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]


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


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



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)



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



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


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?


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



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



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


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)


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



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



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



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



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



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



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



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



“HOPING FOR THE BEST, PREPARED FOR THE WORST, AND UNSURPRISED BY ANYTHING IN

BETWEEN.”

- MAYA ANGELOU


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



• 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



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


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



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



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



“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


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

sweat equity: best practices for valuing equity …

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