ASU 2024-01’s Guidance for Profits Interests: The News and Our Views

Profits interests are in the accounting headlines. With the recent release of ASU 2024-01, the FASB aims to clarify the accounting for profits interests. While the new guidance isn’t surprising to most practitioners, it does highlight some of the complexities that profits interests present in the market.

A profits interest is commonly granted to employees and members of a partnership. Partnerships have compensation and ownership structures[1] that operate not unlike publicly traded corporations. A key difference is that the ownership of the company is through capital interests and profits interests instead of common shares, preferred shares, or stock options.

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

Types of profits interest

The key to a profits interest is that it 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 that corporations may have, profits interests can differ in how they define the profits of the company. These definitions can have different twists, but generally fall into two groups.

• Profits based on distributions to investors. This means the value is driven by increases in market value that investors realize. 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 akin to holding at-the-money stock option grants.[2]

• Profits based on the company’s accounting measures (frequently operating profits). As an example, the pool of profits interest may receive 10% of the company’s net operating profits after tax, after the first $10 million. This is like an earnings-based compensation plan. Importantly, the equity value of the company doesn’t determine remuneration under the plan.

With ASU 2024-01, the FASB clarifies 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 those subject to ASC 710.

The clarification was necessary because although the second plan type (the one based on accounting profit) isn’t indexed to the company’s equity value, it’s still a partnership interest in the company.

Breaking down the guidance

To understand further, let’s start with the original text from ASC 718.

ASC 718-10-15-3 (Pre-Update)

The guidance in the Compensation—Stock Compensation Topic [ASC 718] applies to all share-based payment transactions in which an entity acquires employee services by issuing (or offering to issue) its shares, share options, or other equity instruments or by incurring liabilities to an employee that meet either of the following conditions:

a. The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award of share-based compensation may be indexed to both the price of an entity’s shares and something else that is neither the price of the entity’s shares nor a market, performance, or service condition.)

b. The awards require or may require settlement by issuing the entity’s equity shares or other equity instruments.

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

• If profits are defined based on growth of the overall market value of the entity, ASC 718 applies.[3]
• If profits are based on accounting profits or other factors not directly tied to market value, ASC 710 is used.[4]

Here’s a summary of each of the four examples, paired with our take on how the results tie back to this theme.

A. [ASC 718-10-55-140 to 55-141] Class B Units which 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. These units should be accounted for under ASC 718.

Our take: Because distributions are based on the value of the entity, including distributions made as dividends or from a sale, the value of the units is based on the price of the shares or other equity instruments. Note that these units have a payment structure mirroring that of stock options.

B. [ASC 718-10-55-142 to 55-144] Class B Units which 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. These units should be accounted for under ASC 718.

Our take: The economics are primarily the same as in Case A, so the conclusion is unchanged. Further, the fact that interim distributions aren’t paid to these holders doesn’t change the classification. This would be similar to option holders not receiving dividends prior to exercise.

Note that even if the vesting were based on EPS, revenues, or a multiple of investment received by investors, the fact that the payout amount is based on the company’s value means that these will fall under ASC 718.

C. [ASC 718-10-55-145 to 55-146] Class B Units 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. These units should be accounted for under ASC 718.

Our take: In this case, the payout of the Class B units is clearly linked to that of the Class A units of equity. As a result, this falls under the ASC 718 scope. Note this could cover either restricted share or option-like payouts. Again, vesting requirements shouldn’t change the classification.

D. [ASC 718-10-55-147 to 55-148] As in Example C, Class B Units 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 net income. The holder receives no proceeds from an exit event. These units should be accounted for under ASC 710.

Our take: Here we see that the distributions aren’t based on the equity value of the entity and don’t result in equity payouts. Instead, all payouts are cash based and determined by accounting metrics. As a result, this award is accounted for like a bonus plan that pays out based on earnings and is unaffected by equity value.

The bottom line

Overall, this clarification is consistent with what we’ve seen applied as well as with guidance for similar units that aren’t classified as profits interests. If value is based on the market value of the entity 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. With that said, these updates and examples are helpful given the market sees instruments with similar names but different features.

ASU 2024-01 is effective for fiscal years beginning after December 15, 2024 for public companies and after December 15, 2025 for private companies. But 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 who may reclassify past grants based on this feedback.

Still not sure what to do with your profits interests? We have extensive experience valuing, tracking, and accounting for profits interest plans. If you need any assistance, please don’t hesitate to reach out.

[1] By partnership, we mean businesses (including LLCs) taxed as partnerships for federal income tax purposes. The individual interest holders, rather than the corporation, typically pay the taxes. Profits interests are a tax-advantaged form of compensation.

[2] For additional context on the similarities and differences between profits interests and options, see our article, The Curious Case of Marketability Discounts on Profits Interests.

[3] 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.

[4] Valuations of these arrangements are typically based on expected payouts, like a bonus, and don’t require statistical modeling.