PRINT THIS PAGE Winning management’s vote - alternative approaches to equity compensation23/05/2007. Source: Weil, Gotshal & Manges. Michael Nissan, Shayla Harlev 
Auctions have become a fact of life for private equity sponsors, says Weil, Gotshal & Manges, with most privately-held companies, even mid-market and smaller companies, being sold through some form of competitive process. Although management may not be able to direct the outcome of an auction, they usually have some influence and potentially a casting vote between competing bidders who are offering roughly similar prices for the business. In order to gain a competitive edge in an auction, private equity sponsors increasingly are trying to structure equity incentives in a tax-efficient manner for management. Private equity sponsors also are responding to the increasing sophistication of management in negotiating equity compensation arrangements and their demands to structure equity compensation in a manner that provides them with the benefit of capital gains treatment. “Leveraged common stock” and “profits interests” are two types of equity compensation plans that may be proposed by private equity sponsors to management as tax-efficient alternatives to the less tax-efficient stock options or traditional restricted stock. This article describes the principal advantages, as well as the costs and risks, of such plans.
Leveraged Common Stock
The “leveraged common stock” method of equity compensation is used to reduce the value of restricted stock awarded to management, while preserving management’s right to a disproportionate share of the post-acquisition appreciation of the total equity invested in a company. The “leverage” used to reduce the value of the common stock granted to management is achieved by substituting preferred stock for a substantial portion of the common stock the private equity sponsor otherwise would use to capitalize the company. The reduction in the value of the common stock makes it feasible for management to elect to be taxed currently on the restricted stock grant, which, in turn, permits any post-acquisition appreciation of such stock to be eligible to be taxed as long-term capital gain.
For example, instead of capitalizing a portfolio company exclusively with common stock, a private equity sponsor would substitute a class of participating preferred stock for 90% of the common stock. The class of preferred stock would be senior to the common stock and have a cumulative dividend (e.g., 10% per annum) and also would participate with common stock in some percentage (e.g., 10%) of all distributions after payment of the preferred stock’s liquidation preference (i.e., the issue price of the preferred stock and any accrued but unpaid dividends). Management would be awarded shares of common stock (e.g., 10% of the common stock, in the aggregate). Alternatively, instead of an outright grant, management may be asked to make an investment in the common stock, which it may make through a rollover of stock it holds in the target company.
For federal income tax purposes, management and the portfolio company would take the position that the common stock granted to management (i.e., 10% of the common stock in the aggregate) has a value at the date of grant equal to 1% of the total initial capital of the portfolio company. For example, if the portfolio company were capitalized with $100 million, $90 million of which was the issue price and initial liquidation preference of the preferred stock, the value ascribed to 10% of the common stock would be $1 million. In order to have the post-acquisition appreciation of the common stock treated as capital gain when ultimately realized, within 30 days after the stock is received, management must elect to be taxed currently on the amount by which the “fair market value” of the common stock exceeds the amount management paid for it (a so-called “83(b) election”). Such excess is treated as ordinary income to the recipient of the stock upon receipt.
The principal issues associated with using “leveraged common stock” are:
If the IRS is successful in establishing that the stock has a higher fair market value than the value ascribed to it by the parties, additional ordinary income would be includible by management (subjecting management to additional tax, interest and potential penalties) and the portfolio company may be liable for unpaid withholding tax. Therefore, when using “leveraged common stock” as an equity compensation method, the parties should obtain an independent appraisal of the fair market value of the stock awarded to management.
The “leveraged common stock” method is more costly to the employer than stock options because the employer is entitled to a tax deduction only for the amount of ordinary income includible by the employees. Because the amount of ordinary income includible by the employees is limited to the initial value of the stock, the employer foregoes a deduction in the amount of any post-acquisition appreciation.
There are economic differences between leveraged common stock and stock options the parties may need to address in determining other aspects of the overall compensation plan. For example, the cumulative dividend on the preferred stock will reduce the amount of post-acquisition appreciation of the common stock. Also, the preferred stock’s residual participation may need to be accounted for in determining management’s percentage share of the common equity.
Profits Interests
“Profits interests” in a limited liability company (“LLC”) acquisition vehicle may be the most beneficial equity compensation method for management. A profits interest essentially is the right to a share of the future income and/or appreciation of a partnership, or an entity that is treated as a partnership for federal income tax purposes, such as an LLC. A profits interest generally can be designed to have pre-tax economic consequences that are the same as, or come very close to, those of stock options.
The benefit of profits interests hinges both on the ability of the recipient of a profits interest to use, in essence, “liquidation value” rather than “fair market value” to value the interest and on the tax treatment of an LLC as a “pass-thru” entity for federal income tax purposes:
If certain requirements are met, the recipient of a profits interest has no income upon receipt of the interest because the interest has no “liquidation value,” even though the interest may have a “fair market value.” The requirements include, among others, that the profits interest not be disposed of within two years after the date of receipt and that the interest be received for the provision of services to or for the benefit of the issuing partnership or LLC.
The federal income tax treatment of an LLC as a pass-thru entity enables the holder of a profits interest to realize long-term capital gains rather than ordinary income to the extent that the profits that are allocated to the holder from the LLC are long-term capital gains. For example, a profits interest holder’s percentage share of the gain from the sale of stock of a portfolio company held by an LLC for more than one year generally would be taxed as long-term capital gain.
The principal issues associated with profits interests are:
There is some uncertainty under current law concerning the taxation of profits interests in cases in which the recipient does not provide services exclusively to the issuer of the interest (e.g., if the issuer is not an operating company, but a holding company which owns an operating company that employs the recipient). If the grant of a profits interest does not qualify under current IRS administrative guidance as a non-taxable event, there is a risk that the “fair market value” of the profits interest would be taxed as ordinary income to the recipient when the interest is granted.
A portion of the current income or gains of an LLC may be required to be allocated to the holders of profits interests even though, as a result of distribution priorities or vesting, they may not be entitled to any corresponding current cash distributions. As a result, holders of profits interests will want “tax distributions” to enable them to pay their taxes, which, typically, would be treated as advances against future distributions.
A subsidiary corporation of an LLC that has issued profits interests will receive no tax deduction as a result of the issuance of the interests or the cash distributions made to interest holders.
Because holders of profits interests are taxed as partners rather than as employees, all of their income from the LLC, including any salary paid to them by the LLC, is reported on a Schedule K-1 and is not subject to withholding taxes. Holders of interests will be required to pay estimated taxes on all of their income from the LLC and self-employment taxes on certain types of income such as salary.
Despite some of the uncertainty associated with the tax treatment of profits interests, because of the potential tax benefits arising from the current tax rate differential between ordinary income and long-term capital gains, profits interests are used by a number of private equity firms as a method of providing equity compensation to management. Nonetheless, because of some of the potential disadvantages of profits interests, the leveraged common stock method may provide management with another tax-efficient alternative to stock options, provided that the valuation of the common stock issued to management can be supported.
Leveraged common stock or profits interests may be a “win-win” for the private equity sponsor and manage-ment because, using either method, the private equity sponsor may be able to deliver more after-tax dollars to management with the same amount of equity, thereby reducing its own potential dilution. Nonetheless, each method has costs and risks that must be considered before it is used in any particular transaction.
Weil, Gotshal Manges is a leading legal specialist in private equity services, with dedicated private equity lawyers in major financial centres throughout the world. For more information please visit www.weil.com.
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