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.
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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 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.
ASU 2024-01 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. Entities can apply the ASU’s amendments either “(1)
retrospectively to all prior periods presented in the financial statements or (2)
prospectively to profits interest and similar awards granted or modified on or after
the date at which the entity first applies the amendments.” See Deloitte’s March 22,
2024, Heads Up
for more information about ASU 2024-01, including its effective dates and transition
guidance.
Example 2-6
On January 1, 20X1, Entity A grants
employees profits interest awards that vest quarterly over
four years. The profits interests are legal-form equity, and
the grantees are entitled to receive distributions,
including upon liquidation, on their vested awards once A’s
distributions exceed a threshold amount established on the
grant date. Entity A has substantive net assets.
If a grantee terminates his or her
employment voluntarily, A has the right to repurchase the
vested profits interest at the lesser of fair value or cost
(i.e., $0). The repurchase feature does not expire upon an
IPO or a change in control.
Entity A accounts for this repurchase
feature (i.e., the right to repurchase at the lesser of fair
value or $0) as a forfeiture provision rather than a cash
settlement feature. As a result, the grantees cannot retain
a residual interest in A upon voluntary termination. Rather,
the grantees are entitled to distributions only as long as
they remain employed at A, and any distributions would not
be based on the price of A’s shares or other equity
instruments. Entity A concludes that the profits interest
awards are similar to a performance bonus or profit-sharing
arrangement and are not within the scope of ASC 718.
Note that these awards are different from
the award in the example in Case B in ASC 718-10-55-142
through 55-144, which vests upon an exit event and thus
permits the grantee to retain the profits interest after
voluntary termination. Further, the awards are different
from the award in the example in Case C in ASC 718-10-55-145
and 55-146 because that award vests upon an exit event and
is immediately cash settled by reference to the price of the
Class A units of Entity X in a manner similar to a
cash-settled stock appreciation right. By contrast, the
profits interest awards discussed in this example never
vest; rather, the grantee has only the right to be entitled
to any future distributions until termination of employment,
which is akin to a performance bonus or profit-sharing
arrangement.
Example 2-7
On January 1, 20X1, Entity B grants
employees profits interest awards that vest quarterly over
four years. The profits interests are legal-form equity, and
the grantees are entitled to receive distributions,
including upon liquidation, for the awards that have vested
once B’s distributions exceed a threshold amount established
on the grant date. Entity B has substantive net assets.
If a grantee terminates his or her
employment voluntarily, B has the right to repurchase the
vested profits interest at fair value. Any unvested awards
are forfeited for no consideration upon voluntary
termination.
Entity B accounts for these awards as a
share-based payment arrangement that is within the scope of
ASC 718. Upon voluntary termination, the grantees retain
their vested profits interest, subject to a fair value
repurchase feature. Entity B recognizes compensation cost
for the awards over the requisite service period of four
years in a manner consistent with its policy election to use
either a straight-line or an accelerated attribution method
for awards with only a service condition and graded vesting.
Entity B would separately evaluate whether the awards will
be classified as equity or a liability under ASC 718.
Profits interest awards may also include vesting conditions that are
based on, for example, a target MOIC or an IRR on capital contributions from private
equity investors. See Section
3.7.2.1 for further discussion of how to evaluate an award that vests
when these types of conditions are met.
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
3
A significant demotion, a significant reduction in
compensation, or a significant relocation are commonly considered “good
reasons” for termination.