LLC waterfall user guide

The Limited Liability Company (LLC) waterfall is designed for portfolio companies whose waterfall does not fit the standard C corp logic.

The Diligent Equity LLC waterfall can handle the following concepts:

• Profit interest units shares awarded to management based on performance. Unlike time-based vesting, these units vest when specific financial targets, like the multiple over invested capital (MOIC) or internal rate of return (IRR), are achieved.

• Nominal unit price Calculate return of investment based on a nominal unit price.

• Concept of company type LLC vs C corp.

How it works

The portfolio company must be created as an LLC in Diligent Equity Invest or directly as a new cap table in Diligent Equity.

After the new LLC is created, terminology in the cap table management tool is slightly changed. You will see Units instead of Shares. The new settings enable the specification of new types of vesting schedules.

This is a step-by-step guide to create a new LLC company, how to specify a nominal unit price, investment rounds, options pools and profit interest unit allocations so that you can run the new way of calculating waterfalls.

Create a cap table for an LLC company

Follow the below steps to create a new cap table for an LLC company in Diligent Equity from either the Invest platform or from Private Company Cap table tool

From Invest:

1. Go to the Administration section in Invest.

2. Select the Companies sub-tab and select Add Company.

3. Enter the company name.

4. In Company Type drop down, select LLC- Limited Liabilty Company.

5. Fill out any other relevant company details before selecting Submit to create the company.

From Biz (Private Company Cap Table Tool)

1. Go to Manage Captables and select New Captable.
   The Add Captable dialog box opens.

2. Enter a name for the cap table and make sure that you choose LLC – Limited Liability Company as the company type.

   Note

   Unlike C corporations in Diligent Equity, the new cap table will not automatically contain a holding of common shares for the founder of the company so to start the dashboard has no data.

Set a nominal share price

1. Go to the Securities section in the navigation sidebar and select Units.

2. Select the first round of units.
   By default, this is called Common and contains no allocation when the cap table is created

3. Select Settings above the allocation table.

4. In the Settings dialog, go to the Summary tab and change the Price per unit setting to the desired nominal price. By default, the nominal price is $0.01. You may want to change it to another value like $1.00 or $1,000.00.

5. You may want to rename the units to the name used by your fund in the Name tab.

Allocate investments at the nominal unit price

1. Open the first round under Units and select New Allocation.

In the New Unit Allocation dialog

1. Fill in the unit holder name. (If the unit holder does not exist in the system, Diligent Equity will ask for confirmation to create a new unit holder.)

2. Enter the investment amount OR the number of units. (Filling in one of the fields will automatically fill in the other.)

   Note

   At the moment it is not possible to enter decimal numbers in the Investment Amount field. However, the Units field does accept decimal numbers up to 5 decimals precision, and the investment amount will be calculated accurately (including decimal places) from the number of shares. For example, with a nominal unit price of $1,000/unit, entering 1.23456 into the Units field will calculate the investment amount as 1,234.56.

3. If you want to use only your own fund's performance as the basis for awarding profit interest shares to management members, check the "Include in MOIC/IRR calculations for performance based shares" checkbox in the LLC distribution waterfall settings section.
   You may specify other data, but it is not essential for the functioning of the calculations.

Allocate an investment price that differs from the nominal unit price

Subsequent investment rounds might be concluded at a price different from the nominal unit price. If this is the case, you need to create a new investment round at a unit price different from the nominal unit price, i.e. the unit price of the first round.

1. Select New Unit Class under Securities/Units.

2. Enter a name for the new unit class

3. On the next dialog, enter the price per unit, e.g. $1,200. The pre-money valuation price will be calculated automatically

4. You can set liquidation preferences etc., the usual way already implemented for C corporations in Diligent Equity.

   Note

   To allocate units in the new round, follow the steps Allocate investments at the nominal unit price.

Create performance interest units

Performance interest units are awarded based on the achieved growth in the portfolio company's value. These units are usually awarded to management members as an incentive.

Go to the Equity section under Securities and select New equity plan.

Give a name to the unit plan and set an initial pool size. (This is important as the system will not let you allocate more units than the pool size. Only allocated units are considered in calculations.)

Allocate performance interest units

To allocate performance interest units, follow the below steps.

1. Go to your performance interest unit plan under Securities/Equity and select Add New Grant.

2. Choose or add a unit holder and click Next.

3. Specify the number of units.

4. To specify a vesting schedule based on MOIC and/or IRR achieved, select Show details next to the vesting schedule and specify MOIC and/or IRR as the condition.

