Bite-Sized Bits of Knowledge

Hi. This is Barry Haimo. Thanks for tuning in to another dose of Bite-Sized Bits of Knowledge, where we give you meaningful information in a short amount of time. 

Today, we’re talking about the ownership portion of what goes into governing documents. What does ownership mean?

It can mean a lot of things, actually. The more flexible entities we talked about have the ability to have more options. The less flexible entities we talked about have the least options. And so, to give that kind of a tangible example, LLCs and partnerships have all these options. C corps and particularly S corps have very few options. Okay?

I’m going to talk about all the options more generally so you can just understand them. I’m not going to get too nitty gritty into which one applies to which, because we don’t have time for that. 

So, when it comes to ownership, that usually means equity, okay? That means equity. That means that you’re a shareholder, you’re a member, you’re a partner, living partner, general partner. You have equity in the business, you’re an owner of the business, okay? 

And that can take several forms. You could be a shareholder of voting shares, you could be a shareholder of non-voting shares. The difference being that, one of those shareholders voting shares has the right to participate in management of the business, whereas the other one, the non-voting shareholder, that really means you’re more of an economic owner because you can’t participate in the management of business. 

So you’re still a member, you’re still a shareholder. You have rights as a shareholder but your rights to participate in management are limited. So you’re kind of along with the ride as a shareholder financially or economically, if you’re not a voting or a non-voting member shareholder, et cetera, you could still be included as an owner if you’re an owner of what’s called a profits interest or an economic interest. These are pretty cool. CPAs like them.

And they could be attractive to give to key personnel because you can give them kind of a financial interest in the company without making them a member, without making them a shareholder, without giving them those rights that shareholders have, like books and records and other duties and obligations and rights under the statute to take action against the company or the management of the company. 

Don’t forget minority shareholders have rights. There’s a lot of them. So we’re not against that here. But you could be a voting or non-voting shareholder or you can give somebody a profits interest, which is a non-membership or non-shareholder interest limited to the economic interest.

Now, the reason why it’s kind of interesting is it’s called a non-capital interest, meaning that if you give somebody a profits interest, you’re giving them an interest in the future profits, the future appreciation. In other words, if the company liquidated the day after the profits interests were awarded, then that person who has the profits interest wouldn’t receive any of the value of the company prior to that time. 

Because of that, they’re not receiving anything of value. There’s nothing to report for income tax purposes, which could be a very significant deal. An alternative, or in contrast, if you give a key person stock, they’re getting something of value, a capital interest. And they have to report that value as income and therefore pay taxes on that income. 

And when they pay taxes on it, if there’s restrictions, that’s a whole other concept that, you know, revolves around something called an 83 B election, which deals with timing. But we’re not going to talk about that today. 

The point today is to talk about ownership could be vested in a key person by way of a profit interest or an economic interest. That’s a non-capital interest. It’s not a shareholder, but they can be vested in the profits of the company, the appreciation of the company beyond that time. It’s a very attractive way to bring in people and keep people interested.

I want to talk about preferred shares: preferred shares or preferred units. There’s preferred shares in corporations, C-corporations, or LLCs. There’s also common shares. 

Preferred shares usually have a preference on dividends or distributions. They get paid first a certain amount before common shareholders. That preference will obviously extend to liquidation. If the company’s going out of business, they get paid their share first before common shareholders.

Of course, creditors get paid first before any shareholders. But then of the shareholders, preferred shares go first. 

You could also have an LLCs and partnerships. You can have investors or partners that invest money. They want to get a distribution preference, which is to say that they get a priority of payment first, like a waterfall. If the company is going to pay out to the partners, investors get paid back first, plus what’s called usually, a preferred return. And only then when that’s paid out in full, plus the preferred return, then do the preferred shareholders and the common shareholders get what’s left. Think of it as a waterfall. It kind of trickles down as a waterfall would. 

And I think the overarching concept of all these things is something called vesting. Vesting can be really helpful, because when there’s vesting you don’t necessarily earn your shares immediately upon signing a contract as an employee, or a contractor, or even as a partner. 

There could be a commitment period like, say, three years before you’ll vest, which could be like a cliff. After a certain period of time, you vest all at one time. It could be a pro-rated vesting over time, where you vest like ten shares over ten years, pro rata each year. So it’s like every end of each year you kind of vest one share. You could make it over time like that. 

Of course, if things don’t work out, you’ll get the shares that you’ve vested and you won’t get the shares that have not been vested. So there’s a lot of ways to deal with vesting to incentivize a long term commitment. You can incentivize people with vesting based on time, based on milestones, et cetera. There’s a lot of ways to do it and there’s a lot of tax consequences of doing these things.

So you really need to think them through, think this through. Get that holistic council that we’ve been talking about throughout our videos.

I think it’s important to also mention that you want to make sure you’re identifying the owners as individuals. Are they companies? Which one’s better, which one’s worse? There’s definitely consequences of doing it each different type of way. Ownership can also be in the form of a trust, which we do a lot. 

And there’s a lot of reasons why you don’t want to have partners as an individual, but when you have a partner as not an individual, you have to really think it through for reasons I’m not going to get into right now, but really it gets complicated.

The last thing I would say would be ownership is really something that needs to be thought through in the beginning, because there’s tax consequences of changing it later in almost every way. So just be mindful of what you’re doing, how you’re going to do it, who you can do it with, what’s the long term vision. Do your best, get counsel. 

The next video, we’re going to talk about meetings, so thank you for stopping by. Stay tuned for more and don’t forget to download our free Business Planning Stress test. The link is below in the description.