Profits interests: Jump-starting the value-recovery process

The coronavirus disease 2019 (COVID-19) pandemic and other economic and financial events have caused many public and private companies to lose significant value. In fact, over the 22 trading days between February 19 and March 12 of 2020, the S&P 500 lost nearly 30 percent of its value of its value. This decline was the fastest drop of such magnitude in history. For perspective, the second, third, and fourth fastest 30-percent declines all occurred during the Great Depression era: in 1934, 1931, and 1929, respectively. The market has partially recovered since March 12, but the S&P 500 is still approximately 20 percent below its peak valuation on February 19. Although valuation declines in public markets do not necessarily translate into similar valuation declines in the private market, their movements are typically correlated, and there is little reason to doubt that many privately owned companies have suffered similarly sharp declines in their valuation during the last 50 days.

While these facts are not rosy, there are always opportunities and benefits to be found in any situation, and the current state of affairs is no different. For companies seeking to rebuild lost company value and new value-building opportunities, equity incentives − and, for many privately owned companies, the often overlooked “profits interest” − can be a powerful tool for jump-starting the value-recovery process.

Lower company valuations and the need to rebuild lost value create an opportunity for companies to build service providers’ loyalty, boost morale, and align the incentives of service providers with those of the company’s investors and principals by issuing equity incentives. Equity incentives can be structured in a variety of ways, each of which has pros and cons and all of which require compliance with federal and state securities laws. Although there are many equity incentive compensation methods, three common equity incentive approaches are (1) outright grants of equity (often subject to certain vesting conditions); (2) options; and (3) profits interests.

• Equity grants are the simplest method of providing equity compensation to service providers. The service-provider recipient typically becomes a full owner immediately, sharing in the current value of the business, although the grant may be also be made subject to a vesting period with a substantial risk of forfeiture.  Significantly, a grant of an equity interest is a grant of something of value, so the recipient generally must pay tax on the value received; provided, however, that a recipient of an equity grant that is subject to a substantial risk of forfeiture is subject to tax on the value of the granted equity at time such equity vests unless an election pursuant to Section 83(b) of the Internal Revenue Code, as amended (the “Code”), is timely made to accelerate the tax-recognition event to the date of issuance.
• Options provide the holder with the right to buy a specified amount of equity interests at a specified exercise price. Options are typically granted by corporations or entities taxable as C corporations for US federal income tax purposes, but limited liability companies taxed as partnerships and limited partnerships are increasingly issuing options to service providers.  To avoid the penalties and adverse tax consequences of Section 409A of the Code, the exercise price of an option must be no less than the fair market value of the underlying equity interest at the time the option is granted.  Options to service providers are often subject to vesting.  The vesting period is usually time-based, but it may be performance-based or provide for a combination of time- and performance-based vesting.  Options are often exercisable for a specified exercise period after the option vests, typically for five to ten years. 

• Profits interests are probably the least well known of the trio (ie, outright grants, stock options, and profits interests), but, if and when available, typically deliver the most upside potential with the least downside for the parties involved, especially when considering that the primary goal of equity incentive compensation is normally to provide tax-efficient compensation that aligns a service provider’s incentives with those of the issuer’s owners.  A profits interest is a tax-efficient way for a partnership (or a limited liability company taxed as a partnership for US federal tax purposes) to grant equity interests to key employees or service providers to motivate and reward them to grow the business.  A profits interest is an interest in the future profits and appreciation of the assets of a partnership without the recipient incurring tax upon the grant of the interest − there is no immediate transfer of value.  A profits interest is distinguishable from a “capital interest,” in which the holder would receive his or her proportionate share of the partnership's assets in the liquidation (similar to an outright equity grant) if the partnership were to liquidate immediately after granting the capital interest.  Accordingly, the grant of a profits interest should not result in any taxable income to the recipient because the granted profits interest, by definition, has no liquidation value at the time of grant.  

Like a grant of equity or an option, a profits interest may be fully vested when initially granted or may vest based on continued service or the achievement of business benchmarks related to the issuer’s business operations.¹ If the granted profits interest is subject to a substantial risk of forfeiture, such as a vesting period, then the service-provider recipient may make what is known as an “83(b) election” with the IRS to pay taxes on the total fair market value of the profits interest at the time of grant. Although an 83(b) election may similarly be made by any equity- or option-grant recipient whose interest is subject to a substantial risk of forfeiture (such as a vesting period), only the profits interest has zero value at the time of grant, making its issuance tax-free to the service-provider recipient (unlike an equity grant or an option).

A profits interest is often more attractive to the recipient because the grant of a profits interest can provide that all appreciation in value be taxed at a later date as capital gains, specifically at long-term capital gains rates if the holding period is long enough. A profits interest holder, unlike the recipient of an option, (1) need not pay an exercise price to obtain the equity interest represented by the profits interest because the recipient is already viewed as a partner under the law and (2) may fully participate in the partnership in a manner similar to other partners (or in a lesser role if that is what is decided) while the original members retain the full value of the partnership created prior to the grant of the profits interest. 

Although many privately owned companies, including private equity and venture capital portfolio companies, have suffered significant valuation losses over recent weeks, the unprecedented events that resulted in those steep valuation declines also offer owners, principals, and management teams with an opportunity to utilize equity compensation, such as profits interests, to provide amplified and tax-efficient incentives for their service providers to rebuild lost company value.

If you have any questions regarding these issues and their implications, please contact your DLA Piper relationship partner or any member of DLA Piper’s Corporate or Tax teams.

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