Growing companies need to attract, retain and incentivize key employees.  These companies often need to give priority to allocating liquid cash resources to other aspects of the company's business.  If the company is a limited liability company with a tax partnership structure, the company may wish to use "profits interests" to reward its key employees.

How Profits Interests Work  Profits interests are actual LLC units that a company issues to key employees.  Once an employee receives profits interest units, they become a member of the company.  Profits interest units may be subject to vesting provisions if desired by the Company.  The units can be voting units or they can be crafted without voting rights.  On the date the profits interests are granted to employees, the company's full value is determined.  The profits interests are eligible to participate in operating earnings according to their percentage interest, but they will only participate in a sale of the company to the extent that the company's value appreciates after the grant date.

Example  Consider a company that is currently valued at $5 million.  The company issues profits interests equal to 10% of the company's outstanding units on a post-issuance basis to a key employee.  If the company generates $500,000 of profits that year, 10% of the profits would be allocated to the employee.  Profits could either be distributed currently or act as an increase in the employee's capital account.  However, if the company were to be sold the following year for $5 million, the employee would not receive any cash as a result of the sale because there was no increase in company value after the date of the grant.  If the company were sold for $10 million, the employee would be entitled to $500,000 of the sale proceeds (10% of the $5 million increase in company value over the grant date value).

Why Profits Interests Make Sense for Companies  A company is able to incentivize key employees without the need for immediate cash liquidity.  The company is also protected from overpayment if its value does not increase after the grant of the profits interests.

Advantages from an Employee's Perspective  Profits interests give an employee a feeling of equity ownership in a company and can provide for substantial cash payouts if the company's value increases after the date of the grant.  Another major advantage to the employee is that, if properly structured, profits interests are not subject to tax at the time of the grant.  Also of great benefit to the employee, on a future sale of the company, the employee's portion of a payment with respect to profits interests is normally eligible for capital gains treatment rather than ordinary income treatment.  Thus, the tax experience of a profits interest can be very favorable to an employee, essentially providing a greater incentive by allowing the employee to keep more after-tax dollars in their pockets.

Comparison with Stock Options  The economic structure of a profits interest is similar to that of a corporate stock option that is issued with an exercise price that is equal to the company's stock value on the date of grant.  However, a profits interest allows the employee to be an actual owner immediately without the need to find out of pocket funding for the stock option exercise price.  As noted above, profits interests often allow employees to receive proceeds that will be taxed at capital gain rates.  Stock options under a nonqualified stock option plan subject employees to ordinary income and employment taxes to the extent of appreciation in the stock at the time of exercise.  Qualified stock options can facilitate capital gain treatment; however, the employee must exercise the options at least 12 months prior to the date of a sale of the underlying stock.  Thus, in the event of a sale of the company, the employee must fund the exercise price of the stock option payment (or, borrow funds from the company to do so) and exercise the option at least 12 months prior to the sale.  For those reasons, profits interests are often preferable to stock options.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.