2.6 Profits Interests and Other Awards Issued by Pass-Through Entities

Nonpublic entities such as limited partnerships, limited liability companies, or similar pass-through entities may grant special classes of equity, frequently in the form of “profits interests.” This may include the grant of profits interests tied to carried interest on a particular investment fund that an employee manages or the grant of profits interests in a private equity backed portfolio company. In many cases, a waterfall calculation is used to determine the payout to the different classes of shares or units. While arrangements vary, the waterfall calculation often is performed to allocate distributions and proceeds to the profits interests only after specified amounts (e.g., multiple of invested capital [MOIC]) or specified returns (e.g., internal rate of return [IRR] on invested capital) are first allocated to the other classes of equity. In addition, future profitability threshold amounts or “hurdles” must be cleared before the grantee receives distributions so that, for tax purposes on the grant date, the award has zero liquidation value. However, the award would have a fair value in accordance with ASC 718. In certain cases, distributions on and realization of value from profits interests are expected only from the proceeds from a liquidity event such as a sale or IPO of the entity, provided that the sale or IPO exceeds a target hurdle rate.

While the legal and economic form of these awards can vary, they should be accounted for on the basis of their substance. If an award has the characteristics of an equity interest, it represents a substantive class of equity that is within the scope of ASC 718; however, an award that is, in substance, a performance bonus or a profit-sharing arrangement would be accounted for as such in accordance with other U.S. GAAP (e.g., typically ASC 710 and ASC 450 for employee arrangements).

In a speech at the December 2006 AICPA Conference on Current SEC and PCAOB Developments, Joseph Ucuzoglu, then a professional accounting fellow in the SEC’s Office of the Chief Accountant, discussed observations of the SEC staff related to special classes of equity and associated financial reporting considerations. He stated that in determining whether an instrument is a “substantive class of equity for accounting purposes, or is instead similar to a performance bonus or profit sharing arrangement,” an entity must “look through” its legal form. He also indicated that “when making this determination, all relevant features of the special class must be considered [and that there] are no bright lines or litmus tests.”

Mr. Ucuzoglu further noted that Issues 28 and 40 of EITF Issue 00-23 “provided guidance on the accounting . . . for certain of these arrangements.” Although FASB Statement 123(R) (codified in ASC 718) superseded and nullified such guidance, we believe that some of the indicators identified within this guidance are still relevant and may be useful in the determination of whether profits interests represent a substantive class of equity within the scope of ASC 718-10-15-3(a). Those indicators, as well as others, include:

The legal form of the instrument (a profits interest can only be a substantive class of equity if it is legal form equity).
Distribution rights, particularly after vesting.
Claims to the residual assets of the entity upon liquidation.
Substantive net assets underlying the interest.
Retention of vested interests upon termination.
Any investment required to purchase the shares or units.
An entity’s intent in issuing the interest (i.e., whether the entity is attempting to align the holder’s interests with those of other substantive equity holders).
Provisions for realization of value.
Repurchase features that may affect exposure to risks and rewards.

A key focus in the determination of whether profits interests represent a substantive class of equity is the ability to retain residual interests upon vesting, including after termination. This includes the ability to realize value that is tied to the underlying value of the entity’s net assets, through distributions that are based on an entity’s profitability and operations as well as on any liquidity event (even if through a lower level of waterfall distributions). By contrast, in a profit-sharing arrangement, a grantee typically is only able to participate in the entity’s profits while providing goods or services to the entity, and a residual interest is not retained upon termination. A profit-sharing arrangement may contain provisions (e.g., repurchase features) that limit the grantee’s risks and rewards upon termination (e.g., a repurchase feature that, upon termination of employment, is at cost or a nominal amount).

While retention after termination is an important focus in this evaluation, profits interests retained upon termination may not always represent a substantive class of equity. For example, certain entities, such as general partnerships, may grant profits interests that allocate a portion of the general partnership’s carried interest earned to a grantee for managing a specific investment or fund of investments that, by design, have a finite life. In these instances, an entity may conclude that the profits interests do not represent a substantive class of equity because there are no substantive net assets underlying the profits interest other than a right to cash distributions solely on the basis of the realization of a specific investment or fund of investments.

