The use of so-called “profits interest” awards as a tool to attract and retain skilled workers has increased, as more companies are being structured as limited liability companies (LLCs), rather than as corporations. But accounting complexity has caused some private companies to shy away from these arrangements. Fortunately, relief from the Financial Accounting Standards Board (FASB) may be coming soon.
New twist on equity compensation
Corporations tend to award traditional stock options. But profits interests are used exclusively by LLCs. As the name suggests, these arrangements provide recipients with a share of the company’s future profits. Under existing U.S. Generally Accepted Accounting Principles (GAAP), these transactions may be classified as:
- Share-based payments,
- Profit-sharing,
- Bonus arrangements, or
- Deferred compensation.
The classification is determined by the specific terms and features of the profits interest. In most cases, the fair value of the award must be recorded as an income statement expense. Profits interest can also result in the recognition of a liability on the balance sheet and require footnote disclosures.
Need for simplification
Profits interest arrangements can accomplish a variety of business objectives. Though they’re most often awarded to employees, profits interests can also be given to investors, third-party service providers and other individuals.
These awards are usually issued in exchange for future services, without direct payment or financial investment. Various terms and features can be incorporated into a profits interest. For example, these awards often have contingency features, such as vesting requirements, participation thresholds, the occurrence of certain events, limited time periods, expiration dates and forfeiture provisions. In turn, this variability can cause additional complexity compared to other forms of equity compensation and require special valuation techniques.
“Profits interest continues to come up as an area private companies are struggling with,” said Candace Wright, Chair of the Private Company Council (PCC) during a meeting with the FASB earlier this year. Private companies have been clamoring for practical expedients and additional guidance from the FASB on such issues as acceptable valuation methods, audit techniques and disclosure requirements.
Work in progress
Simplification of the financial reporting guidance would be welcome news for employers, employees and other stakeholders. Contact us for help reporting these transactions under existing U.S. GAAP or for an update on the latest developments from the FASB.
Please reach out to your trusted Smolin professional with any questions or concerns.