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How to account for profits interests

Aug 26, 2021

As a way to recruit, retain, compensate and incentivize employees, entities often grant employees equity-based awards to share in the successes of the company.

Corporations will often award employees with stock options. Limited liability companies (LLCs) will often use profits interests, which are sometimes referred to as incentive units.

While a stock option grants the employee a right to buy stock in the future, profits interests have ownership stake immediately, subject to vesting conditions. They provide a right to receive a share of future profits, after defined thresholds are met. But since the terms and conditions of profits interests vary significantly, it makes the accounting more complex.

Profits interests may be accounted for under ASC 710 or ASC 718 dependent on the terms and conditions of the award.

The option approach vs. the performance bonus approach

The first step when profits interests are issued is to understand the terms of the award, which will dictate whether it’s accounted for under ASC 710, Compensation – General, or ASC 718, Stock Compensation.

In a 2006 speech during the AICPA National Conference, the SEC raised questions that some profits interests might not be a substantive class of equity for accounting purposes and is similar to a performance bonus or profit-sharing arrangement.

If you conclude that profits interests are a substantive class of equity and required to be settled based, at least in part, on the price of the entity’s equity or equity instruments, they are accounted for under ASC 718.I If they are aligned closer to performance bonuses or profit-sharing arrangements, they are accounted for under ASC 710.

Judgement is required to make this determination.

Read the award document carefully to make this determination.

Accounting under ASC 718: Accounting under ASC 710:
  1. It is a legal equity unit of the entity.
  2. The holder has typical rights associated with having ownership interest:
    1. Participate in fair value changes of the company
    2. Subordinated claims to residual assets in liquidation
  3. The employee retains rights to profits interests even upon termination of employee services.
  4. There are proportionate voting rights.
  5. The employee is required to make an initial investment and is exposed to risk of loss of initial investment upon liquidation.
  1. The rights to receive value from the profits interests are tied to continued employment, even after vesting.
  2. There are fixed redemption dates or a specified return.
  3. Receipts of profits interests have similar rights to a creditor (even if subordinated).
  4. Profit interests are used as an alternative to a cash bonus plan.

The scope of the award will also determine its accounting treatment:

ASC 718 ASC 710

Determine whether the award should be equity or liability-classified.

Equity-classified awards are measured at the date of grant fair value and recognized over the requisite service period, provided vesting of any performance conditions is probable.

Liability-classified awards are remeasured each accounting period at fair value until cancellation or settlement.

Accrue a liability for the best estimate of the payouts to be made under the profits interests when it is probable that such payments will be made.

Common items that result in liability-classification under ASC 718

If the risks and rewards of ownership are not passed to the holder, the award should be liability classified. There are two common items that would cause the risks and rewards of ownership to not pass to the holder.

Cash-out rights timing: Some profits interests provide the employee an option of cashing out at fair value. If this cash-out period is shorter than six months and one day after vesting, it is generally accepted that the risks and rewards of ownership are not transferred to the holder and the award is liability classified.

However, classification must be evaluated each reporting period, so if the holder did not exercise the option after six months and one day after vesting, the award would be reclassed to equity at fair value on the date of the reclassification. Any changes in fair value from the date of grant are recognized through earnings and not reversed.

Some cash-out rights are contingent upon an event, such as employee separation, death or disability. Guidance in EITF 00-23 should be used to determine the classification of shares with a fair value put right, and the assessment starts by determining who controls the contingent event. If the employee controls the contingent event, assessing the probability of the event occurring is not applicable. If the contingent event is controlled by other factors, entities should consider probability of the event occurring.

Cash-out rights not at fair value: If the holder can cash-out at an amount other than fair value, the risks and rewards of ownership are not transferred to the holder. Examples are fixed price repurchase features or formula repurchase prices. Some awards will use a formula (e.g., five times annual EBITDA) as a quasi-representation of fair value, but this is not considered fair value, and the award should be liability classified.

Common issues observed in practice

How do you value profit interests?

Profits interests subject to ASC 718 must be measured at fair value. Issuers will frequently argue that the fair value of profits interests is zero because 1) if the entity were liquidated immediately, the holder would normally not be entitled to a distribution and 2) a basis of zero is frequently assigned to profits interests for tax purposes (as seen on 409(a) valuations).

This assertion should be rejected because it is not consistent with the concept of fair value, and a valuation of zero would suggest that there is no retention benefit in granting profits interests to employees. It is inappropriate to assume immediate liquidation when estimating fair value because that assumption would be inconsistent with the financial statement presumption that the entity is a going concern.

The SEC staff has also rejected the use of valuation methodologies that focused predominately on the amount that would be realized by the holder in a current liquidation.

The valuation of profits interests should consider future reasonably possible cash flow scenarios. A monte carlo simulation is best, but depending on expected materiality, a probably weighted expected return model (PWERM) may be acceptable.

Is the high distribution threshold an implied performance vesting condition?

A common feature for profits interests is to have a high distribution threshold. A distribution threshold is the amount that all other equity holders must receive in distributions before the profits interests’ holder would receive a distribution. It’s common for the distribution threshold to be set so high that the only probable way the profits interests holders would receive cash would be upon a sale of the company or change in control event.

If distributions are the only way the holder would receive cash (i.e., there are no fair value put options), and there is a high distribution threshold, some consider there to be an implied performance condition of a change in control or sale of the company event.

In the scope of ASC 718, change in control events are generally accepted to not be probable until they actually happen. Since it is not probable, no compensation costs would need to be recognized.

As of June 2021, there is diversity in practice. To our knowledge some accounting firms consider there to be an implied performance vesting condition, and other accounting firms do not. We do not think this situation is an implied performance vesting condition because it is generally stated in the terms of the award that vesting occurs over time and this approach is more conversative.

Wipfli can help

If you are new to profits interests, it is best not to navigate alone. We recommend consulting with a member of Wipfli’s valuation group. Contact us for assistance.

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Author(s)

Joe E. Paulus, CPA
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