Choice in Executive Compensation Incentives for Limited Liabilities Companies

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1 Choice in Executive Compensation Incentives for Limited Liabilities Companies Sabino (Rod) Rodriguez III Partner Day Pitney LLP New York NY 2012 Day Pitney LLP

2 Categories of Business Activities of Limited Liability Companies that Impact Compensation Pure Service Entities e.g., Fee-based service providers like Most Law firms Most Accounting firms Many Consulting firms Mixed Property-Services Entities e.g., Asset intensive businesses like Real estate owner/manager Equipment based service companies Software development companies Property-Investment Entities e.g., Private Equity and Hedge Fund Fund manager/fund Relationships Page 2

3 Factors Influencing Compensation Incentives Types of Executive/Company Relationships Family Controlled Business Family Member Non-Family Member Private Equity/Venture Capital Backed Business Serial Executive with the PE/VC Fund Other Special Purpose Company Subsidiary of an operating company Joint Venture Vehicle Additional Characteristics of Executive Public Company Experience Equity Compensation Background Limited Tenure for Executive Likely Retirement Limited Engagement (e.g., turn around retention) Page 3

4 Additional Factors Influencing Compensation Incentives Characteristics of the Company Cash Cow Unlikely to be sold Resources to pay cash compensation Dividend history/opportunity Exit Likely Sale to Financial or Strategic Buyer IPO Growth Likely Aggregator or other Acquisitive Strategy Turn Around Situation Cash strapped Monetizing assets may be required Start-up Low initial valuation Page 4

5 Basic Elements of Compensation Base Salary or Partnership Share Short Term Incentive Compensation Long Term Incentive Compensation Page 5

6 Short Term Incentive Compensation Common Features Form and Amount: Cash bonus, often as a percentage of base salary Tied to achieving annual individual and/or company performance targets Payment Timing LLC Executive Compensation Incentives Annually or Deferred and Paid at Fixed Intervals Subject to Final Determination of Targets/Audit Vesting of Entitlement Employed When Performance Period Ends or Subject to Continued Employment to Time of Payment Page 6

7 Long Term Incentive Compensation Common Features Performance Based/Payout Phantom Equity or Other Formula Based Deferred Compensation Target Performance Over period of years (commonly 3-5) Event Based Exit Strategy or Retirement/Change in Control Event Based Actual Equity Equity Forms Capital Interest Profits Interest Events Exit Strategy: Sale of Business or Entity Retirement: Change in Control Page 7

8 Long Term Incentive Compensation Forms of Equity Forms of Equity Profits Interest Capital Interest Options on the Foregoing Timing of Grants Up front Over time Page 8

9 Table: Common LLC Long Term Incentives Alternative Key Attribute Other Attributes Taxation Grant of LLC Units as a Capital Interest (actual equity) Fully participating including in share of sale proceeds and annual income to the extent provided and in current value, even upon liquidation. Could be made subject to: Vesting Forfeiture for bad acts including violation of a non-compete Annual profits allocation can be by bonus without regard to Units ownership Could be vehicle for succession upon death or redemption of a founder Value of the Capital Interest is taxable at the time of grant as compensation income. Participation is otherwise taxed in the same manner as present owners; exit can result in capital gain, which under current law is taxable at lower preferred rates Grant of LLC Units as a Profits Interest (actual equity) Same as Capital Interest except no participation to the extent of current value upon a liquidation Same as Capital Interest Same as Capital Interest except that there is no taxation at the time of grant There is a risk of reclassification as a Capital Interest if there is a sale of the company within two years. Options to Acquire LLC Units (right to future actual equity) No actual equity before exercise of Options, so no ownership burdens apply Commonly not exercised prior to a sale of the company Same as Capital Interest No tax at grant if exercise price is equal to current value of a share at the time of grant Ordinary income tax at the time of exercise -- Post-exercise gain is capital gain, but rarely is there exercise before exit event. Phantom Equity Plan (not real equity, just economic rights ) Participation can be designed to match any of the foregoing, though most commonly tied to an exit event like sale of the company Same as Capital Interest (except for succession vehicle). All amounts payable are ordinary income (no opportunity for capital gain) Need to comply with Section 409A deferred compensation rules. Page 9

10 Tax Issues Related to Capital Interests Capital Interest: At grant holder shares in: Partnership s liquidation proceeds Share of future profits Tax treatment of Capital Interests Similar to tax on compensatory stock transfers Service provider recognizes income equal to FMV value of interest at vesting (less any amount paid) Basis equal to income recognized Section 83(b) elections Partnership (partners) get compensation deduction equal to FMV included in service provider s income Page 10

11 Tax Issues Related to Profits Interests Rev. Proc Guidance: what constitutes a profits interests and related tax consequences Profits interest is an interest other than a capital interest. A capital interest gives holder share of proceeds if partnership assets sold at FMV and proceeds distributed in liquidation Profits Interest under Rev. Proc 93-27: Profits interest must be granted for provision of services to (or for the benefit) of a partnership in partner capacity or in anticipation of being a partner, If so, then grant is not a taxable event for service provider or partnership Rev Proc does not apply if: Profits interests relates to substantially certain stream of income from partnership assets (such as high grade debt security or net lease) Profits interests is disposed of within two years Profits interests is an LP interest in a publicly traded partnership Page 11

