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What is a Profits Interest?

Profits interests are the most well-known and commonly used form of equity compensation used by partnerships and limited liability companies that are taxed as partnerships to incentivize key service providers to remain invested in the success of the company. Profits interests are granted to service providers or key employees in exchange for their contribution of services to the partnership (as opposed to cash or other property).

They are similar to stock options in a corporation context, although profits interests are not ‘options’. For purposes of this article, we will refer to “partnership” as an entity, including LLCs, that are taxed as partnerships for federal income tax purposes.

A profits interest is an equity interest in a partnership that gives the holder the right to a share of future profits and appreciation of the partnership, but the holder is not entitled to participate in the capital and accumulated profits or value of the partnership as of the day of the grant of the profits interest. While a profits interest legally constitutes a form of equity (i.e. the holder is deemed an owner of the partnership and receives annual K-1s), it is not a “capital interest”. 

For example, if a partnership was valued at $1mm on the day of grant of a 5% profits interest to a grantee and later sold for $10mm, the grantee would receive 5% of $9mm ($10mm sale price minus $1mm value on grant date, multiplied by 5% (i.e., $450,000). In other words, unlike a capital interest (based on actual cash or other tangible value contributed to the partnership), a profits interest has only the right to “post-grant” partnership income and gain. 

Key Considerations in Granting Profits Interests

Following are a few key issues that typically need to be addressed in structuring profits interests:

Determination of Profits Interest Distribution Threshold

In order to satisfy federal tax law requirements, the value of the capital interests in the partnership should be determined as of the date the profits interest is granted, and this valuation should be included in the profits interest recipient’s grant agreement.

This amount, sometimes referred to as the “hurdle”, must be paid to the capital interest holders upon a complete liquidation of the partnership’s assets before any proceeds of such liquidation are paid to profits interest holders. This ensures that the value of the profits interest is $0.00 as of the date of grant.

Another way of stating this is a fair market value determination of the partnership must be established at the time of each grant of a profits interest (to do otherwise would mean the partnership could not ensure that the value of a profits interest at the time of its grant is actually $0.00). 

Vesting

Profits interests can be fully vested upon grant or can vest over time. Whether or not to require vesting differs for each partnership and transaction. Profits interests that vest over time are used in order to incentivize the key employee or service provider to remain aligned with the partnership over a longer timeframe. A couple of key differences between the treatment of vested and unvested interests are laid out below:

• Distributions. Vested profits interests receive distributions as other owners of the partnership receive distributions, subject to the distribution threshold discussed above. With unvested profits interests, a partnership could choose for distributions to be distributed to the other owners such that the holder would not receive any distributions with respect to their unvested profits interests, or for distributions to instead be held in a separate account to be distributed to the profits interest holders once the profits interests vest. 

• Forfeiture and Repurchase. Unvested profits interests are typically forfeited by the holder upon certain events, such as separation of service, whereas vested profit interests would typically be subject to repurchase by the partnership under those same scenarios. 

• Allocations. If a partnership contemplates profits interests that vest over time, the partnership or operating agreement will often include a provision that allocations from prior years (when the profits interest percentage was lower) will be re-allocated to the holder of the interest upon full vesting.

Company Repurchase Rights

Profits interests are generally subject to repurchase by the partnership on certain events, most typically on discontinuation of providing employment or services to the partnership by the profits interest holder. A “put” right of the profits interest holder, which is the right to force the partnership to buy the holder’s profits interest on certain events, is rare and would only be included in an individual grant agreement negotiated specifically by the partnership and the applicable recipient.

Other Rights of the Profits Interest Holder

Often, profits interests are designated as a separate class of interests under a partnership or operating agreement. By structuring the profits interests in this manner, different rights can be set with respect to those interests, and it is almost universal that the rights attributable to profits interests are much more limited than the rights attributable to capital interests.

Among other things, profits interests are rarely entitled to vote, to be involved in management, or to have preemptive rights or rights of first refusal, etc. (which rights are typical for capital interests or interests held by founders). 

83(b) Election 

Depending on the circumstances, it may be advisable for the profits interest recipient to make what is known in the startup world as an “83(b) election”. Under Section 83(b) of the IRS Code, a taxpayer that receives property subject to vesting as compensation for services (like a profits interest) may elect to include in gross income the fair market value of the property at the time of the grant, rather than in a later year when the property becomes vested.

