Although the concept of profits interest awards for equity compensation has been around for decades, popularity and widespread use has certainly increased in recent years.
In response to some confusion around when profits interest awards should be accounted for under stock compensation rules, the Financial Accounting Standards Board (FASB) issued updated guidance. On March 21, 2024, updates were rolled out which included illustrative examples to help people better understand the rules. Read on for a brief overview, as well as highlights from the updated guidance.
What Are Profits Interest Awards?
Partnerships and limited liability companies (LLCs) use profits interest awards to incentivize exceptional performance. Under these plans, participants may be granted an equity interest in a company’s future profits, but not any current capital. Profits interest awards may be given to employees, as well as contractors and other “nonemployees” in exchange for goods or services.
Much of their appeal lies in their flexibility. The term “profits interest” can refer to whatever is agreed to by the company and the recipient of the award. This allows companies to customize awards for various purposes. Moreover, the awards offer tax benefits to employees because they vest without triggering tax and then ideally can be sold at a capital gain.
But there’s a potential downside: The arrangements can be tricky to report under the tax rules and U.S. Generally Accepted Accounting Principles (GAAP). So, the FASB decided to issue updated guidance to help companies better understand how to account for profits interest awards.
How Are Awards Valued?
Accounting for these awards requires a current business valuation. Plus, you’ll need to track the number of profits interests awarded and the threshold values of each grant on the date on which it’s granted.
Unlike capital interest units, which convey the full rights of ownership, awards of profits interest units give the recipient rights to a specific type of future income. What the term “income” refers to is explicitly defined by the company’s operating agreement, employment contracts or other owners’ agreements. Income often refers to future appreciation in value or residual value — say, after the business is sold or liquidated. But it can also refer to a stream of income, such as earnings before tax, operating cash flow, cost savings or revenue from a division of the business.
On the grant date, the recipient isn’t entitled to anything. So a profits interest award generally has no value if the company liquidates on the grant date. It grows in value as the company’s value increases. Valuing these awards is similar to determining the exercise price for a stock option.
Profits interest awards may be restricted by various terms and conditions, such as:
- Vesting requirements,
- Time limitations,
- Specific performance thresholds, and
- Forfeiture provisions.
The varieties of terms and conditions that can be incorporated into a profits interest require the use of customized valuation techniques.
How Does the Update Provide Additional Clarity?
The existing accounting rules don’t explicitly discuss profits interest awards, which has led to inconsistent reporting for the awards and the resulting compensation expense. Some have concluded that profits interests fall under the scope of Accounting Standard Codification Topic 718, Compensation — Stock Compensation, and others have reported them in accordance with Topic 710, Compensation — General.
Accounting Standards Update (ASU) 2024-01, Compensation — Stock Compensation (Topic 718): Scope Application of Profits Interest and Similar Awards, provides examples to demonstrate how a business should determine whether an award needs to be reported as a share-based payment arrangement under the stock compensation rules. An award that doesn’t fall under these rules should be reported in the same way a cash bonus or profit-sharing arrangement is reported under Topic 710.
When Do the Changes Take Effect?
Profits interest awards are typically issued by private companies, but the FASB extended the guidance to all entities that issue these types of awards, including public business entities. Public companies — such as those that haven’t yet completed a public offering but have filed a Form S-1 registration statement — must implement the changes in fiscal years beginning after December 15, 2024, including interim periods within those years. Private entities will get an additional year to apply the updated rules. Companies can apply the rules either prospectively or retrospectively with relevant disclosures. Early adoption is permitted.
Need some guidance? That’s why we’re here. Contact your CSH advisor for help navigating the new rules. Although the update brings much-needed clarity, the rules remain complicated and valuation challenges abound.
