Profits Interest Awards Require Business Valuation Expertise
The top concern among U.S. business executives is attracting and retaining qualified employees, according to the fourth quarter 2019 Duke University/CFO Magazine Global Business Outlook survey. Awarding equity-based compensation can help alleviate this concern by creating an incentive for employees to work harder and stay with their employers longer.
Limited liability companies (LLCs) can offer a special kind of equity-based compensation — known as “profits interest” — that provides significant flexibility in achieving business objectives. But these awards can be challenging to value for tax and accounting purposes. Here's what LLC members should know before issuing profits interest units.
What Is a Profits Interest Award?
Unlike capital interest units, which convey the full rights of ownership in an LLC to members, awards of profits interest units give the recipient rights to a specific type of future income. What the term “income” refers to is explicitly defined by the LLC operating agreement, an employment contract or another agreement between the LLC members.
Usually it refers to a stream of income, such as earnings before tax (EBT), operating cash flow, cost savings or revenue from a division of the business. But it can also refer to future appreciation in value or residual value, say, after the business is sold or liquidated.
Profits interest units may be further restricted by various terms and conditions, such as:
- Vesting requirements,
- Time limitations,
- Specific performance thresholds, and
- Forfeiture provisions.
There's no standard definition of a profits interest; it can refer to whatever is agreed to by the LLC and the recipient of the profits interest. An LLC may offer infinite types of profits interests, allowing it to customize awards for various purposes. In addition, the awards may receive favorable tax treatment for the LLC and the recipient. The varieties of terms and conditions that can be incorporated into a profits interest requires the use of customized valuation techniques.
What Methods Are Used to Value Profits Interests?
The same general approaches to valuing a business — the cost, market and income approaches — are relevant when valuing profits interests. But these techniques often need to be tailored for the terms and conditions of the interest being valued.
For example, a discounted cash flow analysis might be relevant when valuing a profits interest that has a right to receive a share of a future income stream. In this situation, a valuation expert would project future income as defined by the contractual agreement between the parties and then discount the income stream to its present value. In some cases, income is shared with profits interest members for only a finite time period.
When developing the discount rate, the expert must consider the expected return for the source of the income, based on its perceived risk. For example, if the interest will share in pretax earnings, the LLC's overall cost of capital might be used. However, if the interest will share in pretax earnings from a specific business segment, the discount rate might be higher or lower than the business's overall cost of capital, depending on the perceived risk of the business segment.
When valuing profits interest units that have a right to future appreciation or residual value, the Black-Scholes method or a binomial lattice model might be appropriate. Owners of these types of interests don't share in any of the profits or current equity value of the company, and they generally aren't required to pay for the interest at issuance or redemption. There's a payout only if there's any appreciation or residual value at redemption. These features make these profits interest awards similar to corporate stock options.
Option-pricing models essentially measure the present value of the probability that future value would be greater than a given threshold at redemption — and by how much it would be greater than that threshold. This present value estimates the amount that a hypothetical investor would pay to acquire the profits interest.
What Other Issues Arise When Valuing Profits Interests?
It's also important to consider the effect that profits interest units have on capital interests. In general, profits interest awards “dilute” the value of capital interests.
For example, an LLC with 1,000 capital interest members has a fair market value of $1 million on a controlling, marketable basis. The company decides to award 100 profits interest awards to employees worth $500 each on a controlling, marketable basis. By giving away $50,000 in value to employees, the value of each capital interest is effectively reduced by 5% ($50,000 / $1 million).
Valuation discounts also may apply when valuing profits interest awards. The rights of profits interest owners are restricted, so they don't have control over day-to-day operations. And profits interest units in an LLC aren't sold on an active market. So, these interests must be valued on a minority, nonmarketable basis. This basis of value may require the application of separate discounts for lack of control and marketability, unless the discount is already incorporated into the valuator's methodology.
Outside Expertise in Essential
Few private businesses handle the complexities of valuing profits interests in-house, but with the help of a business valuation professional, these awards remain a viable option for attracting, retaining and motivating workers.