5. Set the appropriate MOICs.

   The display will always snap to two decimal points, but you can enter up to 5, and it will be stored accurately.

6. Set approval by the board as appropriate. The system will only consider unit grants approved by the board. You also need to set the participation threshold in this dialog.

   Close the dialog and you are done.

   Note

   Create a custom vesting schedule and use it for every performance interest unit grant. To do this, follow the steps in Create a custom vesting schedule.

Create a custom vesting schedule

1. Select the option plan under Securities/Equity > Settings above the grant list.

   The Option plan settings dialog opens.

2. Go to the Vesting schedule tab and select New Schedule.

3. Enter a name for the schedule and select Use as default to use as the default for all new grants.

4. Set up the schedule as desired and select Close to save your settings.

Notes on vesting schedules and calculation precision

If your vesting schedule is, for example, in thirds of the granted units, it may cause tiny rounding errors. The reason for this is that some fractional numbers are impossible to represent accurately by a computer. Examples of these numbers include 1/3, 1/7, 1/9 etc. (For the technically minded, some background on why this is so can be found e.g. in this Wikipedia article.) For example, if you are awarding 3000 units on a 1/3-1/3-1/3 vesting schedule, the internal representation of the first tranche may be 999.9999999999. In classical C corp waterfall calculations, this usually causes a negligible (below 1 hundredth of the currency unit, e.g. 0.01 cent) error. However, the LLC waterfall is very specific in one regard: when the proceeds are in the hundred millions or billions of the currency unit used, the breakpoint where the switch to a higher number of performance interest shares happens might be off by one whole unit of money (e.g. one USD) as a result of rounding errors. Given that a higher number of performance interest units does affect the distribution significantly (e.g. it may result in a seven figure difference in distribution for the holders of the performance interest unit and a corresponding drop in the distribution for the investors), it is important to be as accurate as possible. Below are some tips on how to increase precision.

Comparison to Excel

It is important to be aware of the fact that Excel, which is widely used for financial calculations, has a precision of 15 decimal digits. This precision can be decreased by some advanced settings, but not increased.

Here is an example that you can try out yourself on number representation in Excel. Format a column as numbers up to 15 decimal digits precision (right-click the column, choose Format Cells…, choose Numbers and set the Decimal places setting to 15). Then enter "1/3" in the first cell of the column. Excel will convert this to a decimal representation. Follow by entering 10/3, 100/3, 1000/3 and 10000/3. This is the result:

You can see how the number of zeroes keeps increasing from the right, as only the first 15 digits (whether left or right of the decimal point) are correct.

This is usually fine for financial calculations in strong currencies like the US dollar: if the sums involved are below 10 billion USD, there is a 5 decimal points precision (i.e. 10 digits for the whole part of the number, like 1,234,567,890 – and five decimal digits (example: 1,234,567,890.12345).

This is relevant when calculating with unit numbers. For example, one third of 10 units is 3.33333333333333 (fourteen 3s after the decimal point), one third of 100 units is 33.33333333333330, while one third of 10,000 units is 3333.33333333333000.

Unit numbers in Diligent Equity

By default, Diligent Equity will allow calculation with fractional units (you can switch this off, in which case any already entered fractional unit numbers will be lost), and the precision is 5 decimal points. To increase this precision, you can increase the number of decimal digits.

1. Go to the Company section in the navigation sidebar and select Company.

2. Scroll down until you find the Allow fractional shares setting.

3. Set the precision to the desired level.

Set up a vesting schedule with impossible-to-represent numbers

When dealing with real life situations, there are many scenarios where you have to deal with fractional shares, and some scenarios where what should be a whole number ends up being a fractional one. If you want to achieve maximum precision, our recommendation is to use the following strategy:

Increase the precision as outlined above.

When you are aware that the individual tranches of the vesting schedule should end up as whole numbers, enter the actual share numbers instead of percentages. This is possible in Equity by adding "s" to the end of the number entered. For example, entering "33" in the vesting schedule will be interpreted as 33%, while entering "33s" will be interpreted as 33 shares (Diligent Equity will immediately convert the calculation to shares on leaving the field and the "s" will disappear from the display). Entering a number above 100 will be automatically interpreted as a share number. Entering fractional unit numbers this way is not possible.

You can observe the difference between a percentage-based schedule and actual number based schedule in the below screenshot. Both holders were awarded 3000 units with 1/3-1/3-1/3 distribution at MOIC values of 1, 2 and 3.