Incentivizing, rewarding and retaining the most productive partners, executives, managers and employees of a partnership or Limited Liability Company (LLC) can be challenging without stock options. Fortunately, the profit interest has been created as an alternative. Under the Internal Revenue Service (IRS) Code, Section 409A, a profit interest can be defined as a form of deferred compensation, hence the need for a 409A valuation.
Profits interests are a special form of equity compensation issued typically by limited liability companies. When used as incentive compensation, profits interests offer several benefits including flexibility and the potential for favorable tax treatment.
The value of profits interests is required for financial reporting, tax, and transactions. The economic features of profits interests, and the relationship to other capital interests in the company, determine their value. The variety of features that may be created in profits interests can require special valuation techniques when compared to equity compensation issued by C and S corporations.
Profit vs Capital Interest
Partnership and LLCs enjoy a pass-through taxation status with few owners retaining an equity stake. This makes it easier to make decisions, but the lack of corporate shares can make it difficult to properly compensate certain productive employees. The profit interest allows for these enterprises to maintain their current ownership stake and reward employees at the same time.
A limited liability company can issue two basic types of member units:
A capital interest is like a common share in a C or S corporation. It normally results from a capital investment and provides participation in current and future equity value, a share of income, and distributions. Capital interests can also include features such as a required return or liquidation preferences.
Profits interests are distinct from capital interests. They represent a restricted economic interest and generally provide only a share of a specific future income. Profits interests issued as equity compensation are usually a junior class of equity and do not have all the rights of capital interests, think common versus preferred stock.
There is no standard definition for the terms for a profits interest. On a simple basis, it’s whatever the parties agree to, or just identified as any equity unit that is not a capital interest. This flexibility in the design of profits interest is an attractive component in their use as equity compensation.
In practice, a profits interest may have a different name, such as an appreciation interest, management unit, performance share, or other terms.
Identifying Profits Interest
A profits interest used as equity compensation can be defined by the following basic characteristics:
- Provides a share of future economic value. The future economic value representing the “profit” could be items such as revenue, net income, EBIDTA, equity, or proceeds from a sale.
- The interest is identified in operating or other legal agreements. The specific terms and features of the profits interests are usually detailed in the operating agreement or in documents such as grant, employment, or compensation agreements.
- Can be defined from a financial perspective. A key factor in the value of a profits interest is establishing the economic “profit” that it provides in the future economic value of the company.
- Separate from a capital interest. This difference should be identifiable, meaningful, and include an economic basis.
Proper Valuation Methods
The valuation of profits interest typically uses common valuation methods which included but certainly not limited to option pricing models, guideline company and transaction approaches, as well as several versions of a discounted cash flow valuation. Depending on the features of the profits interests these approaches may need to be adjusted.
An equity or invested capital value for the business enterprise is developed and the corresponding total value is allocated across the capital structure (i.e. to all equity related interests). The resulting value for profits interests may then be adjusted with discounts for non-controlling interest, marketability, or other items.
The specific financial characteristics of profits interests, represented by the future “profit” or financial returns received, define the valuation methods used. The profit characteristics fall into three basic categories as a share of: (a) income, (b) increases in equity value, or (c) a residual value.
These categories, and the related valuation methods, are further described below:
Future Income – A profits interest can provide a share in future income such as net profit, EBITDA, or revenues. This feature provides only a share of future income and does not include participation in any existing or future equity value. The value of an income feature will be based on an income approach, such as a discounted or capitalized cash flow.
Increases in Equity Value – A profits interest could provide a share of increases in the future equity value resulting from appreciation above a threshold amount. The threshold is often based on the value of equity on the grant date. A profits interest with an appreciation feature is like a stock option or stock appreciation right in a C or S corporation. This feature of a profits interest is valued using an option pricing method (OPM), such as Black Scholes, however, the overall equity value must be determined first.
Residual Value – A profits interest could be designed to provide a share of equity value after a specific future requirement is achieved. This may be associated with a liquidity event, such as proceeds from a company sale, or an investor return. This feature of a profits interest is valued using option-based techniques such as binomial, Black Scholes, or a probability weighted expected return model (PWERM).
