I place this information in the public domain. Use of any of this information is entirely at your own risk, and legal and accounting advise should be sought with respect to each situation, and especially for intended tax treatment, such as pass-through considerations, self employment tax issues, etc.