As a special type of equity-based compensation used by limited liability companies (LLCs) profits interests can bring a range of benefits to shareholders (members). Profits interests can help attract, retain, and reward key employees, and offer an opportunity to share in future earnings, increases in equity value, or proceeds from a sale of the company.
When used strategically, profits interests can support business growth and value creation objectives, potentially offering more income and wealth to employees, investors, and shareholders.
To put profits interests to best use, stakeholders need to understand several factors about what profits interests are and how they work.
LLC ownership interests
First, let's look at the types of ownership in an LLC. An LLC can issue two principal types of equity ownership interests: capital interests and profits interests. In an LLC, equity-related interests are referred to as units, or a percent of ownership.
Both profits and capital interests offer flexibility to be designed with a variety of names, rights, and features. The specific terms of profits and capital interests are defined in the LLC operating agreement and other legal documents.
Capital interests
Next, to understand profits interests, it's helpful to consider the characteristics of capital interests.
Conceptually, a capital interest in an LLC is similar to a common or preferred share in a C- or S- corporation. A capital interest gives the member participation in the company’s current and future economic value 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 generally is the result of a financial investment or another form of economic consideration made by the member. Capital interests are usually held by founders, investors, and members who have contributed cash, equity, or assets to the company. There can be multiple classes and types of capital interests, and each may have different features and rights.
Profits interests
Now, let's move on to profits interests. These are an entirely separate and distinct class of securities from capital interests. Profits interests are a restricted form of equity ownership and give the recipient the right to participate only in a specific form of future income. Profits interests normally don’t convey the same rights 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 many purposes. As equity compensation, they can be granted to employees and awarded to consultants, advisors or board members in exchange for services. They also may be issued to investors or other capital providers as a form of additional return on investment.
In the capital structure of an LLC, profits interests tend to hold a junior position. Companies that issue profits interests often have multiple equity interests with different distribution rights, the order of which is referred to as a “waterfall.” Profits interests issued as equity compensation typically don’t share in waterfall distributions until after capital interests have begun to receive value. Profits interests commonly only share in distributions after the company has reached a specific equity value or another threshold.
Vesting conditions
When used as equity compensation, profits interests are granted as of a certain date and often include vesting conditions, which are the requirements that must be met before the employee is entitled to the full value of the units granted.
Companies can base vesting conditions on continued employment for a given period of time (service) or achieving specific business goals set by management, shareholders, or investors (performance). Often, companies set performance vesting targets to increases in income and equity value or a sale of the company.
Once vesting conditions are satisfied, the employee will be fully entitled to the economic value of the units. When payout on vested units occurs is defined in the LLC operating agreement and can include distribution of income, redemption, or a liquidity event (such as a sale) of the company.
Favorable tax treatment
Companies often design profits interests 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 aren’t taxable to the recipient at the grant date.
For overall tax purposes, LLCs typically operate as pass-through entities. As a result, any share of income attributed to the profits interests would be subject to income taxes for the recipient, as a member of the LLC. At any redemption, profits interests would be potentially subject to capital gains taxes.
Accounting requirements
As a form of equity compensation, profits interests are reflected on the LLC’s financial statements, according to U.S. GAAP. Notably, the value attributed to profits interests for accounting differs from the value assigned for tax purposes.
For financial statement reporting, profits interests are classified as subject either to expense or liability treatment, which determines how the fair value of the units should 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.
Creating opportunities
As the number of private-equity-owned businesses organized as LLCs grows, the use of profits interests as a form of equity compensation is expanding. Profits interests provide an attractive combination of flexibility, tax benefits, and the ability to support members’ business objectives while also creating opportunities for greater income and wealth for employees, shareholders, and investors.
