Wendy Heilbut is founder of Heilbut LLP
Any opinions, analyses, and conclusions or recommendations expressed in this article are those of the author alone and do not reflect the views of their employer or eShares, Inc. DBA Carta, Inc.
A lot of LLCs grow, raise capital, take on debt, grant equity to employees, bring in other stakeholders called members and even go public. But many LLCs, if they are on a traditional VC-backed journey, seek a conversion from LLC to corporation.
Along this journey, many LLC founders and executives want to know what type of equity plan will easily convert with the company when it ultimately converts to a corporation. The answer is a profits interest plan.
Why this equity structure might work best
A profits interest plan allows the LLC to grant employees, advisors, board members or other strategic partners ownership in the LLC without also granting them control. Like most things in an LLC, a profits interest plan can offer the LLC tremendous flexibility. Founders and executives of an LLC can structure the profits interest plan to allow participants a variety of rights including transferability, vesting, annual participation in distributions (if any), or forfeiture on departure from the company.
Important factors to consider
By nature, a profits interest plan has a hurdle or a threshold that is equivalent to the fair market value of the company at the time of the grant of the profits interest to the participant. If an LLC converts to a corporation shortly after establishing the profits interest plan, participants won’t have had time to actually earn any value over and above the threshold before the conversion. As such, if an LLC plans to convert to a corporation before much additional value would be garnered in the LLC, it might be worth waiting until after the conversion to set up an equity incentive plan.
For example, if XYZ LLC (a hypothetical company) offers a profits interest plan to its employees on September 1, 2022, and as of that day, its fair market value is $1 million, grantees under the profits interest plan will only be paid out on money collected in the sale of the company over and above $1 million. If Eve Employee is granted 1% of XYZ LLC as a profits interest, which will vest over four years (assume no dilution). If on September 1, 2027, XYZ LLC is sold for $5 million, profits interest plan participants will be paid their portion of the profit over and above the $1 million fair market value determined on the equity grant date. Here, Eve Employee will be paid 1% of $4 million or $40,000 since she does not participate in the first $1 million of the sale as that was her threshold.
If Abe Advisor was also granted 1%, but his grant happened in 2024 when the company’s fair market value was $2 million, and assuming he was on a two-year vesting schedule, he would participate in $3 million of the sale and receive $30,000 since his threshold would have been $2 million.
Tax treatment
Profits interest plans allow LLCs to grant equity without a tax burden since the value passed to the participant is $0 at the time of grant. The participant is only receiving profitsover and above the threshold so there is no value in the profits interest at the time of grant. The participant should timely file an 83(b) election and will pay long- or short-term capital gains (depending on how long the profits interest are held) on future distributions.Generally, there is no deduction for the company.
What valuations are needed for this equity type
Fair market value and 409A should be accurate at the time of grant. Fair market value will determine the threshold and the company will also want the grant to fall within an exemption under Code Section 409A. Good corporate hygiene requires a new valuation either each year, or after a large action such as an equity financing, major new business relationship or line, or the sale or acquisition of any portion of the company.
It is very important for employees to understand the threshold and that such employees will not participate in that portion of any distributions. This can be explained in light of the tax consequences the employee would be subject to should they not be granted a profits interest and rather be given capital interest.