Incentive-based equity is a significant form of compensation for employees, consultants, and other service providers for many types of businesses, but perhaps no more so than for startup companies that have limited resources to pay cash compensation. Given the popularity of the limited liability company (LLC) as the entity of choice for new companies, the issuance of “profits interests” as a form of non-cash compensation to attract, incentivize, reward, and retain employees, consultants, or other service providers has become more prevalent. When used as incentive compensation, “profits interests” offer many benefits for both the company and the recipient, including flexibility and the potential for favorable tax treatment.
What are “Profits Interests?”
Generally, “profits interests” are a restricted form of economic interest in LLCs and other entities taxed as partnerships that provide rights to receive a share of the future increase in income or profits from, and appreciation in value of, the company (most frequently from proceeds received in connection with a sale or other cash-out transaction). All company value existing at the time of grant is attributed to the then-existing equity holders of the company. “Profits interests” are usually junior in right to the “capital interests” of the equity holders of the company (those parties who have invested actual money) and usually do not possess all of the rights held by holders of such “capital interests” (such as voting and consent rights). Vesting requirements and other restrictions (such as company repurchase rights) can also be attached to “profits interests” by the company.
What are the Benefits of “Profits Interests?”
While a company could issue restricted capital interests, options to buy interests or interest appreciation rights (very similar to restricted stock, stock options, and stock appreciation rights in a corporation), “profits interests” carry some tax advantages over such other forms of equity-based compensation, including:
- Tax Timing – Since a “profits interest” represents a right to a share of future company value, it has zero value upon receipt and the grant of the “profits interest” does not result in taxable income to the recipient at the time of grant (unlike in the case of the grant of restricted stock in a corporation, where, at the time of grant, the recipient is subject to tax (at ordinary income rates) on the difference between the price paid for the restricted stock and the value of the restricted stock).
- Favorable Tax Treatment – Since a “profits interest” represents an actual equity interest in the company, upon its later sale or redemption, it will generate income to the recipient subject to favorable capital gains treatment, subject to certain tax rules (unlike in the case of stock options and appreciation rights issued in a corporation, where, until such securities are exercised by the holder for actual shares of stock, they do not represent equity in the company, and any value attributable to such rights will be taxed at higher ordinary income tax rates).
- Equity Holder Status – The grantee of a “profits interest” becomes an actual equity holder of the company for tax purposes (unlike in the case of the recipient of stock options and appreciation rights issued in a corporation, where, until such securities are exercised by the holder for actual shares of stock, the grantee is not the holder of any actual ownership interest in the company).
What Issues Should Companies and Recipients Consider in Connection With the Grant of “Profits Interests?”
Before deciding to grant “profits interests” companies should consider:
- the administrative cost of issuing “profits interests” (there is an administrative cost to managing the issuance of “profits interests,” which increases over time as the company makes additional grants);
- how the “profits interests” will be valued (at the time of each grant of a “profits interest,” the company will need to determine the proper value of the company, which in most cases is done using a third-party valuation firm); and
- the differences in reporting for financial and tax purposes (because of differences in standards of valuing “profits interests” for financial reporting and tax reporting purposes, “profits interests” can present challenges for the company and its accountants in establishing proper values for these purposes).
Before agreeing to the receipt of “profits interests” as a form of equity-based incentive compensation, recipients should consider:
- the value that has been set for the company at the time of grant of the “profits interests” (a value that has been set too high may mean that the recipient will never likely share in future company value);
- whether the “profits interests” are subject to a vesting schedule (and if so, what happens if applicable vesting conditions are not satisfied); and
- whether the class or series of equity for which the “profits interests” are being granted are subject to different rights or benefits than other classes or series of equity in the company (such as rights to distributions of operating income vs. distributions upon “capital transactions;” rights to tax distributions on allocable company income; voting or consent rights on company actions; and transfer restrictions or company repurchase rights).