SWEAT EQUITY: BEST PRACTICES FOR VALUING EQUITY …
Transcript of SWEAT EQUITY: BEST PRACTICES FOR VALUING EQUITY …
Copyright ©2015 The Craft Beer Attorney, APC
SWEAT EQUITY: BEST PRACTICES FOR VALUING EQUITY LABOR IN
LLC’S
NOVEMBER 19, 2015
KATHLEEN A. SPERO, ESQ. [email protected]
Copyright ©2015 The Craft Beer Attorney, APC
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
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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
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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)
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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
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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
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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?
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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
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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
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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
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OVERVIEW OF COMMON PROBLEMS AND SOLUTIONS TO ADDRESS
MEMBER 1: INVESTMENT PARTNER
• $50,000.00
MEMBER 2: SWEAT EQUITY PARTNER
• BREWER
EQUAL OWNERSHIP SHARE (50/50)
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND 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$50,000.00
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
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND SOLUTIONS TO ADDRESS: CONFLICT
“HOPING FOR THE BEST, PREPARED FOR THE WORST, AND UNSURPRISED BY ANYTHING IN
BETWEEN.”
- MAYA ANGELOU
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND SOLUTIONS TO ADDRESS: TAXESSOLUTION 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
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND 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
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OVERVIEW OF COMMON PROBLEMS AND 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
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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