What are PIUs with catch-up?
A typical profits interest grant would normally give the recipient a percentage share of proceeds from the sale of the company based on the future growth of the company beyond the Fair Market Value or “threshold” of the company at the time of the grant.
In certain cases, an LLC might consider structuring the grant to allow the recipient to also participate in the existing enterprise value of the company—essentially, to enable that holder to “catch up” to existing shareholders. This is what is known as a “catch-up” profits interest.
This is accomplished by allocating profits that would otherwise be allocated to the existing members to the capital account of the holder.
Let’s take a look at a couple of examples, first showing what happens without a catch-up provision:
No catch-up provision
Let’s say an LLC with a current Fair Market Value of $10M makes a 5% profits interest grant to an executive, with no “catch-up” concept. If the LLC is sold over the $10M threshold amount, the executive would receive 5% of the proceeds above $10M.
As you can see, a typical profits interest grant is less valuable than a regular capital interest in the LLC because it only shares in proceeds above the threshold amount and receives nothing attributable to the threshold amount itself.
A catch-up provision would provide the grantee with an enhanced share of exit proceeds above the threshold amount until the grantee is “caught up” to their pro rata share, with any additional proceeds being shared pro rata.
Now let’s see what would happen for the executive if they had a “catch-up” provision in their profits interest plan.
PIU with catch-up provision
If the LLC subsequently sold for $10M or less, the executive still receives zero. But suppose the LLC is sold for anything greater than $10M. In that case, the executive receives 100% (not 5%) of the excess proceeds until the executive has received 5% of total proceeds (i.e. roughly $526,000 to the executive*), and 5% after that. Thus, if the LLC were sold for, say, $15M, the executive would receive $750,000, which is the same amount they would have received (i.e., 5% of the total) had they held a regular capital interest in the LLC, rather than a profits interest.
*$10M to the pre-grant members, and then $526K to the executive, which ensures that the executive “catches up” to 5% of total proceeds ($526,000 / $10,526,000 = 5%); example assumes that only the single executive holds a catch-up provision on their PIUs.
Advantages
Great for recipients
With the catch-up provision, in the right circumstances, the recipient can be paid out as though they had a full capital interest in the LLC rather than a profits interest based only on company appreciation post-grant.
Tax-friendly
As with regular PIUs, there are two major tax advantages for the holders.
The PIU holders can typically minimize their tax obligation at issuance and at vesting with the timely filing of an 83(b). Additionally, at liquidity, the holders’ profits can be taxed at long-term capital gains rates if held for the applicable holding period.
Considerations
Not a perfect solution
The LLC must still appreciate in value or generate profits after the grant in order for the holder to be “caught up.” If the LLC is ultimately sold for an exit price equal to or less than the threshold amount, the holder is still at risk of not receiving the same sale proceeds that a capital interest holder would have been entitled to receive.
Even still, the catch-up profits interest can significantly minimize the executive’s economic risks in this regard, while still preserving the beneficial tax treatment of the profits interest grant. This is because, in many cases, the LLC will only need to appreciate in value by relatively small amounts for the grantee to be caught up in full. For example, in the examples above, the LLC would only have to appreciate in value from $10M to $10.526M in order to fully catch up a 5% profits interest holder.
Tax treatment
For the company:
Because a profits interest grant is non-taxable to the grantee, the issuing LLC does not receive a tax deduction attributable to the grant. However, at the time of exit or other distribution on the PIUs, the PIU holder’s share of proceeds are directly taxable to that holder, thus providing an “effective” tax deduction to the other members.
For employees:
As with regular PIUs, there are two major tax advantages for the holders.
First, the PIU allows for potential tax savings by minimizing the tax obligation at issuance and at vesting. Typically the PIU holder files a protective 83(b) election (within 30 days of receiving the PIU grant) to elect to pay taxes on receipt, when the equity has no value, instead of at the time of vesting, when the PIUs value may have increased. By paying taxes on the total Fair Market Value of the award at the time of issuance, which is $0, they lower their tax burden.
At liquidity, typically the sale of a company or repurchase, holders’ profits can be taxed at long-term capital gains rates if they held the interests for the applicable time period.
