The 2020 recession: Are your profits interests underwater?

Profits interests are a special form of equity-based incentive compensation provided by limited liability companies (LLCs) to help recruit, retain, reward, and align employees with long-term value creation strategies.

Profits interests provide the employee a potential share of future distributions of income and/or capital gains under waterfall provisions of the LLC operating agreement and other conditions such as vesting requirements. When the business increases in value and has a successful liquidity event down the road, profits interests can generate an attractive payout to the employee. Profits interests are used extensively in private equity where they’re frequently granted to key employees of portfolio companies.

Valuation of profits interests

The equity value of the company at the time the units are issued is an important component in the value of profits interests. It sets the threshold required for compliance with special IRS safe-harbor tax provisions, supports any 83(b) election, and creates the basis for future waterfall distributions to the employee.

When the equity value of the company rises above the threshold, profits interests increase in value. However, if the equity value of the company declines, so does the value of profits interests. 

Impact of the COVID-19 pandemic and recession on the value of profits interests

How have economic conditions in 2020 related to the pandemic and resulting recession impacted the value of profits interests?

As a result of declining economic conditions, some companies’ value creation strategies have lost ground, leading to declined valuations. In some situations, the equity value is now below thresholds of previously granted profits interests — a condition referred to as being “underwater.” When profits interests are underwater, two things happen.

First, the value of the profits interests declines. This is because there is now business value that must be regained before the profits interests get back to where they were in the waterfall. As a result of economic conditions in 2020, the time frame over which this may occur can be uncertain and could even take years.

The impact of a decline in value of the company is a condition faced by all equity stakeholders; however, the impact to employees with profits interests is different than for investors. This is because, in most cases, employees didn’t make a cash investment for the profits interests. When value declines, employees don’t have the same financial stake at risk as investors.

These factors lead to the second issue: when profits interests are underwater, the incentive and retention features are reduced or potentially wiped out. These conditions can also create the unintended situation where profits interests issued to new employees have greater upside potential and value than those for current employees. 

As a result, a drop in the perceived value of compensation packages could prompt employees to look for job opportunities at other companies where they would receive profits interests that aren’t underwater and have greater value.

Managing devalued profits interests

In situations where profits interests are underwater, the objective is to assess what actions are needed to maintain the incentive and retention features while supporting the long-term value creation strategies of the business. To address the situation where profits interests are underwater, there are several alternatives to consider:

• Ride it out. One alternative is to leave the existing profits interests “as is” and wait for better times to rectify the situation. This approach is based on the concept that employees and investors will continue to share in the inherent risks of declines in business value. However, this approach leaves the issue of retention open for key employees. Also, to maintain fairness to existing employees, thresholds on profits interests for new employees may need to be set above the current business value, creating potential obstacles in recruiting new talent.
• Make changes to existing agreements. A second alternative is to modify or amend the existing profits interests agreements to address the decline in business value. This would mean “resetting” the threshold to match the current equity value of the company, thereby restoring the full upside potential in the original grants. This also creates parity with new hires coming in with thresholds set at the current equity value. But this approach carries potential tax and accounting ramifications that can result from the modification of equity-based awards.
• Add a sweetener. A third alternative is to leave the existing profits interests unchanged because they still have potential upside and could issue new units to make up for some of the lost incentive. The new profits interests would be at the current equity value threshold, and when combined with the existing units, would work to restore the overall package. Since profits interests are equity-based, there’s no current cash cost to grant additional units versus other forms of incentive compensation — a potentially big benefit for companies conserving financial resources that may be needed for other purposes.

In light of economic conditions in 2020, the status and effectiveness of equity compensation strategies that use profits interests should be reviewed prior to your audit and an action plan created based on the specific circumstances of your company and stakeholders. The evaluation may require the assistance of legal, tax, accounting, and valuation advisors — start your preparations early. For assistance with your profits interests strategy, give us a call.