“There is no such thing as a free lunch.” It is a common expression with a clear meaning— don’t expect to receive something for nothing. But there is an important corollary expressed less often: it is possible to receive something that will have value in the future, but without having to pay for it now. Like seeds waiting to sprout, the concept of a private company profits interest fits this description of an asset with no current worth, but which may become quite valuable over time. The profits interest therefore has an important role to play in the private company context, but what exactly is a profits interest and how does it work?
Defining a Profits Interest
In brief, a profits interest is a creative way for private company business owners to provide their employees with a significant financial incentive—an ownership stake in the company—but without saddling them with a tax burden when they receive this interest. A profits interest can serve a purpose that is similar to a stock option by granting an equity interest in the company to the employee, but unlike some stock options, the employee does not recognize income or pay taxes on the grant of a profits interest because the profits interest has no value when it is granted.
The absence of value is because a profits interest is forward-looking; it provides the employee with a share in: (i) the company’s future profits and (ii) the appreciated value of the company. If the company was liquidated on the day that the profits interest was granted, the employee would receive no proceeds from the liquidation. The employee receives financial benefits only when the company’s assets are sold for a higher value than the date the profits interest was issued or when the company makes distributions with respect to future profits. Further, the employee is not required to contribute any capital and is awarded a profits interest based on the services that the employee has provided or will provide to the company.