Getting Over That Hurdle (Rate)

Compensating service providers with equity is a pretty regular occurrence with startups. New companies don’t have a lot of cash (or any) to pay the people they need to run the business (just get a quote on the cost to develop an MVP of your new app if you don’t believe me) and providing equity is a great way to build buy-in because…we know…a startup, at least from the perspective of the Founders, is a long-play, not a short term investment.

Trigger warning: This post includes a discussion of math.

In a partnership taxed entity like an LLC there is a unique equity interest called a “profits interest” which allows the Company to compensate a service provider based on the future growth of the company while minimizing the income tax implications for the service provider upon grant of the equity. Read on for more information.

What Income Tax Implications?

I’ll keep this part short. When a service provider “trades” services for equity, the service provider has an income tax event on the day the equity is granted. Why? From the perspective of the IRS, if I engage in legal services and get paid cash for those services, I pay tax on that income. With my “tax-paid” take home money\income I can buy stock in a company. The IRS is happy because they received their cut. If I trade services however, how does the IRS get paid? Well, the IRS will impute income to the service provider based on the value of the equity they receive. This is because, under normal circumstances as a service provider, I would get paid for my services, pay tax on my income, and then buy stock with that tax paid income. In other words, the IRS is not going to give me a break on income tax because I traded services for equity – they will impute income to me at the value of the equity received – and I will owe income tax on it.

This occurs almost every time a service provider is granted equity “in trade” for their services. But there is a way to get around it and still keep the IRS happy.

Capital Interest vs. Profits Interest

A “Capital Interest” is an equity interest in the LLC that has value today. The Company is always worth something and that value is what is represented by the Capital Interest. If my company is worth $1MM today and there are 100 units in the LLC, the units are capital interests with a value of $10,000 per unit (and this is how my income is calculated by the IRS when I receive one of those units as a service provider – I receive 2 units? I have income equal to $20,000).

A “Profits Interest” is a “unique to LLCs” equity interest that rewards a holder (in this case, our service provider) based on the future growth of the Company, not the current “capital” that its worth. Here is how it works, in general.

The Company is worth $1MM today and there is one Member of the LLC named John. John wants to expand the Company and bring on Joe as a partner. Joe will be trading coding services for a 10% ownership stake in the Company. Once Joe joins the Company the equity split will be 90% John and 10% Joe.

However, Joe doesn’t have the money to pay the imputed income tax on his 10% interest, and John doesn’t feel comfortable granting Joe an equity interest in the Company that will include some of the Company’s current value (the $1MM) because Joe had no part in building that value (because he wasn’t part of the Company yet!). A Profits Interest can make both John and Joe happy, here’s how.

If John grants Joe a Profits Interest in the LLC, there are no income tax obligations for Joe, and John is happy because Joe will not share in the existing\accrued\current value ($1MM) of the Company. This is because a Profits Interest is forward looking only. On the day Joe receives his 10% the current value of the 10% is $0 – if the Company were to liquidate the day after Joe receives his 10%, he would get nothing. However, as a going concern, nothing is different between Joe and John. If the Company makes a distribution of cash, Joe and John will split the distribution 90\10 according to their ownership in the Company. If Joe sticks around for a year and the Company grows in value to $2MM and is then purchased, Joe will share in the increased value of the Company upon sale, but not the original value (in this example, the increased value over the original $1MM is $1MM (1+1 =2)). This is because, remember, the Profits Interest is forward looking so Joe will only share in A) Distributions of cash as a going concern that come after he receives his 10% equity and; B) The increased value over the original $1MM valuation of the Company upon sale. The original $1MM is called, for fun, because lawyers and accountants have boring lives and we have to come up with fun words for everything to keep ourselves sane, the “hurdle rate” because in order for Joe to get any value upon liquidation\sale of the Company, the value of the Company has to be over the hurdle of $1MM (the original value of the Company).

Here’s a quick recap:

Value Today: $1M (the Hurdle Rate)

Equity Split once Joe joins: 90% John\10% Joe

Liquidate Tomorrow: John gets everything\Joe get’s nothing (because we’re assuming the value of the Company is still $1MM)

Company operates for the next year and Joe and John are taking distributions of cash from the Company: They split the distribution 90%\10% according to their ownership

Company grows to $2MM and is sold: John keeps $1MM because that was the original value (Hurdle) of the Company the day Joe joined. John and Joe split the increased (over the hurdle) amount of $1MM 90%\10% because Joe helped grow the company to that value.

Why does this avoid the income tax problem described above?: Because on the day the Profits Interest is granted to Joe it is worth $0 so, no income is imputed to Joe. Why is it worth $0? Because the profits interest is forward looking only, and if the Company were to liquidate tomorrow, Joe would get nothing (and, there is never a guarantee that anyone will get a distribution from the Company).

How do you set the Hurdle Rate? Can I just make it up?: I wish! But no. In order to establish a hurdle rate that will be respected by the IRS, the Company needs to have a proper valuation done by an outside valuation firm (in the best case scenario). Once the value of the Company is established, we know what our Profits Interest holders’ hurdle rates will be, and can grant them their profits interest with comfort.

Wait. What if I convert my LLC to a Corporation, then what happens? Good question – an LLC with profits interests on its cap table will make conversion to a Corp more complicated. This is because there is no straight analog to a profits interest in the corporate world, so when the LLC units convert to stock in the Corporation, you need to “back out” the hurdle rate and grant shares in the new converted corp based on the increased value of the Company only. (This sounds easy in practice, and it is, if you keep good records and actually establish the hurdle rate in a proper way. However, from a philosophical perspective, you have to gear the profits interest holder up for the reality that if they have a 10% profits interest in the LLC, it will not translate to a 10% interest in the Corporation (again, because we have to back out the value of the hurdle in order to get the proper number of shares the profits interest holder should receive in the corporation)).

This post was admittedly longer than I had hoped. But, thanks for reading. Happy to answer follow up questions if there are any.