Dynamic Profit Sharing for Startup LLCs [Gaille Energy Blog Issue 45]
- Posted by scottgaille
- On May 30, 2017
- 0 Comments
Energy ventures often begin with the formation of a limited liability company (LLC). A handful of founders agree to contribute their skills and relationships toward a common purpose—the success of the LLC. Just like new parents, the founders are giddy with delight over their creation. Only later does reality set in. For example, initial expectations of equal work and contributions by each founder may not be realized.
Posit that there are three founding members of a new LLC: (1) a geologist, who will tap her network to identify potential acquisitions and then evaluate their technical merits; (2) a financier, who will use his relationships with hedge funds and banks to raise capital; and (3) an operator, who will run the acquired asset. They enter into an LLC Agreement that divides ownership and profit sharing equally (one third each).
During the first year, the geologist toils around the clock pursuing acquisitions. Similarly, the financier works 3,000 hours, eventually securing the capital needed to purchase an oil field identified by the geologist. Meanwhile, there’s just not much for the operator to do until a deal closes.
The next four years of the project see a reversal of the first year’s responsibilities. The operator now works days, nights, and weekends to increase the oil field’s production. Yet the geologist and the financier clock half as many hours, often taking long weekends to go hunting and fishing. They even rent a house together in Hawaii for an entire month one summer. Nonetheless, each founder continues to receive equal profits.
The operator’s resentment gradually builds. He’s missing kids’ Little League games while watching the geologist and financier flood Facebook with beach photos. When they return from Hawaii, the angry operator tells them that equal sharing is no longer fair. The operator demands two thirds of the LLC’s profits—since he is doing two thirds of the work.
The geologist reminds the operator that it was her skills that detected the oil field’s potential from wavy seismic images. The financier points out that it was his relationship with a New York hedge fund that delivered the project’s capital. Simultaneously, they both say, “Without me, there would be no project for you to operate.”
This asymmetrical timing of contributions is the dilemma of many startups. Some members contribute relationships and specialized skills at the front end, but the contributions of others occur later and take longer in terms of cumulative hours. In such cases, fixed profit sharing may be too rigid and eventually lead to conflict.
One way that Members can mitigate this risk is through a dynamic profit-sharing clause in the LLC Agreement. For example, the LLC Agreement can establish two series of LLC shares (Units):
- Founder Units (Entitled to 50% of the Profits). These Units’ profit shares are fixed, based on the skills and relationships that the members contribute at the outset. In the story above, each of the geologist, financier, and operator would own one third of the Founder Units and would be entitled to one sixth of the LLC’s profits indefinitely.
- Dynamic Units (Entitled to 50% of the Profits). The allocation of profits to Dynamic Units is adjusted annually, based on the value of each member’s contributions to the LLC during the prior year. In the example above, the allocation may have been as follows: (Year 1) – not applicable, no profits; (Year 2) – 20 points to geologist, 20 points to financier, and 10 points to operator, reflecting the disproportionate contributions of the former two in the first year; and (Years 3-5) – 25 points to operator, 12.5 points to geologist, and 12.5 points to financier, reflecting the operator’s dominant role in those years.
Ideally, the parties would be able to mutually agree on the dynamic allocation each year, but what happens if consensus cannot be reached? The LLC Agreement should include an expert determination to resolve such impasses—each member explains the value he or she has contributed, and then an independent expert decides the allocation.
Dynamic allocations need not be perfect. Simply having a mechanism that recognizes disproportionate contributions helps to defuse conflict among founders. The early contributors know in advance that their profit distributions are likely to decline; the late contributors expect to be rewarded by theirs increasing. No one is surprised.
About the Gaille Energy Blog. The Gaille Energy Blog discusses issues in the field of energy law, with weekly posts at http://www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, and the author of two books on energy law (Shale Energy Development and International Energy Development).