Profits Interests in LLCs: Key Features Explained

What Are Profits Interests?

Profits interests are a special form of equity compensation issued in private equity portfolio companies organized as limited liability companies, or LLCs, and partnerships. Profits interests are issued in exchange for services and are used to attract, retain and reward employees.

The term “profits interests” is a legal and tax definition. In practice, companies may use other names, such as “incentive shares,” or assign a certain class of units.

Profits interests provide the potential for employees to share in distributions and proceeds from a successful exit transaction. Profits interests have broad flexibility and can be designed to support a wide range of business objectives. In addition, profits interests can qualify for favorable tax treatment.

While profits interests are most often granted to employees, they may also be provided to investors, third-party service providers, corporations or other individuals. As with any equity compensation program in a privately owned company, the objective in providing profits interests is to create and share greater equity value than would have been achieved without such a program.

In fact, there is no standard definition of a profits interest, allowing the terms to become, in effect, whatever is agreed to by the parties. This provides a flexible form of equity compensation that can be customized for many purposes.

Another benefit of profits interests as a form of equity compensation is the potential for favorable tax treatment.

Capital Structure in an LLC

In an LLC, the person who has an equity interest is referred to as a member. The equity interests held by a member are referred to as units. Ownership interests in an LLC may also be expressed as a percentage and can be referred to simply as shares. Members may also be referred to as unit holders, shareholders, owners, or partners.

An LLC can issue two principal types of member interests: capital interests and profits interests. LLCs can also issue other equity-related interests, such as phantom shares, or units, and share, or unit, appreciation rights. LLCs can also issue options and warrants to acquire membership interests.

Phantom shares are financial interests that do not provide actual equity or membership rights but have a value tied to an underlying equity interest. Share appreciation rights are financial interests that do not provide actual equity or membership rights but have a value based on increases in the value of an underlying equity interest. Phantom shares and share appreciation rights are typically settled, or paid, in cash, which makes them similar to a cash bonus.

Options and warrants are similar equity-related interests. They each provide the right for the holder to purchase certain shares, for a specified price, over a certain period, after which they expire, and may have other conditions, such as vesting requirements. Options are generally issued to employees or service providers. Warrants are typically issued to investors or capital providers.

LLCs can also have convertible debt that gives the holder the right to convert, or change, the debt into an equity interest. Convertible debt gives the holder the right, but not the obligation, to exchange the debt instrument for a specified equity interest subject to certain conditions.

LLCs may also have other financial interests, such as earnouts, that may give the holder the right to receive equity interests subject to certain conditions.

In addition, LLCs can issue an economic interest that is often referred to as a carried interest, or “carry.” A carried interest provides the holder with a specified share of future equity value, such as on the sale of the company. It may be subject to contingencies or thresholds, where payment is made only after a certain amount of value has been attained or an event has occurred. A carried interest is most often a form of profits interest and not a separate type of equity interest.

As discussed above, LLC interests defined as capital interests, profits interests, options, warrants, phantom shares or carried interests may be identified by any number of names or classifications. The features and characteristics necessary to identify the interest are described in the related shareholder and other legal agreements.

Capital Interests in an LLC

A capital interest usually provides the holder with participation in the current and future equity value of the company, a share of income, distributions and voting rights. A capital interest will often result from a capital contribution or other form of consideration made by the member to the issuing company.

A capital interest in an LLC is conceptually similar to equity ownership in a C corporation or S corporation. The holder of a capital interest is entitled to a defined amount of income and distributions. The member receives a percentage of current and future equity value. A capital interest is often acquired with the payment of consideration, such as a cash investment. Capital interests may also be issued in exchange for a contribution of assets or other value. Capital interests generally have voting rights, and one or more members holding a capital interest may have a controlling interest in the company or other management and governance rights. Capital interests can have liquidation, distribution, or other preferences. Capital interests are normally unrestricted, without vesting or other contingencies.

Individual capital interests in the same LLC could have different allocations of ownership, income and distributions. For example, one capital interest unit could provide 10% of the equity value and 25% of the income, and another capital interest unit could provide 25% of the equity value and 10% of the income.

There could be multiple classes of capital interests, each with similar or very different features, rights and preferences.

In private equity, capital interests often take the form of preferred shares that may have liquidation preferences, a preferred rate of return and participation rights. Capital interests can also be issued as common shares.

How Profits Interests Differ From Capital Interests

Profits interests are an entirely separate and distinct class of securities from capital interests. Profits interests represent a restricted type of equity participation and are principally a form of future income, distributions or both to the member. Profits interests normally do not convey the full rights and features generally associated with a capital interest.

Even though profits interests and capital interests are separate and distinct, the differences may be subtle, and there can be similarities that make the distinction harder to identify. For example, a capital interest and a profits interest may both have:

• A proportionate share of income.
• The right to distributions.
• A share in proceeds from the sale of the company.
• Preferences.

The flexibility in the design of a profits interest can add to the complexity of the capital structure of an LLC. Each profits interest granted will not necessarily be the same. There can also be multiple grants of profits interests, with different vesting provisions, issued at different times, with different economic features, resulting in a variety of different rights. Further, within each profits interest award, multiple features and economic rights may be defined, creating separate series or tranches within a grant.

Unlike many of the equity securities issued by C corporations or S corporations, there is no standard or statutory definition of the terms for a profits interest. In the simplest sense, it is whatever the parties agree to.

Identifying Profits Interests

While no standard definition or terms exist for profits interests, the specific economic characteristics of profits interests can be identified. The first step in identifying profits interests is to define the capital interests and then potentially consider anything that is not a capital interest to be a profits interest.

The principal difference between profits interests and capital interests is that a capital interest generally represents full equity rights and ownership in the LLC, whereas a profits interest gives the holder only a form of future income in the form of distributions.

Another basic distinction is that a capital interest is often issued in exchange for a capital contribution in the form of cash, assets or other consideration. However, capital interests may also be issued in exchange for services. Profits interests are usually issued without direct payment or financial investment and are primarily issued in exchange for services.

Profits interests typically have contingency features such as vesting requirements, participation thresholds, the occurrence of certain events, forfeiture provisions or other restrictions.

Finally, profits interests are often specifically defined in shareholder agreements by language that indicates they are intended to comply with safe harbor provisions, including IRS Revenue Procedures 93-27, 2001-43 and proposed 2005-43.

For more resources, visit the Private Company Stock Plans section on NASPP.com.