What Are Profits Interests?

Profits interests are a special form of equity-based compensation used in limited liability companies (LLCs) and partnerships.? They are granted as an incentive to attract, retain, and reward employees. Profits interests can provide employees with the opportunity to share in future earnings, increases in equity value, or proceeds from a sale of the company.

Profits interests are used to support a variety of business growth and value creation objectives, and provide the opportunity for greater income and wealth to employees, investors, and shareholders.

This article provides an overview of profits interests and how they are used as a form of equity compensation in LLCs.

Types of Ownership Interests in an LLC

An LLC can issue two principal types of equity ownership interests: capital interests and profits interests. Other equity related interests such as options, warrants, or phantom units can also be issued, although these are less common. In an LLC, equity related interests are referred to as units (or a percent of ownership). The owners (shareholders) in an LLC are referred to as members.

Profits and capital interests have the flexibility to be designed under a variety of names, rights, and features. ?The terms of profits and capital interests are defined in the operating agreement and other legal documents of the LLC.

Features of Capital Interests

To understand profits interests, it is helpful to begin with an explanation of the characteristics of capital interests.?

A capital interest in an LLC is conceptually similar to a common or preferred share in a C or S corporation. A capital interest provides the holder with participation in the current and future economic value in the company through a share of income, distributions, and other rights. A capital interest may also give the member other rights, such as a liquidation preference, preferred return, tax and other distributions, conversion rights, participation features, voting privileges, board representation, or veto powers.

A capital interest will generally result from a financial investment or other form of economic consideration made to the issuing company. Capital interests are usually held by founders, investors, and members who have contributed cash, equity, or assets to the company. There may be multiple classes and types of capital interests, and each may have different features and rights.

How Profits Interests Work

Profits interests are an entirely separate and distinct class of securities from capital interests in an LLC. Profits interests are a restricted form of equity ownership and give the recipient the right to only participate in a specific form of future economic income. Profits interests normally do not convey all the terms and features associated with a capital interest. In fact, profits interests are often identified as anything that is not a capital interest.

Profits interests have the flexibility to be used for a wide variety of purposes. Profits interests are frequently used as equity compensation and granted to employees, consultants, advisors, or board members in exchange for services. ?When used as equity compensation, profits interests help attract, retain, incent, and reward employees or other service providers. Profits interests may also be issued to investors or other capital providers as a form of additional return on investment.

Profits interests typically have a junior position in the capital structure of the company.? LLCs that issue profits interests will often have multiple equity interests, rights, and order of payout distributions, which is referred to as a “waterfall”.? Profits interests issued as equity compensation typically do not share in waterfall distributions until after capital interests have begun to receive value. Further, profits interests will commonly only share in distributions after a specific equity value or other threshold amount has been reached.

Vesting Conditions

When used as equity compensation, profits interests are granted as of a certain date and often include vesting conditions. Vesting conditions are requirements that must be met before the employee (service provider) is entitled to the full value of the units granted. ?Vesting conditions relate to the achievement of certain objectives for the employee or company, and are often designed to support shareholder value creation strategies.

Vesting for profits interests can be based on service or performance conditions. Service vesting is based on continued employment for a certain period of time. Performance vesting relates to achieving specific business goals set by management, shareholders, or investors. Performance vesting targets are often tied to increases in income and equity value, or a sale of the company.

Once vesting conditions are satisfied, the employee (or service provider) will be fully entitled to the economic value of the units. This will be defined in the operating agreement of the LLC and based on the waterfall. ?Payout on vested units can result from distribution of income, redemption, or a liquidity event (such as a sale) of the company.

Favorable Tax Treatment

Profits interests are often designed to take advantage of favorable tax treatment under certain “safe harbor” provisions of the IRS revenue procedures and tax code.? Profits interests that comply with these requirements would not be taxable at the grant date.? For overall tax purposes, LLCs typically operate as pass-through entities. As a result, any share of income or distributions attributed to the profits interests would be subject to income taxes for the recipient.? At any redemption, a member holding profits interests would be potentially subject to capital gains taxes.

Accounting Requirements

As a form of equity compensation, profits interests are reflected on the financial statements of the company according to U.S. GAAP.? Notably, the value attributed to profits interests for accounting is different than for tax purposes. For financial statement reporting, profits interests will be classified as subject to either expense or liability treatment, which will determine how the fair value of the units will be recorded. The fair value of the units is based on a valuation method that considers the capital structure of the company, rights of various equity interests, and the potential for future income and equity value of the profits interests.???

Summary

With the growth in businesses organized as an LLC, the use of profits interests as a form of equity compensation continues to expand.? Profits interests provide an attractive combination of flexibility, tax benefits, and the ability to support a variety of business objectives. ?This special form of equity compensation provides the opportunity to create increased income and greater wealth for employees, investors, and members.