Disgruntled business owners often ask us at the Clinic “how could this happen?” This is frequently the question when a co-founder received equity in the business at its inception but then left the business for some reason. The following hypothetical illustrates this problem, and then we suggest a way to avoid this situation.
Mary and Marty are recent graduates of Penn State’s hospitality school, and they decided to open an Italian-themed restaurant together in Ebensburg, PA, Mary’s home town. Mary is the sole beneficiary of a trust fund started by her grandfather and contributed $50,000 in order to provide initial working capital for the new business. Marty only had a few hundred dollars on hand Mary did not expect Marty to contribute any cash to the business and was more interested in getting Marty’s culinary talents for the business.
Mary and Marty used an online forms service and organized an LLC called “M & M Comfort Food LLC” (the “Company”). They used Units to represent the membership interests in the LLC, and each of them received 100 Units.
They signed a one-year lease for a small space in downtown Ebensburg that was already “fit-out” for a restaurant. The landlord was not satisfied with the creditworthiness of Mary and Marty so Mary’s parents, Mickey and Mona, guaranteed the lease. The Company issued 20 Units each to Mickey and Mona in exchange for their guarantee of the lease.
Mary and Marty opened their restaurant under the name “M & M’s Pasta Delite” and realized that they could attract a large clientele quickly during the COVID pandemic if they did some work to provide seating in the large outdoor space in the rear of the leased premises. They needed $25,000 and none of the members was able to contribute any more to the LLC at that time. Marty convinced his Uncle Mo to invest the full $25,000 in exchange for 60 Units.
Mary and Marty worked at the restaurant full time. The other members were not involved in day-to-day operations. After the business grew, the Company hired Tony, a chef from Padua, Italy, to make their menu more distinctive and help Marty with the cooking.
After a very successful two years of operation, Marty announced that he was following his fiancé, Molly, to Dallas, Texas, where she was starting a medical residency in cardiology, following her recent graduation from medical school. Mary was shocked and begged Marty to stay. Marty said that he had to follow his true love and left town abruptly.
The restaurant continued to grow and at the end of the year, Mary could not believe the Company’s accountant, Marsha, when Marsha advised Mary that the Company would need to allocate 33%of the Company’s profits to Marty (i.e., a proportionate share based on the number of Units outstanding).
Mary contacted the Clinic and said that Marty forfeited his Units when he left town. The Clinic asked to see the Company’s Operating Agreement, and Mary provided a “barebones” Operating Agreement that provided for the allocation of income and distributions based on the Units owned, but not much else.
The Clinic advised Mary that if they intended for the Units for Marty to be linked to his service with the Company, the Company could have imposed vesting conditions on the Units granted to Marty. For example, the Units could have vested over a four-year period under which a 25% installment (100 Units) vested on each anniversary of the date of grant. If this vesting schedule had been used, Marty would have retained just 50 Units (assuming that he made it to the second anniversary), rather than the full 100 Units. When this arrangement is used with a corporation, the shares subject to vesting are usually called “restricted shares.”
There are no typical vesting guidelines. Large corporations often use anniversary dates for vesting, with a certain portion of shares (or options) vesting each year. Startups often use a monthly vesting schedule so that, for example, one forty-eighth of the total shares would vest each month in a four-year vesting schedule.
In contrast to vesting with options, with restricted shares or units the recipient receives all full rights to the equity on the date of grant. In the hypo above, Marty would receive all rights (except, most likely, transferability) to his 100 Units on the date of grant, and would vote the Units and receive distributions in the same manner as if they were fully vested. The big difference between outright ownership and vesting, however, is that Marty could lose all of his rights to the equity to the extent that any of the equity fails to vest.
In addition to “getting equity back” when an owner leaves, restricted shares can also have significant tax advantages for the recipient. The tax issues are beyond the scope of this post but, in summary, the big advantage is that if a recipient receives equity that is subject to forfeiture, as with vesting, the recipient may elect to pay income tax on all of the equity in the first year, when the value is expected to be at its low point. If the recipient does not make the election, the recipient must pay tax with respect to each vesting year on the fair market value of the equity that vests that year—if the value goes up each year, as intended, the tax liability goes up as well.
Another way to recover equity from a founder or senior employee who was expected to stay is to have a “call” option on the person’s equity. This gives the Company (or perhaps another owner) the right to buy the departing owner’s equity, often at a discounted price. This can be more complicated because the exercise price is often a point of intense negotiation.
The Clinic would be happy to discuss vesting further with the founders of any Pennsylvania-based businesses.