As mentioned in an earlier post, companies sometimes issue stock to employees as compensation for services rendered. However, as was pointed out in that post, if the employee does not pay for the stock she will have to pay taxes on the value of the stock, with the value determined as of the time of issuance. In order to avoid that result, a company might instead issue a stock option to the employee, giving her the right to purchase stock at a price based on the value of the stock when the option was granted. Thus, if the value of the company’s stock rises, the employee could choose to exercise the option (particularly if the company is being sold) and benefit from the gain in value. Of course, in order to exercise the option the employee will have to pay for the stock, paying what the stock was worth at the time the option was issued.
An alternative to the grant of an option is for an employer to issue a “profits interest” to its employee. Under the Internal Revenue Code, limited liability companies (though not corporations) can grant an employee or other service provider a “profits interest” in the LLC. In certain fundamental ways a profits interest is similar to ownership of equity in a company, in that the holder shares in profits distributed by the LLC just as an equity owner would. For instance, if an employee owns 10 units of a profits interest, and the other LLC members own 90 units representing equity interests, the holder of the economic interest will receive 10% of distributed profits which are generated from day to day operations of the LLC. Where economic interests differ is that, on a sale of the LLC, that same holder of the 10 units of profit interests will receive 10% of the amount the value of the LLC increased from the time the profits interest was issued until the LLC is sold. For instance, if at the time of the grant of the profits interest the LLC was worth $5,000,000, and the LLC sells for $9,000,000, the holder of the profits interest will receive 10% of the $4,000,000 increase in value, rather than 10% of the total $9,000,000 sales price. On the plus side, unlike the issuance of stock, the issuance of a profits interest is not taxable to the recipient, and unlike a stock option the recipient need not pay the LLC anything in order to receive the benefit of the profits interest. Thus, profits interests are often favored over options. However, as noted above, profits interests are not available to corporations, and thus corporations usually turn to stock options as an alternative to an outright equity grant.
If you would like to know more about profits interests and other means of compensating employees or other service providers please contact Stephen Goldstein at email@example.com, or at (212) 586-5555.