12 Tax Issues Related to Profits Interests (cont) Rev. Proc Guidance on profits interests subject to vesting Rev. Proc applies at grant even if not vested if: Service provider treated as owner of the partnership interest from the date of grant and takes into account allocations of income, loss, etc. in determining tax liability Neither partnership nor partners claim a deduction upon grant or vesting of the profits interests Section 83(b) elections Importance of book-ups; valuations Forfeitures Page 12

13 Tax Issues Related to Profits Interests (cont) Capital Shift: One partner becomes entitled to a portion of the capital otherwise allocated to another partner Risk: Partner receiving the interest in capital may be taxed on value of the shifted interest Example: Recipient of profits interest becomes entitled at a future date to an allocation of a portion of the capital value that existed prior to the grant of the profits interest. Result: Holder of the profits interest may be subject to tax, and at ordinary income rates, on that value at the time he or she becomes entitled to it." Page 13

14 Tax Issues Related to Profits Interests (cont) Proposed Regulations and Notice : NOT IN EFFECT Proposed Regulations: Treat any LLC membership interest as property for purposes of Section 83 Taxable income to recipient as of grant date or later vesting date based on FMV on that date Uses general valuation techniques and all applicable facts and circumstances Profits-only interest treated as just another LLC membership interest, with its lack of a present interest in existing capital just one of the factors to be used in determining its fair market value. Proposed Rev Proc: LLC and all of its members may make a Liquidation Value Election with safe harbor under which FMV treated as liquidation value, but only if LLC and all members make the election and a Section 83(b) election filed. Carried Interest Legislation Page 14

15 Tax Issues Related to LLC Options Options to acquire capital interests Similar to stock options Upon exercise service provider and partnership have same tax treatment as grant of capital interest (taking into account payment of exercise price) Options to acquire profits interests No income to service provider at time of exercise and No deduction for partnership Generally not economically attractive to service providers Page 15

16 Applicability of Section 409A to LLC Equity Final Section 409A Regulations Do not address partnership equity compensation Preamble: Rely on Notice in interim: Treat issuance of partnership interests or options to acquire partnership interests for services under same principles as stock issuances If profits interest doe not resulting in inclusion of income by service provider, then not treated as Section 409A deferred compensation May treat issuance of capital interest in same manner as issuance of stock Page 16

17 Tax Issues Related to Phantom Equity Phantom LLC Equity is Similar to Phantom Stock Service provider recognizes ordinary income at time of payment Partnership gets deduction equal to amount paid Can be subject to Section 409A if not eligible for short-term deferral exception or other exceptions Page 17

18 Phantom Equity Plans Planning Issues Number of Shares/Units. How many units of phantom equity will be issuable under the plan (think in terms of a percentage of the company or of outstanding units). Timing of Grants. LLC Executive Compensation Incentives Consider how often grants are going to be made. Keep in mind the aggregate percentage or number of units to be awarded over time. Starting Value Valuation Methodology. Is there a ready mechanism/formula for determining the current price of a share/unit? The valuation method must be defensible and consistently applied over time, absent special circumstances. Payout arrangements can be based on the economics of the event, like a sale of the company, and are measured by a portion of sale proceeds, subject to constraints under Section 409A. Consider the potential forms of the transaction, the types of consideration that might be received and the need to retain personnel as a condition to payment. Note: Formula can simply measure the change in balance sheet net equity from a grant date to a future date. A well-designed formula should encourage behavior that creates the desired result (generally increased profitability and overall equity value). Often-used formulae include change in company earnings or in EBITDA. Page 18

19 Phantom Equity Plans Planning Issues (cont) Vesting Covenants. Will the phantom equity be subject to vesting? What terms? What additional covenants will be required? (A non-compete is common as is a requirement not to take other action adverse to the interests of the company posttermination, often with a claw-back attached.) Payout Date and Terms. How and when will the phantom shares become payable? Upon a liquidity event, like a sale of the business? Or upon an event unrelated to liquidity, like retirement or death? How will the phantom equity payout be made cash, note, combination? And over what period of time? If funds are to be set aside, on what basis? Commonly, the payout is stretched out as a way of making certain the covenants are adhered to and to facilitate cash needs. Note: Keep in mind that phantom equity is deferred compensation and once the amounts are no longer subject to a substantial risk of forfeiture, Section 409A will apply to limit the times at which payment can be made. Keep in mind that a phantom equity plan that pays upon retirement may cause ERISA compliance issues if it is not a top hat plan (which requires a filing). (A bonus plan payable upon an event without regard to termination of employment should not be deemed a retirement plan.) Page 19

20 Consequences of Non-Employee (Partner) Status Income Tax Consequences Withholding issues Employment taxes Employee deductions State tax considerations Compliance burdens Employee Benefits Not eligible to participate in cafeteria plans Health benefits not excluded from income, but deduction for premiums paid by self employed No group term life insurance exclusion Qualified transportation and qualified moving expense reimbursements not available Can still participate in qualified retirement plans Page 20

21 Other Issues Related to LLC Equity Liquidity/exit considerations Complexity Governance Corporate Conversions Page 21

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