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.” 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 and should be accounted for under 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. Specifically, he stated:

Public companies often create special classes of stock to more closely align the compensation of an employee with the operating performance of a portion of the business with which he or she has oversight responsibility. That is, rather than granting an equity interest in the parent company, employees are granted instruments whose value is based predominantly on the operations of a particular subset of the parent’s operations. The staff has observed the use of these arrangements in diverse industries, ranging from the grant of an interest in a group of restaurants that an employee oversees, to the grant of an interest in a particular investment fund that an employee manages.

Similarly, pre-IPO companies often create special classes of stock to provide employees with an opportunity to participate in any appreciation realized through a future initial public offering or sale of the company, with limited opportunity for gain if no liquidity event occurs. In order to accomplish this objective, the special class is often subordinate in both dividend rights and liquidation preference to the company’s main class of stock, and may have little or no claim to the underlying net assets of the company. In many cases, the terms of these instruments mandate conversion into the entity’s main class of common stock upon the completion of an IPO.

Several accounting issues arise when a special class of stock is granted to employees. First and foremost, one must look through the legal form of the instrument to determine whether the instrument is in fact a substantive class of equity for accounting purposes, or is instead similar to a performance bonus or profit sharing arrangement. When making this determination, all relevant features of the special class must be considered. There are no bright lines or litmus tests. When few if any assets underlie the special class, or the holder’s claim to those assets is heavily subordinated, the arrangement often has characteristics of a performance bonus or profit-sharing arrangement. Instruments that provide the holder with substantive voting rights and pari passu dividend rights are at times indicative of an equity interest. Consideration should also be given to any investment required, and any put and call rights that may limit the employee’s downside risk or provide for cash settlement. Many of these factors were contained in Issues 28 and 40 of EITF Issue 00-23, which provided guidance on the accounting under APB Opinion No. 25 for certain of these arrangements.

When the substance of the instrument is that of a performance bonus or profit sharing arrangement, it should be accounted for as such. In those circumstances, any returns to the employee should be reflected as compensation expense, not as equity distributions or minority interest expense. Further, if the employee remitted consideration at the outset of the arrangement in exchange for the instrument, such consideration should generally be reflected in the balance sheet as a deposit liability.

On the other hand, when 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. [Footnotes omitted]

Although Issues 28 and 40 of EITF Issue 00-23 (referred to in the speech above) were superseded and nullified by FASB Statement 123(R) (codified in ASC 718), the indicators provided in them are useful in the determination of whether profits interests represent a substantive class of equity. 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.
Transferability after vesting.
Voting rights commensurate with those of other substantive equity holders.
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 also contain provisions (e.g., repurchase features) that limit the grantee’s risks and rewards (e.g., a repurchase feature that, upon termination of employment, is at cost or a nominal amount).

In addition, not all the indicators described above are given equal weight. While voting rights and transferability may be indicative of an equity interest, 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), 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

On May 11, 2023, the FASB issued a proposed ASU that would clarify how an entity determines whether it is required to account for profits interest awards (and similar awards) in accordance with ASC 718 or other guidance. The proposed ASU would add to U.S. GAAP an example illustrating four scenarios in which an entity applies the scope criteria in ASC 718-10-15-3 to determine whether to account for a profits interest award in accordance with ASC 718. The illustrative example is intended to reduce (1) complexity in the determination of whether a profits interest award is subject to the guidance in ASC 718 and (2) diversity in practice. For further details on this project, see Deloitte’s May 12, 2023, Heads Up.

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 a manner consistent with the SEC staff’s speech above, the profits interests generally have a fair value because of the upside potential of the equity.

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.