Considerations for Profits Interest
By Marilea Campomizzi, Director, Assurance Services
Non-cash compensation is a common form of motivating and engaging vendors, board members, employees and consultants of start-up companies. Start-ups are typically tighter on cash and looking for creative ways to fund operations and growth. Non-cash compensation can take many different forms, including equity, restricted equity, phantom equity, profits interest, options or warrants. All forms of non-cash compensation offer flexibility from a cash standpoint but can create unexpected costs in the way of legal, accounting and tax compliance, especially if the start-up is privately held and may have difficulty in determining fair value of the equity compensation.
The following are considerations for profits interest:
Profits interest typically doesn’t have an immediate tax implication. The individual receiving the profits interest shouldn’t see an impact to their personal taxes until the issuer becomes profitable. In some cases, profits interest does not affect the individual receiving the benefit. However, the issuance does create an added layer of compliance for the tax return preparation, as the individual receiving the interest will receive a K-1 from the partnership or LLC. If the individual was previously a W-2 employee, they will now need to receive their wages through a guarantee payment on a K-1.
From an accounting perspective, profits interest is generally accounted for under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 718 Stock Compensation or FASB ASC 710 Compensation. Management should determine the characteristics of the profits interest to determine which standard applies to the compensation award.
Under ASC 718, the compensation award typically is recognized as compensation expense and is designated as either equity or liability.
- If reported as equity, it’s recorded on the grant date at the estimated fair value of the profits interest.
- If reported as a liability, it’s recorded at each reporting date and adjusted to its estimated fair value.
Compensation under ASC 710 is recognized as compensation expense and a liability when payment is both probable and reasonably estimable, potentially recordable over multiple reporting periods.
Various aspects of profits interest need to be evaluated in order to determine whether the award falls under ASC 718 or 710. Management should evaluate the different features in total before making a determination. These can include:
- The value of the award – Is it based on the fair value of the company’s equity or a fixed value or formula?
- The settlement features – Would the profits interest survive a change in control or exit event? Or would it be required to be settled under such a circumstance?
- Distribution rights – Would a distribution to the profits interest holder occur before an exit event or is it designed to be limited to occur only at an exit event?
- Cash bonus plan – Is there a separate cash bonus program? And are the profits interest holders eligible to participate?
The company’s legal structuring, award agreement, and intent of the award should all be considered as these evaluations are made, to determine the proper accounting method.
An additional difficulty management may encounter is determining the value at which the awards should be recorded once the correct standard is determined. In some cases, an award may include certain hurdle rates before any distributions are eligible to be paid to the holder. These hurdle rates could cause the award to have very little to no value at the date of issuance. While the face of the financial statements may not have an impact, management will still need to ensure that the proper disclosures are included in the financial statements so users are fully aware of any future implications to the company.
Tracking and maintaining proper documentation related to profits interest can also be difficult for management teams and boards. Vesting considerations, personnel terminations, and timing of the award issuances need to be tracked and considered. Transactions may not always be caught in the accounting considerations above because they are non-cash and can often be missed unless the right questions are asked and discussed. It is imperative for management and boards of directors to be sure these awards are being handled correctly for compliance purposes, so they do not cause unforeseen legal liabilities in the future.
The Private Company Council (PCC), which advises the FASB on private company accounting matters, has identified the rules for profits interest as a potential area where clarification and simplification may be needed. Based on the PCC meeting in September 2020, the Council is collaborating with specialists to identify practice issues as well as potential solutions to better understand the common legal, tax, and valuation issues associated with profits interest.