An 83(b) election also allows the recipient to be taxed at a capital gains rate and not an ordinary income rate down the line (if more than one year from the grant) when and if the profits interest becomes valuable. To be valid, an 83(b) election must be filed with the IRS within 30 days of the profits interest grant date.    

Example: You are granted 100 profits interest units in a startup (based on a deemed valuation of $0.00 per unit on the grant date). There is a three-year vesting period. The units are worth $500.00 per unit after 3 years and become vested. You didn’t file an 83(b) election. At the time of vesting, you will be deemed to have income of $50,000 (whether or not you have been able to actually monetize the units) and you will be required to pay ordinary income tax on that amount.

Applying a 39.6% ordinary income tax means writing a check to Uncle Sam for $19,800. Had an 83(b) election been made, no tax would be payable at the time of vesting and tax would only be payable at the time you actually monetize the units – such as on a sale of the business and then the tax is at the capital gains rate (say a cap gains rate of 20% x $50,000 = $10,000, or savings of $9,800 for this example). 

The filing or non-filing of an 83(b) election is highly important with tax consequences and is a decision that recipients should determine only after consulting with a qualified attorney or certified public accountant. 

Conclusion

Profits interests can be an effective way for partnerships to align the economic interests of key employees and service providers with those of the partnership. However, the legal considerations associated with profits interests can be complex and need to be thought through carefully by both the issuing partnerships and recipients alike.

At Linden Law Partners, we have represented hundreds of partnerships with formation, capitalization and partnership agreement considerations, including the structuring and implementation of profits interest plans and all their associated agreements. Contact us here today to let us know how we can help you.

What is Convertible Debt? 

Startups and entrepreneurs seek to raise early stage capital in a variety of ways, but one of the most common is through a convertible debt structure utilizing a promissory note that can be converted into equity securities of the issuing company on the occurrence of various events stated in the note. 

In the last few years you may have also heard of alternatives to convertible note financings through similar instruments like a “SAFE” (Simple Agreement for Future Equity) or “KISS” (Keep It Simple Securities). These instruments are very similar to convertible notes in that they contain some of the same conversion features as convertible notes, but lack certain debt features such a maturity date and interest. 

Convertible notes are technically debt and could be called due by the holder on the maturity date or a default event just like any other promissory note. However, the primary purpose of a convertible note is not that it be repaid like a loan, but rather that the note investor, in exchange for making a lower priced but higher risk early-stage debt investment, convert that debt to equity and ultimately realize on the upside of a later liquidity event for the issuing company, such as a sale, recapitalization or IPO.

Benefits of Convertible Debt.  

Permits Seed and Early Stage Companies to Raise Capital Without Measurable Valuation 

It is difficult to determine the “pre-money valuation” of an early stage company that has an idea or technology, but little or no revenues, net asset value or cash flows. A convertible note structure allows both the issuing company and its early stage investors to “defer” the valuation determination to a later date when the company raises more money based on more reliable valuation components down the road,

Such as achievement of a product development milestone, realization of revenues or profitability, a stated offer from a third party to acquire the company or raise additional financing based on a specific and more quantifiable valuation, or an IPO.

At one of those specific points in time, where a reliable valuation exists, the outstanding principal amount of the note plus accrued interest would ‘convert’ into equity of the issuing company.

Investor Avoids Overpaying for its Investment; Rewards Early Stage Investors With Equity at a Discounted Price in a Later Financing Round

The note investor typically avoids “overpaying” for any equity securities it receives upon a conversion, such as could happen if it instead purchased straight equity based on overinflated pre-money valuations that are literally pulled out of thin air – which is not uncommon in VC and other early stage investments.

The expectation is for the investor’s debt investment to convert into equity securities upon a later equity financing (typically a Series A round led by institutional or venture capital investors, but it may also be for common stock), whereby the investor will receive the same type of equity and associated shareholder rights as the later-stage investors, but will pay less for that equity because of the higher risk it took by making its debt investment when the company’s valuation was low or not yet established. 

