Profit interests are a special class of equity awarded by a partnership or Limited Liability Company (“LLC”) to its employees. This type of award generally allows employees to share in the future value or appreciation of the Company in exchange for continued service. Profits interests are a form of compensation or incentive to employees and used by Companies to retain, recruit and compensate employees. Although recipients have ownership immediately, awards are generally subject to vesting conditions.
To account for a profit interest award, a Company must determine if the award falls under Accounting Standards Codification (“ASC”) 710 Compensation – General or ASC 718 Compensation – Stock Compensation. The company needs to understand all terms and conditions associated with the profit interest award to determine which ASC to apply. The main difference for accounting purposes is the timing of when the expense associated with the award would be recognized. Under ASC 710, the expense would be recognized when payment is both probable and can be reasonably estimated. Under ASC 718 the expense is generally recognized over the period employee services are rendered.
The Company should consider the different characteristics of the award to determine the substance of the award. If it is more akin to equity, the Company would apply ASC 718. If the award is more like a profit sharing or bonus arrangement, or liability like, the Company would apply ASC 710. Characteristics to consider include the following:
- Value of the award
- Settlement features
- Company repurchase rights/obligations upon termination of employment
- Liquidation/distribution rights
- The legal form of the award
- Initial investment (if any)
- Voting rights
- Management’s intentions
If the award falls under ASC 718 the Company would need to determine if the award should be equity or liability classified. In addition, if a measurement date had been reached, the Company would need to determine the fair value of the award on the grant date and recognize compensation expense over the requisite service period. Liability awards would generally need to be revalued at fair value at the end of each reporting period. Determining the value of the award can be difficult and may require the assistance of valuation specialists.
Jessica Pope, MSA
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