United States: Profits Interests 101: Part II: Seven Key Questions Executives Should Ask About Profits Interests

Seven Key Questions Executives Should Ask About Profits Interests

Question: I'm considering a new job offer, and my proposed compensation package includes profits interests (carried interests). What are those, and how do I evaluate them?

As executive compensation attorneys, we hear this from our clients frequently. In Part I of this two-part series, we provided a conceptual introduction to profits interests. (Read Part I Here) In Part II, we introduce a framework for assessing an offer of profits interests. The profits interest award agreement, the equity incentive plan (if there is one) or the partnership or operating agreement will set out the legal framework for your award. However, executives with an offer of profits interests may need to discuss the broader economics and expected yield with the founder, sponsor or key investor.

1. What is the hurdle amount for my profits interests?

Commonly, profits interests are assigned a "hurdle amount," which is the amount that must be distributed to other equity holders before they participate in distributions. Similar to an option strike price, there are many ways to calculate hurdle amount. And similar to an option strike price, you want it to be just right; not too low (or you'll mess up the tax treatment), and not too high (or you'll miss out on post-grant value that you helped build). The hurdle amount should be defensible in diligence or on audit, and it should be consistent with the valuations shared with others – investors, lenders, etc.

While there are situations where your hurdle amount may be greater than the tax-required minimum in order to work in a performance component (meaning, even though the company is worth $X today, you won't participate until our value has increased above $Y). If that's the case with your award, you should understand it up front...and consider pushing back for a "catch up": While company performance can be worked into the vesting mechanics, once you've performed, and thus vested, you should be able to participate back to the first dollar of appreciation since your grant.

2. What are my participation rights?

This is typically set out in the partnership or operating agreement, in the "waterfall" section that spells out the rights of various classes of interest in the event of a distribution. However, overriding provisions may be set out in your award agreement as well. In the most "optionlike" scenario, a profits interest, once vested, will participate proportionately in all distributions in excess of the tax-mandated "hurdle" reflecting the company's value at the time you received your award. However, there can be all sorts of variations. For example:

• Once you vest, you could be guaranteed a special "catch-up" distribution on amounts you would have received if you have been vested at an earlier date.
• Less commonly, once you vest, you could be guaranteed a special "catch-up" distribution on an amount that gives you back all or a portion of the tax-mandated "hurdle" (imagine a special dividend that get you back your option strike price) or otherwise gets you a special payment that takes priority over other equityholders (a special bonus guarantee within the waterfall).
• Even less commonly, you may only participate within the waterfall up to a certain amount (e.g., once you vest and are eligible to participate under tax rules, you receive a proportionate amount of the next $X in distributions, and then you stop participating).
• You may participate only in distributions upon a change in control event, and not in other distributions (such as a dividend recap or minority sale).

3. What is the vesting schedule?

This is typically set out in the award documentation, which the company should provide to you during the offer process. Your considerations should include: Is vesting strictly time-based, or is there a performance component? With performance-vesting interests, there is typically a substantial financial hurdle to overcome before they participate in distributions.

4. What is the company's exit strategy?

The answer to this question will impact your assessment of the award. Is the company being prepped for a sale – and will it be to a financial or strategic buyer? What is the timeline, and what is the anticipated sale price relative to today's value? Particularly in the case of a strategic or add-on acquisition, will the buyer want to keep you in your role post-closing, or are you at risk of redundancy layoff? Some positions are more vulnerable to change-in-control-related termination than others. Does your offer include appropriate change-in-control protection if you are let go? Also: Is there any chance of initial public offering (IPO)? If so, will your profits interests be exchanged for shares of stock of an IPO corporation, and will your vesting accelerate or change?

5. Do I have a path to liquidity absent an exit?

Absent a change in control or IPO within a reasonable timeframe (say, seven to 10 years), is there any way to get liquidity on the profits interests? Often, the answer is "no," but just asking this question opens the door to a conversation about cash liquidity and cash compensation enhancement.

6. If my employment terminates, what happens to my unvested profits interests?

This question is also key, and the answer is often found buried in the back of the partnership or operating agreement. Is there different treatment depending on the reason for termination? While unvested interests are normally forfeited on termination, executives sometimes negotiate additional vesting on good-leaver terminations (death, "disability," termination without "cause," resignation with "good reason") (and the precise language of the definitions can matter a lot here).

7. Do I get to retain my vested interests?

Deep in the partnership documents, there may be a provision that prevents you from participating in future gain after termination of employment. A company "call right" on vested interests is not uncommon. Under such a provision, the company has the right to repurchase your profits interests, typically within a fixed window post-termination and at fair market value (absent a for-cause termination, or less commonly a voluntary resignation). An employee "put right" (your right to make the company repurchase your profits interests) is less typical, but some executives can negotiate for it. Bottom line: It's better to settle these details up front so that you do not have to negotiate under time and financial pressure following a less-than-amicable separation.

8. Bonus Question: Are there other tax complications if I become a partner of my employer?

There may well be, both at the federal and state level, on both your taxes and your benefit plan participation. You'll receive a Schedule K-1 instead of a Form W-2 and you might even be subject to phantom income (taxable income even though you did not receive equivalent distributions). You need an executive compensation attorney or tax professional to help you figure this out.

Bottom line: Companies often promote compensation programs that involve profits interests as a tax-efficient opportunity to lock in an outsized payment (relative to cash compensation) on a liquidity event. While that may well be true, you need to scrutinize the specifics of the award in order to confirm. The questions set out above will help guide your evaluation of the profits interests and inform your counter to the company.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.