Non-diluting equity for founders on an early startup LLC

The CEO of a LLC early startup plans to assign non-dilutable equity to the founders. Each founder will take a small amount of equity, leaving a pool for future employees and investors.

IMHO, what will happen, actually, is that each founder will be receiving pre-diluted equity.

This seems to raise the risks for the founders and may have other negative effects for the founders and even for the company.

• What are the advantages and the disadvantages of doing it, both for the founders and for the company?
• Is it common practice on LLCs?
• What can be the impact for future investors? How this can affect the desire for an investor to invest in the company?
• What are the complications and how should this be handled when converting to a C-Corp?

Let's pretend that this was a corporation with, say, 100,000 shares. Your idea is that each of the four founders gets 5,000 shares each, and the other 80,000 shares will be used for investors, to compensate employees and so on. Implied in that is that the founders won't go below 5% each. (Unless the company amends its certificate of incorporation to authorize more shares, which might require the unanimous consent of the four founders.)

There's nothing wrong with that sort of setup. Heck, it's the typical way of doing thing if you ignore the parenthetical.

That's amazingly easy to do in an LLC operating agreement as well: "The company shall not issue additional membership interests if such issuance would result in any Founder's membership interest falling below 5% without the consent of such Founder."

As to your questions:

• The company loses a little bit of flexibility, and runs into the problem that a single founder might be able to hold up a deal the company really needs. Also, you sort of set a bar for future investors, who may want similar provisions. The founder gets some certainty and control.
• It depends on the management structure of the company. It's more common to require all managers to consent to admitting more members, which actually gives them more control.
• Future investors will want the same thing, see above.
• Conversion to corporation is easy -- just change to the structure I described in first paragraph. If that's really in the plan, then (depending on who your investors are) you might consider just starting off as an S-corp, to make the conversion easier. Taxation would be approximately the same.

That's just generalities. You should talk with your own attorney about your specific situation. (And, no, that's not me.)

I don't know the formal terminology behind it, but in our first incarnation we had equity in an LLC by the firm, and we just didn't know how to use it well. Because we were new to starting companies, we had originally created this firm-owned ownership share (meaning, owned by the LLC and not by a particular member), and in our experience it wasn't very useful. Now granted that we were functioning on bare-minimum levels of legal intervention and we were bootstrapping, I don't know if we had the expertise to use it well, in hindsight. We became a corporation, with share issues, and the dilution was much easier to forecast.

I don't think it's a dilution issue in your case because if you have equity that exists already and has been part of a valuation calculation, that's been factored in. It exists, with a value, and the act of allocation doesn't dilute a founder....