Founders of Seed and Early Stage Companies Can Raise Capital Without Giving Away Too Much Equity Upfront

With convertible notes, the founders mitigate the risk of “giving away too much ownership” out of the chute on the first investment dollars received from investors when there’s little to no operating history for the company. As noted above, a convertible note is debt, not equity, and therefore the investor has fairly limited rights and protections, and the issuing company has few obligations to the note holders outside of standard debt obligations.

More Straightforward Terms and Documentation

Memorializing the terms of a convertible note financing is typically less cumbersome than a straight equity investment. The operative documents are a convertible note and vanilla ‘note purchase agreement’, whereas an equity financing requires, in addition to a purchase agreement, the negotiation and preparation of a number of agreements covering various shareholder rights (such as voting, registration, and co-sale rights, board rights and protections, etc.).

Key Terms in Convertible Debt Notes.

A convertible note will include terms stating the principal amount, interest rate, and maturity date like any other note. However, the key terms in a convertible note center around its conversion features, which include the conversion triggers and the conversion price as further discussed below.

Qualified Financing (or Other Material Event)

A “qualified financing” is usually one of the triggers for conversion of the holder’s debt (other customary triggers include maturity, a change of control, and an IPO). A qualified financing is an equity financing, such as the sale of Series A Preferred Stock, of a specified total dollar amount that will require the note to convert into the equity securities sold in that financing.

The threshold amount necessary to be a “qualified financing” is normally 1x – 2x the principal amount of the convertible notes outstanding, but it varies by company and transaction.

Determining the proper threshold for a qualified financing ensures that the issuing company has raised a certain amount of capital, and that the financing is bona fide, before the investor must convert and lose its priority position as the holder of a debt instrument (which legally has priority of repayment over payment to equity holders on their investments).

Conversion Price

A convertible note investor would not be rewarded for its early investment risk if it had to convert into equity at the identical price being provided to later investors as part of a qualified financing.

Therefore, the price at which the debt will be converted into equity will usually be discounted to the lower of the price obtained by applying one of the following two mechanisms (and what’s common is to give the investor the benefit of the “lower of” conversion price that results from the calculation between the these two following mechanisms).

1. Conversion Discount. A “conversion discount” is a discount on the price per share of the conversion securities to be received by the note investor upon a qualified financing and is almost always included in a convertible note. A 20% conversion discount is typical, but a range between 15% and 25% is not usual. Using the example of a 20% discount, the note holder would be able to convert into equity of the issuing company at just 80 cents on the dollar to obtain the same amount of equity as it would have were it to invest 100 cents on the dollar at the time of the qualified financing or other conversion event.

2. Valuation Cap.  A valuation cap entitles convertible note investors to equity in the company that is priced at the lower of the “valuation cap” or the pre-money valuation of the subsequent qualified financing. Like the conversion discount, a valuation cap rewards seed and early stage investors for taking additional early risk, and it also helps ensure that their stake in the company following conversion upon an extremely large next equity financing will not be unduly small.

For example, if a convertible note provides for a $2mm valuation cap and in the qualifying financing, Series A preferred shares are purchased by investors on the basis of a $4mm valuation at $1.00 per share, the note would convert into shares of Series A preferred stock as if the price per share was actually based on a $2mm valuation, resulting in an effective price of $0.50 per share for the note investor. With this valuation cap, the note investor would receive double the number of shares of Series A preferred stock than it would have if the note did not provide for a valuation cap.

Founders Be Aware of Unintended “Liquidation Windfall”

One issue that founders must think through closely in convertible note financings with valuation caps or conversion discounts is the possible unintended consequences (a windfall of sorts) of inordinately benefitting the note investors at the expense of the founders and other later round equity investors. This risk relates to the “liquidation preference” tied to the equity securities into which the note will convert. 

In its broadest sense, a “liquidation preference” provides that certain shareholders, such as holders of Series A Preferred Stock, will receive a return on their investment prior to the right of other shareholders, such as holders of Common Stock, to receive any proceeds when a company is liquidated, sold, or goes bankrupt.

For example, a 1x liquidation preference entitles the investor to be paid back 100% of its full investment, and a 1.5x liquidation preference entitles the investor to be paid 150% of its full investment, before any common shareholders are paid anything. Multiples are typically 1–2x the original investment but depending on market conditions, they can be 3x or higher.

