Executives at both public and private oil and gas companies commonly receive performance-based incentives. The objective is to link compensation closely to the financial results of a firm. These performance-based incentives can take many forms. One such method that has grown in popularity, especially when private equity is involved, is the use of profits interests. Profits interests allow a partnership or limited liability company (“LLC”) to give key employees a larger stake in the appreciation of firm value without necessarily giving the employees ownership stake to existing company assets. The ability to avoid dilution is appealing to existing owners of capital interests and contributes largely to the increasing popularity of issuing profits interest shares.

What are Profits Interests vs. Capital Interests?

Profits interests and capital interests are the two major equity classes in a partnership (or LLC). Profits interests are a partnership interest other than a capital interest. Capital interests are an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. The most important difference is that capital interests give a proportionate share of the entire partnership value, both current value and future appreciation, whereas profits interests share only to the appreciation of a partnership value after the date of grant.

Key differences between profits interests and capital interests:

Accounting Considerations

Depending on certain factors, profits interests may be accounted for as stock compensation under ASC Topic 718 or bonus or profit-sharing compensation under ASC Subtopic 710-10. When rights to the profits interest arrangement remain with the employee after termination of service, this would generally lead to accounting for them as stock compensation. This is due to the fact that the retained value makes the profits interest behave like a unit of equity. On the other hand, when the rights to distributions from the arrangement are tied to continued employment and termination of employment gives little to no compensation for the forfeiture of the associated distribution rights, profits interests should be accounted for as a bonus or profit-sharing arrangement. The accounting application for profits interest arrangements can be quite complex and requires thorough knowledge of accounting standards.

Valuation Methods

When profits interests are accounted for as stock compensation under ASC Topic 718, a valuation is required. According to the 2013 AICPA Accounting and Valuation guide for the Valuation of Privately-Held-Company Equity Securities Issued as Compensation, the four most commonly used techniques in the valuation of equity securities are the Probability-Weighted Expected Return Method (“PWERM”), the Current Value Method (“CVM”), the Option Pricing Method (“OPM”) and the Hybrid Method, which combines the PWERM and OPM. The PWERM is usually not ideal for modeling profits interests because it is highly complex, requires many detailed assumptions that can be very subjective and usually only considers a limited set of discrete outcomes rather than the entire range of possible outcomes. Furthermore, the complexity of the model makes it expensive and difficult to implement, and the limitation on possible outcomes is inadequate for valuing option-like payoffs such as those associated with profits interest arrangements. The CVM, because it is based on current value only, does not take into account the many variables that could change the value of a private company’s equity. For this reason, the CVM should only be used when the timing of a liquidity event is known with certainty or when a company is very early in its development. The OPM or Hybrid Method (a hybrid between PWERM and OPM) are the most appropriate methods for valuing profits interests securities that have option-like payoffs.

The OPM, most frequently using the Black-Scholes model, works by valuing the profits interests’ share in the future equity value above a threshold, similar to the way the model can value call options where the share price must rise above the strike price in order to have an intrinsic value above zero dollars. A major advantage of the OPM is that it can assign different strike prices based on liquidation preferences. The distribution order as detailed in the LLC or Partnership agreement is used to determine the strike prices. The OPM makes it possible in the case of profits interests to value a stake in only the appreciation of equity value beyond a given point, or strike price.

Other valuation methods are also used to value option-like payoffs, two of which merit consideration when profits interests must be valued as equity-classified compensation. Monte Carlo simulation models can be used when profits interests receive value after a specific future event has occurred, such as reaching a threshold return on investment (“ROI”) or multiple on invested capital (“MOIC”). These simulation models incorporate uncertainty and various market factors through multiple iterations to see how uncertainty, on average, affects the expected equity value. Monte Carlo simulation models frequently use the Black-Scholes OPM model’s structure to arrive at the value for a specific class of equity.

Another valuation method that is frequently used to value profits interest, and other securities with option-like payoffs, is the backsolve method. The backsolve method in an OPM framework can be used to infer the equity value that is implied by a recent financing transaction. This method involves solving for the total equity value of the enterprise such that the value of the most recent financing equals the amount paid (typically the per-unit price contributed by the sponsor in exchange for the capital interests) using assumptions developed for the expected term, volatility and risk-free rate. This method is most dependable when the financing transaction is done at arm’s length with both parties acting in their own self-interest without pressure or undue duress from the counterparty. The resulting equity value is allocated through the distribution waterfall that flows through equity securities from high to low liquidation preference to arrive at the value for all securities within the enterprise, including profits interests.

Key Valuation Assumptions

Valuation assumptions for the company’s equity value, expected term, volatility and discount for lack of marketability (“DLOM”) largely drive the outcome of the valuation. It is very important to gather the necessary information to develop reliable estimates for these assumptions. Though it can take some time to gather, organize and analyze the data required to make accurate predictions for these four factors, the valuation will only be as reliable as the assumptions.

The assumption for the total equity value as of the valuation date is a fundamental input to creating a reliable estimate for the value of various classes of equity. Profit interests are usually issued at the original transaction date when the private equity investment forms the capital interests. If this is true and the transaction is at arm’s length, the issue price of the capital interests can be used to backsolve for the value of the company’s equity on the issue date. However, if the valuation date is different from the issue date and there are no recent transactions from which the equity value can be implied, an enterprise valuation will need to be prepared to estimate the fair value of equity.

In Summary

With so many factors affecting which type of accounting to apply and how to perform the valuations of these profits interests, it can be a daunting task trying to make sure these securities are recorded in the financial statements in a manner that will not give cause for contest from auditors. Opportune is a trusted advisor that assists clients in properly valuing all types of incentive units that have option or option-like payoffs.