Profits interests might incorporate one or more of the features described above, multiple categories of units could be granted, or combinations of valuation methods may be used.
One additional approach used for profits interests, a current value method, should be mentioned. This method assumes the company is “sold” and then calculates the payouts (waterfall) to the various interests on that date. This method is frequently used to establish the current equity value for certain types of profits interests. However, this method is generally not appropriate in other situations because it does not capture the value of potential future returns that are a key feature in profits interests as equity compensation.
Valuation for Tax vs. Financial Reporting
The two most common valuation requirements for a profits interests are financial statement reporting and tax.
Financial reporting deals with how profits interest will be reported as compensation in the financial statements of the company, or in communications with employees. This is used to comply with specific guidelines according to GAAP. A value for financial reporting is generally required at grant, financial reporting dates, modifications, and transactions.
The tax value of profits interests is used to determine income tax treatment for the company and employee. As a form of compensation, profits interests may be subject to taxation to the employee upon grant, vesting, or redemption. Profits interests may be deductible for tax purposes as an expense by the company. Profits interests may potentially receive favorable tax treatment if they comply with specific requirements in IRS guidance. They can also be subject to IRC 409A as deferred compensation.
The value of profits interests for tax purposes is based on a standard of “fair market value” and in financial reporting it is “fair value.” Because of differences in these standards a profits interests may not necessarily have the same value for tax and financial reporting purposes, but often the fair value and fair market value are the same.
A Note on Taxation
The grant of profits interest should not result in any taxable income to the recipient. A profits interest may be initially granted as a fully vested or may vest based on continued service or the achievement of business benchmarks related to the partnership’s operations.
A profits interest may be structured similarly to a stock option but may be more attractive to the recipient because a profits interest grant, in some cases, can provide that all appreciation in value be taxed as long-term capital gains rather than ordinary income. Unlike an option, a profits interest holder need not pay an exercise price to obtain the equity interest represented by the profits interest.
Usually, if the profits interest is structured properly and capital accounts are booked up on entrance of the profits interest member, the IRS should not treat the grant of a vested or unvested profits interest as a taxable event. Most practitioners design profits interests so that they meet IRS safe harbor standards for ensuring profits interest treatment.
These standards include:
- The profits interest must not relate to a substantially certain and predictable stream of income from the entity’s assets, such as income from high quality debt securities or a net lease,
- The recipient of the profits interest must not dispose of it within two years of receipt, and
- The profits interest may not be a limited partnership interest in a publicly traded partnership.
To the extent the profits interest issued is unvested at the time of issuance, most practitioners opt to make an 83(b) election to ensure tax-free treatment upon receipt. When a profits interest is issued, it has no value. If the profits interest is vested, there is no question that it is taxed at the time of receipt, at $0. Unvested property is taxed at the time of vesting, on the property’s value at the time of vesting. Hence, if the profits interest has appreciated in value since the time of grant, then there would be ordinary income at the time of vesting. To avoid this treatment, recipients of profits interests can make an 83(b) election, which is an election to treat the profits interest as vested for tax purposes at the time of grant and to be taxed on the value of the profits interest at the time of grant. Additionally, despite the IRS Safe Harbor protection for vested interest, it is still advisable to file a “protective” Section 83(b) election upon receipt of a profits interest in the event any of the safe harbor requirements are not satisfied (e.g., there is a disposition of the interest within two years). Any downside to filing an 83(b) election is generally considered minimal.
If you want to learn more, please see or post on 83(b) elections or contact us to use our 83(b) election service.
If you want to learn more, please see our post on 83(b) elections or contact us to use our 83(b) election service.
Profits interests provide a very flexible form of equity compensation that can be designed to support a range of business objectives in a limited liability company. As a form of equity compensation, profits interests are used to attract, incent, reward, and retain employees based on the potential future value they offer. The variety of economic features in profits interests can present challenges in establishing a value for tax and financial reporting purposes. Having the right value relies on identifying the key economic features and using the appropriate valuation method.
This discussion is intended to provide a general overview. Contact me if you have questions or if Meld Valuation can be of service to you or your company.