Understanding the Valuation of Profits Interests in Private Equity Transactions

Equity incentives made available to executives, management, key employees and service providers are familiar to most in the form of stock options. Yet, stock options are limited to the corporate domain and are not available in other forms of enterprise. Private equity deals often eschew the corporate form, instead preferring a limited liability company (LLC) form that is a hybrid business entity having certain characteristics of a corporation as well as a partnership or sole proprietorship. LLCs are considered well-suited to a single or small number of owners, which is often the scenario in a private equity transaction. An important consideration for private equity in any deal is the use of equity compensation for retention of key personnel, as well as on-going incentives to align management and shareholder interests. A common form is the award of profits interests.

The definition of a profits interest evokes issues related to taxation that may also be nuanced by legal entity form[1]. But from a valuation perspective, a profits interest comes down to an ownership interest in future profits subject to the total equity’s appreciation relative to the original equity contributed by the private equity investor(s) at the time of the deal. Profits interests together with capital interests comprise the two major equity classes in an LLC structure. Economically the two forms of interest are very different. Capital interests represent real dollars in the form of contributed capital invested at the time of the deal and acquired as part of future capital contributions. Profits interests are upside securities junior in every sense to capital interests that participate in distributions at increasing levels of return to the capital interests. Capital interests are the dominant form of equity in an LLC, typically representing between 85 to 100 percent of the distributable value. They are similar to stock in a corporation. Profits interests lack a corporate analog, but substantively are similar to an option or stock-appreciation right.

To value profits interests, the economics of the equity capital must be clearly incorporated into the valuation. The LLC Agreement is the governing document that defines the equity interests, the contributed capital, any preferred return, and the distribution rights. The Agreement designates both capital interests and profits interests using specific classes of equity (e.g. Class A, B, B-1, etc.) represented by units rather than shares. Profits interests are not acquired like capital interests, but rather are vested. Typically, the profits interests awarded will be both time-vested and performance-vested. Time-vested interests are earned based on duration of service, while performance-vested interests are earned based on the future achievement of targeted equity values relative to the capital interests’ contributed capital.

The valuation incorporates this priority of distribution where economically the capital interests are like a single class of participating preferred and all the profits interests have pro rata distribution rights in the event certain equity thresholds are achieved. Time-vested interests have an implicit equity hurdle; while performance-vested interests have explicit equity hurdles (aka performance thresholds or targets) most commonly defined by IRR and ROI measures pursuant to the LLC Agreement.

In all cases, an option framework is used to value profits interests. The equity structure defines a payoff profile for profits interests that is identical to a call option. The priority of capital interests and the performance-vested targets are analogous to strike prices, while the underlying asset is the total equity value of the enterprise. Because of the structuring and multiple strike prices, option models generally take the form of a Monte Carlo simulation analysis, though some simpler structures may be supported by an option-pricing method (OPM) as detailed in the AICPA Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. A simulation best captures the various thresholds that alter pro rata distributions across the capital and profits interests, which is essential to the valuation of the individual classes.

Total equity as of the valuation date is the most important driver in the valuation of profits interests. The bulk of outstanding profits interests often occurs at the original transaction date when the private equity investment forms the capital interests. That is also the time when the profits interests’ intrinsic value is zero. Thus, the valuation reflects time value and is therefore strongly linked to the estimated timing of the distribution(s) and the volatility of the enterprise’s total equity. The importance of volatility also draws a connection to the leverage in the enterprise relative to comparable sector companies. Timing is associated with the expected holding period, form of liquidation and readiness of the company for a sale or public market entry. This measure brings numerous market factors into consideration.

These are the core elements to estimating the fair value of the existing classes of profits interests. There are other complicating features to consider in the valuation modeling. Significant dividends prior to a liquidity event create additional work around the measurement of performance. Provisions for “clawbacks” and “catch-ups” may be included in the LLC Agreement and be influenced by dividends. Preferred returns may be available to the capital interests and impact the participation levels for junior securities. Altogether, the valuation of profits interests requires a comprehensive view of the equity capital, an option valuation framework, support for key inputs and an allocation framework consistent with the terms of the investor and junior classes of equity.

Profits interests are one specific area of equity incentive securities similar to other forms of share-based payments including stock options, restricted stock and their variants. Each has its own equity context and value drivers relevant to fair value measurement. For more information about the valuation of equity incentives, contact your VRC representative.

[1] Profits Interest is primarily a U.S. tax term defined in IRS Revenue Procedures (Rev-Proc) 93-27 and 2001-43. An 83(b) election is required in virtually all instances.