In addition, while voting rights and transferability are not listed as indicators above (because they are not always relevant and useful for that purpose), their presence may suggest the possibility of an equity interest; however, the absence of such features would not preclude the interest from being considered a substantive class of equity. Nonpublic entities frequently issue equity interests that lack voting rights (particularly to noncontrolling interest holders) and have transferability restrictions. Further, if a grantee does not make an initial investment to purchase an equity interest, the equity interest may still be a substantive class of equity. In that circumstance, consideration for the shares or units is in the form of goods or services.

In determining whether a vested residual interest is retained after termination, an entity typically focuses on what happens to the interest if the grantee is an employee who voluntarily terminates employment without good reason3 or if the grantee is a nonemployee who ceases to provide goods or services. For example, if an employee award is legally vested but is substantively forfeited upon voluntary termination without good reason (e.g., the entity can repurchase the legally vested award at the lower of cost or fair value upon such termination event) and the repurchase feature does not expire upon a liquidity event, the award will most likely be a profit-sharing arrangement (see Section 3.4.3 for a discussion of repurchase features that function as vesting conditions). By contrast, if an employee award is legally vested but substantively forfeited only upon termination for cause (e.g., the entity can repurchase the legally vested award at the lower of cost or fair value upon such termination event), that feature would not affect the analysis since it functions as a clawback provision (see Section 3.9 for a discussion of repurchase features that function as clawback provisions).

An entity should consider the substance of an award rather than its form. For example, an award may legally vest immediately under an agreement; however, the vesting may not be substantive if the award cannot be transferred or otherwise monetized until an IPO occurs and the entity can repurchase the award for no consideration if the grantee terminates employment or ceases to provide goods or services before the IPO. We would most likely conclude that such an award has a substantive performance condition that affects vesting (i.e., an IPO is a vesting condition) even though the award was deemed “immediately vested” according to the agreement.

Changing Lanes

In March 2024, the FASB issued ASU 2024-01, which clarifies how an entity determines whether a profits interest or similar award is (1) within the scope of ASC 718 or (2) not a share-based payment arrangement and therefore within the scope of other guidance. The ASU adds to U.S. GAAP ASC 718-10-55-138 through 55-148, which provide an illustrative example with four cases (A through D) that show how an entity should apply the guidance in ASC 718-10-15-3 to determine whether a profits interest award is within the scope of ASC 718. Since such guidance was not previously included within U.S. GAAP, the ASU is likely to reduce the diversity in practice associated with an entity’s scope assessments in circumstances that are similar to those described in the four cases. In the absence of other relevant factors, however, the conclusions reached in the four cases would be consistent with those that an entity might reach by applying the guidance above. For other types of arrangements, an entity will have to consider the guidance above when determining whether a profits interest is a substantive class of equity within the scope of ASC 718 or a profit-sharing arrangement. See Deloitte’s March 22, 2024, Heads Up for more information about ASU 2024-01, including its effective dates and transition guidance.

From a valuation standpoint, nonpublic entities might consider whether the profits interests that represent a substantive class of equity have no value on the grant date. For example, if the entity were liquidated on the grant date, the waterfall calculation would result in no payment to the special class. However, in the 2006 speech discussed above, Mr. Ucuzoglu noted that profits interests generally have a fair value because of the upside potential of the equity. He stated:

[W]hen the substance of the arrangement is in fact that of a substantive class of equity, questions often arise as to the appropriate valuation of the instrument for the purpose of recording compensation expense pursuant to FASB Statement No. 123R. These instruments, by design, often derive all or substantially all of their value from the right to participate in future share price appreciation or profits. Accordingly, the staff has rejected the use of valuation methodologies that focus predominantly on the amount that would be realized by the holder in a current liquidation, as such an approach fails to capture the substantial upside potential of the security. [Footnote omitted]

Connecting the Dots

Once a nonpublic entity concludes that the profits interests are subject to the guidance in ASC 718 because they represent a substantive class of equity, the entity would next need to assess the conditions in ASC 718-10-25-6 through 25-19A to determine whether the award should be equity- or liability-classified. See Chapter 5 for a detailed discussion of how to determine the classification of awards.

Footnotes

A significant demotion, a significant reduction in compensation, or a significant relocation are commonly considered “good reasons” for termination.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.