Compensating Employees Without Touching Existing Capital Compensating Employees Without Touching Existing Capital

Compensating Employees Without Touching Existing Capital

In today's business environment, management teams play an increasingly important role in the success or the failure of a private equity buyout. As such, savvy equity sponsors are shifting their attention to developing ways to deliver equity based incentives to key employees, while aligning the economic interests of such employees to ownership's interest of long term growth for the sponsored entity. The flexibility in the structure of an LLC offers a way to provide equity-based incentives to management or key employees, while also aligning the interests of ownership and management by allowing management to share in the future growth value of the LLC.  
"Profits Interests" have become an increasingly popular technique with which limited liability companies, and other entities taxed as partnerships, are able to reward and incentivize their management teams and top employees. Under federal tax law, LLCs can create profits interests as a separate class of equity interest which can be granted to management or other service providers. A profits interest in an LLC provides an interest in the LLC's future profits realized over time, without providing an interest in the LLC's existing capital. Thus, a profits interest is an interest in the future increase in value of the LLC. If the LLC does not increase in value, the profits interest itself will have no value to the recipient, thereby creating the incentive to work hard to help the LLC reach its financial goals.
The key feature which distinguishes a profits interest from a simple membership interest in an LLC, is that the profits interest must have zero value if the LLC was liquidated immediately after the grant. As such, if structured properly, pursuant to the Internal Revenue Service's Rev. Proc. 93-27 the profits interest has no taxable value to the recipient on the date of grant and is not a taxable event. Upon the disposition of the profits interest at a future date, any gain from such sale will be taxable to the recipient. However, such gain is taxable as long-term capital gains (as long as the profits interests are held for two years) as opposed to ordinary income (as is the case with restricted stock grants or other stock options in a corporate setting).
Similar to stock options or restricted stock grants, profits interests can be granted to recipients subject to certain vesting provisions. Ownership may choose to structure the grant of a profits interest to vest over a certain number of years in order to encourage the recipient to maintain his or her employment with the LLC until at least the date upon which the profits interests will vest. A profits interest which is subject to a vesting schedule is generally treated as received at the time of grant, even though substantially non-vested at the time, provided that: (1) the recipient is treated as the owner of the interest; (2) at the time the interest vests, no deduction is taken by the company for the fair market value of the interest; and (3) the requirements of the Internal Revenue Service's Rev. Proc. 93-27 are satisfied. If profits interests are subject to such a vesting schedule, vesting generally ceases once employment with the LLC has been terminated. Additionally, such profits interest will vest at on an accelerated schedule upon the sale of the LLC or other liquidity event.
Overall, profits interests create the ability for management to build equity in the company, while allowing that equity to be taxed as long-term capital gains, and at the same time, allow ownership to limit dilution and provide incentives that will help grow the enterprise value of the business.
For more information, contact a member of the Ice Miller Private Equity Group.

This publication is intended for general information purposes only and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.

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