How to Value “Profits Interests” in LLCs
How to Value “Profits Interests” in LLCs
Limited liability companies (LLCs) sometimes offer a unique form of equity-based compensation known as “profits interests.” These awards come in varying formats, requiring a thorough understanding of what’s being awarded and a customized approach to determine their value for tax and financial reporting purposes.
Capital vs. Profits Interests
Private businesses may award various forms of equity-based compensation to employees and independent contractors. These awards can help businesses attract, retain, and reward workers for their contributions to the company.
LLCs aren’t allowed to issue traditional corporate forms of equity compensation, such as common and preferred shares, stock options, restricted shares, and phantom stock. Instead, LLCs generally issue two types of ownership interests:
- Capital interests. Sometimes referred to as “equity units,” capital interests are like common stock in a corporation. They convey the full rights and benefits of ownership in an LLC, including rights to current and future equity value, a share of income and distributions, and full voting rights. However, each capital interest unit may not provide the same percentages of equity and income. In other words, allocations of equity and income may not necessarily be made pro rata based on the number of units owned. Members typically receive capital interests in exchange for a capital contribution of cash or other assets.
- Profits interests. Also known as “performance units,” profits interests entitle the owner (or member) to a share of income, future appreciation in value, a share of the company’s equity (or residual value) upon meeting certain benchmarks — or a combination of these benefits. These owners don’t have the full rights of capital interest holders. Profits interests are generally awarded to employees or contractors in exchange for providing services to the company. Awards made to employees may be deductible by the LLC as a form of current or deferred compensation. Recipients also may be eligible for favorable tax treatment, if the awards meet certain IRS requirements.
Profits interests are subject to various restrictions. Examples include vesting requirements, expiration dates and forfeiture provisions. Profits interests also may be contingent on the LLC meeting certain performance targets (such as revenue or market share thresholds).
It’s important to review the LLC’s operating agreement and other legal contracts between LLC members to determine the rights and conditions associated with each profits interest award. The flexibility in granting different types of profits interests can result in a complex capital structure.
Before an expert can value a profits interest award, he or she must identify all the profits interest units that the company has issued. Essentially, any units that aren’t classified as capital interests are considered profits interests.
The next step is to understand what benefits are conveyed to owners of profits interests. For example, LLCs are pass-through entities that are taxed at the level of the individual owners. So, the term “profit” traditionally refers to earnings before tax (EBT). But it also might refer to revenue, operating cash flow, gross profit from a specific business segment, sales proceeds or future appreciation in value.
It’s also critical to understand any terms and conditions that apply to profits interest units. In general, if a profits interest member will receive a share of future income, value will be based on the present value of the projected income that the member expects to receive from the units.
Profits interests that provide a share of the company’s future appreciation or residual value pay out only when the unit is redeemed. So, these types of profits interest units are generally valued using option-pricing models. These models allow for complex terms, including assumptions regarding volatility, time frame, and probabilities.
For More Information
Finding skilled workers is one of the top challenges reported by private companies today. Profits interests can help LLCs attract and retain workers, but, before you issue these types of compensation awards, discuss the potential pitfalls with a business valuation professional.