If you own a small business and need to make profits, you may resort to cutting down employee compensation. But you’ll need an alternative means to boost employee satisfaction, and profit interest units can provide a better solution.
Profit interest is a form of equity compensation awarded to individuals for their services in an organization that are recorded and tracked as proper cap table management practices. The compensation may involve a percentage of profits made from the business. Profits interest helps employees and other service providers remain invested in the company’s success.
Advantages and Disadvantages of Profits Interest
While profits interest can greatly promote employee satisfaction and improve business profits, equity compensation may not be satisfactory. There are a variety of notable advantages and disadvantages to choosing profits interest for your business.
Advantage: Not Measured as Taxable Income at the Time of Issue
Profits interest has no value upon receipt. Therefore, the recipient of the profits interest is not subject to any tax at the time of grant.
Advantage: Taxed as Capital Gain
As long as your organization meets the conditions, the IRS will treat profits interest as taxable as capital gains. The profits interest holder pays no tax, while the organization provides equity compensation. As a result, the company gains more employee loyalty.
Advantage: Flexibility
A high degree of choice provided in profits interest allows companies to shape their value curve effectively. Profits interest involves two parts—annual profits allocation and a liquidation value that is redistributable upon a significant redemption event. Your organizations can also customize the profits interest in various ways to enhance effective profits sharing. For instance, profits interest can be granted based on time or personal performance.
Advantage: Grantee Gains Equity Holder Status
The grantee does not have to be an equity holder in the business, but upon receiving profits interest, they gain similar status as equity holders. This is an effective way to promote employee loyalty and output in the organization. The grantee feels their needs are met, dedicating their time and expertise to business success.
Disadvantage: Administrative Costs
Granting profits interest attracts administrative management costs, which may be difficult to recover over time.
Disadvantage: Potentially Low Valuation
At the time of granting profits interest, your company may need to conduct a corporate valuation. In case of a low valuation, the business may be at risk of making losses.
Disadvantage: Accounting Challenges
The differences in reporting for tax and financial purposes may result in accounting challenges. These differences may cause difficulties in establishing proper values in determining profit interest units.
Vested vs. Unvested Profits Interest
Profits interest can be vested or unvested. Vested profits interest implies that an employee automatically receives grants by virtually being a company stakeholder. On the other hand, unvested profits interest mean that the employee must meet certain conditions to qualify.
Easily Keep Track of Your Profits Interest
If you own a small business, keeping the business profitable and satisfying your employees’ needs can be daunting, but both elements are essential and must be balanced. However, cap table management software can help you keep track of your investments and profits. Astrella can help you track your investments to manage profits interest effectively.
Contact Astrella to request a demo.