New FASB Guidance for Profits Interests

With the recent release of ASU 2024-01 (a new scope application of ASC 718), the FASB sought to clarify accounting for profits interests and highlighted the existing complexity in the market.

Since profits interests exist within partnerships and LLCs, it's important to understand how partnership compensation and ownership structures operate compared to publicly traded corporations. A key difference is that the ownership of the partnership is not through common shares, preferred shares, and stock options. Instead, it's through capital and profits interests.

What Are Capital Interests?

Capital interests are similar to common shares and are typically purchased by an individual partner. If there is a sale of the partnership at fair market value after they purchase the units, they receive proceeds based on the ownership structure (e.g., a tier-based waterfall).

What Are Profits Interests?

A profits interest is commonly granted to employees and members of the partnership. A profits interest entitles the holder to a percentage of future profits of the company, although, if there were an immediate liquidation at fair market value, these shares would receive no proceeds. While this mirrors certain common compensation plans issued by corporations, profits interests can differ in how they define the company's profits. These plan definitions generally fall into two groups.

• The first defines profits based on distributions to investors. This means the value is driven by increases in market value realized by investors, and these instruments typically pay out upon a future sale of the company above the current value. For example, the profits interest pool may get 10% of the value of the company at an exit event after investors receive the amount of their investment plus an 8% annual return. This structure is similar to holding at-the-money stock option grants. [For additional context on the similarities and differences between profits interests and options, see the Equity Methods blog “The Curious Case of Marketability Discounts on Profits Interests,” which details the two.]
• The second defines profits based on the company's accounting measures, frequently operating profits. For example, the pool of profits interest may receive 10% of the net operating profits, after tax of the company, above $10 million. This is similar to an earnings-based compensation plan. Importantly, the company's equity value does not determine remuneration under the plan.

For more information on profits interests, see my earlier blog “Profits Interest Units Explained.”

The Accounting Update

With ASU 2024-01, the FASB has clarified the scope of ASU 718 as defined in 718-10-15-3. The new language differentiates between profits interest units subject to ASC 718 and when they are subject to ASC 710.

The Original Guidance

The clarification was needed because the plan type based on accounting profit is not indexed to the company's equity value, yet it is still a partnership interest in the company. To illustrate, let's start with the original text from ASC 718.

The New Guidance

The new guidance adds four examples of profits interest, which illustrate when ASC 718 is applicable. The central theme is:

• If profits are defined based on the growth of the overall market value of the entity, ASC 718 applies. In this case, the grant-date valuation for compensation expense purposes will typically use an option pricing model or other forward looking analysis, as discussed here.
• If profits are based on accounting profits or other factors not directly tied to market value, ASC 710 is used. Valuations of these arrangements are typically based on expected payouts, like a bonus, and do not require statistical modeling.

ASC 718 vs. ASC 710

The following units should be accounted for under ASC 718:

• Class B Units that participate pro rata in distributions with Class A Units, subject to a pre-determined payment threshold. These units vest on the earlier of a service period or exit event.
• Class B Units that participate pro rata in distributions with Class A Units, subject to a pre-determined payment threshold (identical to Case A). Vesting is based on an exit event and the holder receives no distributions prior to the exit date.
• Class B Units that do not provide any equity ownership of the company and are instead a phantom share unit. They are eligible to receive cash upon an exit event, and the amount of cash is calculated based on the price of Class A Units.

The following units should be accounted for under ASC 710:

• Class B Units that do not allow provide any equity ownership of the Entity. The holder receives a portion of operating distributions in the amount of a percentage of the prior fiscal year's net income. The holder receives no proceeds from an exit event. These units should be accounted for under ASC 710.

The clarification is consistent with what we have previously seen applied, as well as guidance for similar units that aren't classified as profits interests. If the value is based on the entity's market value or if an award is settled in equity shares, then ASC 718 applies. If not, we fall back to other guidance. Further, these ASC 718 profits interests can be valued using equity allocation strategies such as the option pricing method. That said, these updates are helpful because the market sees instruments with similar names but different features.

Effective Date

While the effective dates are for fiscal years beginning after December 15, 2024, for public companies and after December 15, 2025, for private companies, early adoption is permitted, and retrospective or prospective application is available. Since this is a definition only, we see little impact except for those companies that may reclassify past grants based on this feedback.