If a company completes a Series A round at a $5mm pre-money valuation but the convertible notes previously issued have a $2.5mm valuation cap (and assuming the Series A investors have negotiated a liquidation preference above 1x), then in that instance the note investors would receive a 50% discount on the Series A shares they receive on conversion and, if treated exactly like the Series A shares, would also receive the same liquidation preference. This would likely result in a disproportionately high return for the note investors.

Savvy founders can combat this issue through one of two different approaches. The first option is to issue common stock, and not preferred stock, as the “discounted” conversion shares and issue the balance of the conversion shares as preferred stock.

The note investor would receive preferred shares in the qualified financing such that the liquidation preference matches the actual dollars invested in the note financing pre-conversion, but the remainder of the conversion shares will be common stock, which would not be entitled to a liquidation preference. 

The second option is to include terms in the note that gives the company the right to convert the note into a “shadow series” of preferred stock in the next qualified financing. The shadow series is identical in all respects to the preferred stock issued in the qualified financing, except that the aggregate liquidation preference of the shadow series will equal the principal amount of the note.

Conclusion

Convertible debt can be an effective and convenient financing structure for both startups and their early investors. However, there are key nuances for both sides of the deal that require strategic planning and evaluation in order to avoid unintended adverse consequences for founders and investors alike.

At Linden Law Partners, we have negotiated and advised companies, founders and investors on hundreds of early stage and venture capital investments, including convertible debt, KISS, SAFE and other early stage financing structures. 

Contact us here today to let us know how we can help you.

Whether you’re just starting a new business or are preparing to scale your existing company to get to the next level, it’s common to seek out potential Attract Investors to provide the capital your company needs to take flight. Unfortunately, most founders can’t just make an appearance on Shark Tank and get top deep-pocketed investors immersed in bidding wars over funding their companies.

However, there are some practical things you can do to maximize your chances of landing the investment capital your business needs.

5 Ways You Can Help Your Business Attract Investors:

1. Present Clear Numbers

When talking with investors, you need to come prepared with detailed numbers about your business. If you’ve just started a company, you should understand and be prepared to demonstrate exactly how much cash you have and what you’ll need for all expenses on the foreseeable horizon.

If your business is more established, provide potential investors with your financial statements (which you need to make sure are 100% accurate). Most investors are willing to sign a non-disclosure agreement before being able to look under the hood at your company’s finances. 

2. Explain the Solution to a Problem that Your Business Provides

Investors will want to intricately understand what your business does and what it plans to do in the future. Giving them a detailed outline of the solution to a problem that your business can provide will help shed light on the investment opportunity. Investors are more likely to get on board if you can articulate a relatable problem and how your business is going to solve it. 

3. Walk Them Through Exactly How You Will Use the Money

Investors want to feel very comfortable that your business is going to use their money wisely. Come to any investor meeting with written information that shows exactly how you will be utilizing the investment proceeds and why you believe your strategy presents the best path to your company’s growth and a solid return to the investors.

4. Feature Your Team 

Ultimately, investors buy into people they believe can execute — they don’t just buy into ideas or products. Your team is everything. It’s either your company’s biggest asset or its biggest liability. Plus, investors want to meet and get to know not just you, but the other members of your team that they’re effectively buying into.

So be sure to showcase the key individuals that are going to be integral to the execution of you company’s plan and vision. Make sure the team is prepped and well equipped to shine before they’re introduced to potential investors.

5. Be Ready to Negotiate a Deal 

Be ready to negotiate your deal before, during and after your presentations and meetings with investors. Know what your bottom line is and if it’s reasonably attainable as you begin to negotiate, lock it down and make it happen. Nothing is more off-putting to investors than founders looking for a perfect deal or who are indecisive.

You need to be decisive in your business and good investors look for that trait in the founders they’re willing to get behind. The more you’ve planned ahead and have considered the various scenarios under which you will or won’t do a deal will pay serious dividends for you when it’s time to negotiate the particulars of the deal terms. 

At Linden Law Partners we’ve helped hundreds of businesses and investors in preparing for, structuring, negotiating, and closing investment transactions of virtually all types and sizes. Please contact us to discuss how we can help.