While corporations are able to offer shareholders an equity stake in their business in the form of stock options, limited liability companies (LLCs) taxed as partnerships are more restricted in their ability to provide equity compensation. A stock option is essentially the right to purchase a share of stock in the future at today’s price, and they can be used to compensate employees and other service providers for the work that they perform on behalf of the company.

Compensatory stock options are almost always subject to a vesting schedule, and if the conditions that surround the vesting of the stock option do not come to fruition, then the recipient can’t exercise the option. However, because LLCs do not grant stock options, it may appear that they are very limited in their ability to incentivize workers with upside potential in the value of the business. This is where profits interests can be useful.

By providing employees of the LLC with a stake in the company through a profits interest, the managers are able to more closely align interests and incentivize employees to work hard to increase the value of the business. As the value of the business increases the value of the profits interest also increase.

Profits Interest

Before you give up thinking that it’s just too complicated, think about a mother who tells her son he can only eat one quarter of every pie she makes. While that may not be a lot of pie if the mother is only able to make a small pie, if the boy provides his mother with more ingredients and she is therefore able to make a larger pie he will have more pie to eat despite the fact that he is still only allowed to eat a quarter of the pie. Thus, profit interests encourage employees to help the company grow so that the “pie” gets bigger for everyone and the profits interest holder is therefore entitled to more compensation.

When a business is sold, a profits interest holder will take the percentage that he or she holds via the profits interest from the proceeds from the sale. However, the profits interest holder will only take his or her percentage out of the portion of the business’ value that accumulated subsequent to the grant of the profits interest.

Here is an illustration: Adam and Becca decide to start an ice cream business near the beach and make one million dollars in their first year. They are both 50-50 members of the Ice Cream LLC. They make another million dollars in the second year and decide to expand the business across the entire state of North Carolina. To do this, they hire Charlie to help them and grant Charlie a profits interest equal to 10%. Assume further that at this point the business is valued at $2 million. Three years later Adam and Becca get tired of the ice cream business and decide to sell their LLC. The sale is made for $4 million dollars. At this point, how much is Charlie entitled to? The answer is $200,000 and NOT $400,000. This is because the profits interest was only granted AFTER the business was already valued at $2,000,000. Therefore, Charlie is only entitled to his 10% after that point in time. This means that Charlie gets 10% of the profits of the increase from $2,000,000 to $4,000,000; or $2,000,000 x 0.1. Therefore, instead of $400,000, Charlie will get $200,000 upon the sale and Adam and Becca will each get $1,900,000.

A profits interest contrasts with a capital interest in that a capital interest grants the holder an immediate share of the current value of the company. For example, if Adam and Becca had granted Charlie a capital interest when the ice cream business was only worth $2,000,000 and then sold the business a day later for $2,000,000, Charlie would be entitled to .1 x $2,000,000= $200,000. Compare this to a profits interest in which Charlie would not be entitled to anything if the company was sold for $2,000,000 after he was granted a profits interest in the company. Because a profits interest only is an interest in FUTURE earnings, there is no tax obligation associated with the grant of a profits interest.

Whereas owning a share of stock in a corporation (or a capital interest in an LLC) requires the holder to provide financial capital in exchange for the stock, and a stock option is a right to purchase an equity stake in a corporation at a future point in time, a profits interest does not require the holder to provide financial capital and is a stake in the business value created after the grant.

Like stock options, profits interests can be structured on a vesting schedule based on the time of work or the achievement of performance goals. Profits interests effectively allow LLCs to enjoy a key element of a corporate incentive structure while still maintaining the beneficial elements of pass-through taxation.

If you have any questions about how to structure your startup to best suit your business’ needs while at the same time incentivizing your employees to provide their best work, contact our team at Fourscore Business Law at (919) 307-5356 or here.

Based in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in Raleigh, Durham, Chapel Hill, Wilmington, Charlotte and throughout the Southeast. We also represent venture capital funds and other investors who invest in companies located in New York, Silicon Valley and everywhere between. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on.  Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.