From the company’s perspective, UARs may be an easier option with a lower administrative burden; however, there are material downsides for the employee when compared to a profits interest.
Croke Fairchild Morgan & Beres
What are unit appreciation rights?
Unit appreciation rights, or UARs, are a type of phantom equity that holds some similarities to profits interest units—in both cases, employees are incentivized to help grow the company’s value because the value of UARs and PIUs are both tied to the future growth of the company, starting from the time of the grant.
In addition, UARs, like PIUs, don’t dilute the legacy economic value of existing shareholders. UAR recipients also don’t have to pay for the privilege of holding these rights, just as PIU holders don’t pay for their equity.
The main difference between the two types is that UARs are contractual rights to a cash payment allowing the recipient to remain an employee of the LLC, rather than becoming a member or partner. This means UAR recipients do not receive Schedule K-1 tax forms, file self-employment taxes, or risk losing some employee benefits. However, any cash payments are taxed as ordinary income, rather than long-term capital gains, which can be obtained with PIUs.
UARs are often selected by companies as a suitable right for employees that can directly impact the company’s revenue, such as sales team members.
No buy-in needed
With UARs, no payment is needed from the employee—it is granted by the LLC and gives the recipient the right to benefit from the future growth of the company without a buy-in price.
Because UARs only provide the holder a slice of value that they directly helped create, they are incentivized to do their best work, stick around longer, and contribute more since they’re going to want to create as much value as possible to increase the value of their equity.
UARs are the easier option for a company to roll out from an administrative perspective, as fewer changes are required for the operating agreement.
Recipient retains employee status
This means employees continue to receive company benefits and W-2 tax forms, and their employer can continue to withhold taxes from their regular cash compensation, as they do not hold an equity stake and do not become members or partners.
The tax burden on the employee
UARs can result in a higher tax burden on the employee since they are taxed at ordinary income rates.
Difficulty communicating the equity value to employees
Unit Appreciation Rights are a less common form that some employees see as “not real equity” with uncertain potential value. This may make it more difficult to achieve the alignment companies seek via equity—the feeling that employees have “skin in the game” and are invested in the company’s success.
Little regulatory guidance for UARs
Because it is a less common form, there is less certainty about how the Internal Revenue Service or the courts will view UARs, compared to profits interests, which have more case law and related tax guidance. That’s why it is especially important to consult your legal and tax professionals when granting UARs—especially if the company is located in an employee-favorable jurisdiction such as California.
Time limits on UARs
UARs are generally drafted like options and are only valid for a period of 10 years, meaning there can be additional time pressure on the company-employee relationship if there has not been a change-of-control transaction within 10 years. Absent that transaction, the UARs become worthless unless the company reissues them at the time of expiration.
How it works
The amount the employee is paid out depends on the growth of value of the “units” after the unit appreciation rights are granted. The company must determine its valuation to determine the Fair Market Value or threshold of the units at the time of grant, usually by a 409A valuation. Then, when there is a change-of-control transaction, the company can determine the appreciation, or delta, between the value of the units at the time of grant and settlement.
These valuations generally don’t need to be conducted every time a new grant is issued, but they should be conducted fairly regularly, typically annually or following any material events that may impact this number.
This means that if the company were to liquidate (or enter into a change-of-control transaction at the same value as the equity grant) on the date of grant, the employee would be paid zero dollars. Said another way, the employee only participates in the added upside value of the company (if any) from and after the date of grant.
For the company:
The amount paid out in cash to the UAR holder upon sale or change of control of the company will generally be deductible by the company as a compensation expense. The company will want to run any such payments through their payroll provider and withhold at the employee’s standard withholding rates. This amount will be included on their W-2 for the year as compensation.
A disadvantage of UARs is that they are subject to ordinary income taxes (unlike PIUs, which can be taxed at capital gains rates). Since UARs are not actual partnership interests, the entire amount paid to the employee will be considered income to that employee.
The employee is only taxed on their UAR when they receive a cash payment upon the sale of the company. They are not subject to any taxes at the time the rights are granted, since there is no value at grant and they do not own a membership interest. The same is true at vesting.