Equity compensation in private equity and venture capital
Profits interests are a special form of equity compensation issued by limited liability companies. When used as incentive compensation, profits interests offer a number of 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.
This discussion provides an overview of profits interests, how to identify their economic features, and the methods used to establish the value of this type of equity compensation.
Overview of profits interests
A limited liability company can issue two basic types of member units: capital interests and profits interests. A capital interest is similar to 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.
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.
How to identify profits interests
A profits interest used as equity compensation can be defined by the following basic characteristics:
- It provides a share of future economic value. The future economic value representing the “profit” could be items such as revenue, net income, cash flow, equity, or proceeds from a sale.
- It 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.
- It 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.
- It is separate and distinct from a capital interest. This difference should be identifiable, meaningful, and include an economic basis.
Methods to value profits interests
The value of profits interests issued as equity compensation is determined with common valuation methods including discounted cash flow, market comparables, transactions, and options. However, it is often necessary to adjust these methods for profits interests.
An overall value for the business enterprise is developed and the corresponding total equity value is allocated 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 that will be 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:
- Share of 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 cash flow or the simple present value.
- Share of Increases in Equity Value – A profits interest may 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 similar to 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.
- Share of Residual Value – A profits interest could 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 probability weighted expected returns (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 (“intrinsic”) value method, should be mentioned. This method assumes the company is “sold” and then calculates the payouts 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.
Value 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. It 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.
For tax the 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.
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, want further information, or need assistance. If you find this article helpful, please consider recommending it or using our equity compensation services.