Equity Incentives for LLCs: Profits Interest
UPDATE 12/6/09 I am posting the Excel spreadsheet used in calculations below, as well as a generic profits interest grant document. I do not have a generic LLC Operating Agreement that I can send to you but if someone out there has or creates one, I would appreciate use of it with my audience.
Please review any ideas here with your attorney…I am not an attorney, just a business junkie who strongly believes in rewarding employees through equity.
For years I have preferred Corporations to Limited Liability Companies for three main reasons:
- If outside funding is required, most private investors prefer corporations.
- If the organization is profitable, there is a tax advantage to Subchapter S corporations over LLCs.
- If owners want to incentivize employees with equity, stock options are commonly understood and easy to roll out.
Call me a “flip-flopper” because I may be changing my mind about LLCs vs. Corporations due to the new IRS rules for a Profits Interest.
Background: Recent changes to the potential tax and accounting treatment of stock options have made options less appealing. Backdating option gra
nts also has risks. Restricted stock grants are becoming more “in vogue.” Startup companies, small companies and growing companies can all benefit by incentivizing (to incent?) employees with employee stock ownership plans (ESOPs) and if you are organized as an LLC, a Profits Interest may be just the trick. In my opinion, the new rules for a Profits Interest have a greater benefit to companies and employees over stock options or restricted stock grants.
A Profits Interest works very much like a stock option, in that it gives employees a portion of the upside from the date of grant but since there is no strike price, it more accurately operates like a restricted stock grant. With a stock option, you are granted an option to purchase shares at the strike price, usually fair market value. As the market value goes up, your options are “in the money” and once vested, you can earn the difference between the market price and your strike price, assuming you exercise them and sell them above the strike price.
Taxes: Stock options require you to pay money for them
and if they are granted to you with a strike price below market value, you must pay ordinary income tax on the difference at the time of grant. Restricted stock grants are simply giving you shares but you must pay ordinary income taxes on the market value at the time of grant. If you hold your restricted stock grant longer than a year, income taxes will then be considered capital gains (losses). For options, if you exercise and hold them one year or longer, any income or loss will be considered capital gains (losses). By comparison, so long as you hold a profits interest grant longer than two years from the date of grant, taxes are considered capital gains and moreover, the employee does not risk any capital during the holding period. Assuming the profits interest is issued properly as a different class of Units, the employee may have no tax consequence at the time of grant. We’ll get into more of that in a moment.
If you are still reading, you likely care about employees and want to share in the rewards of your business. Keep reading…
Profits Interest Description: A profits Interest works differently than stock options or grants. First, think of a “unit” in an LLC to be equivalent with a share of stock. Example: Start with an initial 100 units issued to existing owner(s) of the LLC. If after several years the existing unit holders want to incentivize their workforce or consultants/advisors, they can issue a different series of units that give the grantees restricted ownership in the LLC, but only ownership on a percentage of the increase. It’s quite similar to a stock option, but without the strike price. Annual cash profit distribution is completely another matter. A profits interest grant is only advantageous in the event of a sale, if the co
mpany sells for more than the amount at the date of a “Profits Interest Grant.”
Advice: To set this up, you should talk to your attorney who will modify your LLC Operating Agreement to account for the “Profits Interest” or Units of a different series, similar to the difference between Preferred and Common Stock. Then your attorney will create a unit, or profits interest grant for the company, which is the agreement vehicle used to issue additional units to employee grantees. In the example above, the new Operating Agreement will outline those original units as “Series A Units.” Next, you must have your company valued by a professional who will set a price to your overall company and thus, the series A units. More specifically, you will need a 409A valuation.
Back to the Example: Let’s assume in our example that the company is worth $10,000. Now let’s say that the initial owners want to grant roughly 10% of the increase in the company’s value (at sale or public offering, etc.) from this point forward to certain key employees. The new owners, will receive roughly 10 “B” units, likely with some sort of vesting, and existing owners will receive 100 “B” units. The new “B” units are indeed owned by these key employees, but they may have restrictions, such as reverse vesting, mandatory buy-back clauses by the company, no sale clauses, and the like.
The cool thing is that, assuming the valuation was performed properly, employees will not owe any taxes at the time of the grant. So let’s look at some scenarios upon sale.
If the company is sold for $10,000, each of the origional partners keep that $10,000 and the holders of the profits interest receive nothing. If the company is sold for $20,000, the or
iginal two partners receive the first $10,000 for their series A units, and they also receive $9,090 of the second $10,000 (which is 100 B units that they own divided by 110 B total units issued), and the employees who were granted the 10 units will receive $909.
More on the Example: Let’s now add a new group. Consider this: Series A units are preferred over series B, and series B are preferred over series C, and so on. Each Series A unit holder has rights to the same number of B units, C units, and so on as they have in their Series A units. People who were granted Series B units have a right to the same number of Series C units, D units, etc., but they have no rights to Series A units. Upon liquidation, think of each series as water filling a bucket, based upon the 409A valuation performed just prior to the next series being issued. During the first valuation prior to issuing Series B units, Series A units are worth $10,000. If we value the company at $20,000 just prior to issuing Series C units, Series B units are worth $10,000, and so on. Just prior to issuing Series D units, a 409A valuation pegged the company at $30,000, then Series A units are worth $10,000, Series B units are worth $10,000 and Series C units are worth $10,000.
Series A unit holders receive the first $10,000 in any transaction. Series B unit holders receive, and divide among them, the next $10,000. See the table below.
In the example table above, we see the company sold for $100,000 sometime after units for Series A through D were issued. Series A unit holders received $81,2704 made up of $10,000 for Series A units, 10/11’s of Series B units, 10/12’s of Series C units, and 10/13’s of Series D units. Likewise, you can do the math for holders of each subsequent units.
Conclusion: These may seem like difficult concepts but in reality, a profits interest is simple algebra. I am beginning to believe, because of this structure, that LLCs may now be favorable over Subchapter S corporations. Holders of a profits interest receive the benefits of long term capital gains and if done properly, participants do not have to pay income taxes until liquidation and they also do not have to risk any capital. Of course, a company’s restricted profits interest plan should contain all the proper restrictions and management should clearly communicate how liquidation differs from annual profits. What say you?