Do you think your early employees might be interested in sharing your startup’s success through profits interest?
Profits interest is a type of equity compensation used to allow employees, consultants, or investors a percentage of the company’s future profits. If the company gets sold or goes public, the holder will also receive a portion of the proceeds based on their percentage ownership.
It’s a powerful lever for attracting and retaining talent because it gives employees a stake in future profits in exchange for a lower salary upfront. Profits interest is a way of involving them in the business’s future success without handing them the keys to the company.
Take a look at the basics of profits interest, how it works, and the potential benefits for your company.
What is Profits Interest?
Profits interest is a share of a company’s future growth that gives the holder equity rights based on the future value of the business rather than the current value.
Employees can receive this as an incentive for their service to the company. These stakes can be made available to investors and other stakeholders, essentially granting them partner status in the business.
However, these shares are only available to companies taxed as a partnership.
A Way to Share in the Company’s Future Growth
Employees can get profit interest as an incentive for their service to the company. Compensation depends on the business’s future value, and the holder is entitled to a percentage of the company’s future growth.
Structured like a Stock Option
Profits interest is generally structured like a stock option. The claim can vest after a certain amount of time or require that the company or person meets specific goals before receiving them. The price is usually linked to the fair market value of the company at the time it’s granted.
While this may sound like stock options, they’re not the same. Options enable the holder to buy shares in the future. For startups with limited funds, both can serve as compensation. Employees benefit from working hard because they have a stake in the company’s growth.
Profits Interest Holders Can Take Part in Future Gains of the Company
If the company gets sold or goes public, the profits interest holder will receive a portion of the proceeds based on their percentage ownership. But unlike LLC equity holders, these holders receive nothing if the company gets liquidated.
Benefits of Profits Interest
Profits interest partners enjoy several benefits that make them attractive options, especially for companies where upfront cash compensation could be challenging.
1. Taxed as Capital Gains
Rather than ordinary income, profits interests are taxed as capital gains. This is a massive benefit because capital gains tax rates are often lower than regular income. If you file the 83b election promptly after receiving the profits interest, you can lock in the tax basis at its fair market value on the grant date.
However, there are a few conditions. One is that the recipient can’t be treated as a real partner. Otherwise, they’ll lose their preferred status.
2. They are Flexible
These are customizable to fit the needs of the company partners and employees, serving multiple purposes, such as retention and compensation.
Recipients can simply be a “profit-sharing” partner without voting rights, or they could gain access to privileges giving them:
- Voting rights
- Access to corporate records
Also, the payouts can be immediate or vested over time and paid in either lump-sum or installments.
Profits sharing agreements can also include:
- Customized distribution waterfalls
- Clauses to receive a portion of the proceeds if the business gets sold.
3. They Depend on Future Success
Profits interests generally have no value when issued. Instead, they grow as the company grows and becomes successful. Owners benefit by giving up only a tiny portion of the company’s profits.
Further, and maybe most valuable to the business, the recipient has a strong incentive to grow the company.
Valuing Profits Interest
These are tricky to value, and depending on the company’s success, they can be worth anything from nothing to a fortune.
When a startup is first getting off the ground, it’s difficult to put a precise value on profits interest. The best thing to do is wait until the company has grown and is worth more. Then, you can properly value the interest and determine if it’s worth anything.
Here are a few effective methods:
- Identify all issued units
- Outline what the owners receive
- Know the terms and conditions
- Usually valued with option-pricing models
Want to Implement Profits Interest?
Implementing profits interests can be a great way to motivate employees. You can even do it without relinquishing control over the business or giving up too much of your current profits.
If you want to implement a profits interest plan, don’t do it yourself. Instead, get an expert valuation to ensure you’re creating a fair agreement for all, following the right processes, and ensuring that you’re optimizing tax impacts.
At Founder’s CPA, our startup finance experts will help you understand how to grant equity to employees through a profits interest. Schedule a consultation today.