Founders of new companies often want to use equity to help attract top talent into their company. It’s tough when you first start – You need amazing people to help build out your visions, but you’re bootstrapping or on a shoe string budget based on money raised from friends and family, and likely don’t have any revenue. Once you are revenue positive, it becomes even more critical to keep your star employees as the company scales. Giving capital units (granted to the founders or sold to investors) can have tax consequences, profits interest are often instrumental in attracting and keeping key employees or service provider relationships.
Profits Interests are a great tool for two main reasons. First, distributions on profits interests are based on a “distribution threshold”, which is the value of the company at the time the profits interests are granted. The recipient of profits interests doesn’t receive a distribution until the other members receive distributions up to the distribution threshold. So, the profits interest recipient doesn’t receive distributions on his or her profits interests until the company has increased in value from the time of the grant. In this way, profits interests are truly incentive units because they incentivize the holder to increase the value of the company. Second, there is no immediate tax consequence for the profits interest recipient. Ordinarily, when a person is compensated in equity, that person is immediately taxed, as ordinary income, on the value of the equity he or she receives. With profits interests, the profits interest recipient is not taxed until he or she actually receives a distribution. This is obviously beneficial to the recipient because he or she is not taxed on “income” before he or she actually gets paid such “income.”
In order to use profits interest in your LLC, you need to have the proper documents in place. First, your company’s operating agreement must authorize the profits interests and set forth their distribution and other rights. Second, you must implement an incentive unit plan and have a written agreement, an award agreement, between the company and the recipient of the profits interests.
The incentive unit plan is the umbrella plan governing all issuance of profits interest by the company. Once it is adopted (usually by the board or managing member), the company may start awarding profits interests to employees and service providers. Among other things, the incentive unit plan sets forth the general rules for how profits interests can be awarded by the company and the rights and obligations of the profits interest recipients. One of the most important sections of a properly drafted incentive unit plan establishes the company’s call rights upon termination of the employee or service provider. Call rights gives the company the opportunity to force the recipient of profits interests to sell back to the company his or her profits interests upon termination. This is important because it ensures that if the relationship between the company and an employee or service provider is terminated, the company can cut all ties with the employee or service provider (and not be stuck with a difficult minority member on the company’s cap table forever). The incentive unit plan also sets forth what happens to the profits interests upon a change in control of the company and states that any award of profits interests must be evidenced by an award agreement.
The award agreement is the agreement between the company and the recipient of profits interests whereby the holder is granted his or her profits interests. It sets forth the number of profits interests the holder will receive, the vesting schedule (if any) and any other provisions that are specific to the holder. The vesting schedule can be key to the success of using profits interests – it allows the company to set vesting milestones (time, sales goals, revenue goals, etc.), which really align the profits interest recipient’s performance and compensation with the company’s larger vision It also contains certain representations and acknowledgements by the holder regarding the rights of the award and an agreement by the holder to sign a joinder, in which the holder agrees to become a party to the company’s operating agreement.
At Stock Legal, we offer the incentive unit plan and a form award agreement for a fixed fee. As with all of our fixed fee packages, the fixed fee includes an initial meeting with you to explain the documents and go over your specific needs, initial drafts of the documents, and whatever subsequent revisions are necessary to get you a finished product that you understand. Our objective is to walk you through implementing the incentive unit plan and empower you to use the form award agreement to award profits interests to employees and service providers in the future. For a fixed fee cost, you will be armed with everything you need to use profits interests to incentivize employees and service providers of your business.
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