Limited liability companies (LLCs) sometimes award employees and contractors a unique form of equity-based compensation known as “profits interests.” These interests aren’t actively sold on a public market, so a customized valuation approach is required. Here’s an overview of how business valuation pros determine what these awards are worth for tax and financial reporting purposes.

The basics

Finding skilled workers is one of the top challenges reported by private businesses today. Employers may award various forms of equity-based compensation to help 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, they can award profits interests to certain employees and contractors for services rendered.

2 levels of ownership

LLCs generally issue two types of ownership interests. The first type is a capital interest. 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. Members typically receive capital interests in exchange for a capital contribution of cash or other assets.

The second type is a profits interest. People who own profits interests don’t have the full rights of capital interest holders. Also known as “performance units,” profits interests may entitle the owner (or member) to:

• A share of income,
• Future appreciation in the interest’s value,
• A share of the company’s equity (or residual value) upon meeting certain benchmarks, or
• A combination of these benefits.

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.

Valuation process

Before valuing a profits interest award, a valuator 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, depending on the terms and conditions of the profits interest award, it instead 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 the terms and conditions that apply to profits interest units. 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.

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.

Outside assistance is essential

In today’s tight labor market, equity-based compensation, including profits interest awards, can help businesses attract and retain skilled workers. But few private businesses have the in-house expertise to handle the complexities of valuing profits interests.

(This is Blog Post #1276)