In the competitive landscape of the investment advisory industry, retaining top talent is essential for the long-term success and growth of investment advisory firms. To incentivize and reward key employees, investment advisers often turn to equity compensation tools, which are mechanisms through which investment advisers can grant ownership stakes or the right to share in the profits of the firm to key employees. These tools are designed to incentivize employee loyalty, align interests, and encourage long-term commitment. Although there are many flavors of equity compensation tools, in this article, we will provide a summary of the two key equity compensation tools, equity and profits interests, and discuss the terms often associated with the grant of such equity compensation to firm employees.
What Is Equity?
Equity is a direct interest in the ownership of an advisory firm. Advisory firms may grant equity outright to employees or may require employees to contribute capital to the company in exchange for their equity or to buy their equity in the firm from another owner.
Employees who are given the right to participate in the equity of the advisory firm will typically be required to become an owner (or member) of the advisory firm which requires them to sign the firm’s operating agreement or shareholder agreement (which governs how the firm manages its affairs and delineates the rights and obligations of all owners) and to be bound by the terms set forth in the operating agreement or shareholder agreement.
Equity granted to employees can come with two basic sets of rights: economic rights (which allow the employee to receive a share of the ongoing profits of the advisory firm as well as any profits from the sale of the equity of the firm) and voting rights (which allow for participation in certain decisions to be made by the firm’s owners). While equity granted to employees typically includes the economic rights described above, such equity does not always include voting rights.
Employees that must purchase their equity in the firm typically do so at a valuation determined in accordance with the terms in the firm’s operating agreement.
Equity granted to employees is typically not transferrable although limited exceptions may be made for transfers to immediate family members for estate planning purposes. Additionally, there are typically few, if any, circumstances in which employees are allowed to withdraw or sell their equity to a party outside of the firm. Firm employees granted equity may also be required to sell their equity back to the firm or forfeit their equity upon their departure from the firm.
What Are Profits Interests?
Profits interests permit an employee to participate in a pre-determined percentage of the advisory firm’s ongoing profits as well as the profits from the sale of equity over and above a price pre-determined at the date of grant. For instance, a profit interest could grant an employee the right to participate in ten percent of an advisory firm’s ongoing profits as well as the right to participate in ten percent of the firm’s profits in the event of a sale of the firm but only to the extent that the price realized for the equity sale exceeds the current market value of the firm. Therefore, if the advisory firm is valued at $1,000,000 on the date of grant and is ultimately sold after the profit interest grant for a price of $5,000,000, the profit interest grantee would be entitled to receive ten percent of $4,000,000 or $400,000 for its participation in the profits from the sale of the firm’s equity.
Unlike equity, profits interests do not include voting rights to participate in decisions to be made on behalf of the firm.
Profits interests are also typically not transferrable to third parties although limited exceptions made be made for transfers to family members for estate planning purposes. Firm employees granted profits interests may also be required to sell their profits interests back to the firm or forfeit their profits interests upon their departure from the firm.
Should an Adviser Grant Equity or Profits Interests to Employees?
The choice between equity and profits interests should consider the firm’s specific circumstances, tax consequences, and the preferences and circumstances of key employees. There are benefits and drawbacks to both types of compensation.
Equity is often a better fit for firms looking to accomplish succession planning and the ultimate transfer of ownership from the founder to employees who will eventually take over ownership of the firm.
However, equity has several important drawbacks to consider. Any equity granted by the company to employees or purchased by employees from the company will typically dilute the other owners. Therefore, it’s important that advisers consult all current equity owners to ensure that granting such equity to an employee will not be met with a negative reaction. In many cases, consent to the granting of equity to an employee may require the approval of most, if not all, current equity owners of the firm.
Additionally, giving employees equity in the company creates an immediate tax event for the employee and typically requires the company to pay payroll taxes with respect to the equity grant. employees must report the value of the equity as ordinary income in the year it’s granted. Firms should be aware that, depending on the circumstances, employees may not have the funds to pay taxes associated with the grant of equity.
Some firms may opt to therefore have employees purchase their equity at fair market value to avoid the tax consequences to the employee and the company. However, such employees may not have the funds to purchase the equity outright, and therefore, some firms offer employees the opportunity to borrow funds from the company for the purchase of their equity and to pay back the loan in installments over time.
Once granted, any future appreciation in the value of the equity interests may qualify for capital gains treatment if certain holding period requirements are met.
Profits interests, on the other hand, may be more appropriate in circumstances where the advisory firm has already built up significant value (thus making it undesirable for the employee to participate in the value of equity already created), where employees do not have the funds to purchase equity in the firm, or where the advisory firm is still uncertain as to whether the employee should be granted full equity in the firm.
Profits interests are typically not taxable at the time of grant. Instead, employees are taxed only when they realize the economic benefits, usually when they receive distributions or sell their interests. Gains from profits interests are often taxed at the favorable capital gains rates, provided the holding period requirements are met.
What Are Common Terms Associated With the Granting of Equity of Profits Interests?
The grant of equity or profits interests is typically accompanied by terms and conditions that should be customized to meet the firm’s and employee’s needs.
First, many grants of equity or profits interests do not entitle the grantee to immediate access to the equity or profits interests. Rather, such equity or profits interests may “vest” over time in order to incentivize the employee to stay and to align the employee’s interests with those of the firm.
Vesting is the process by which employees earn the right to their equity or profits interests over time. If employees depart from the firm before the equity or profits interests vest, the employee typically will lose the right to receive any unvested equity or profits interests.
Vesting schedules can be time-based or performance-based, and they are a critical component of equity compensation plans. Time-based vesting grants employees ownership rights based on the amount of time the employee remains with the firm. In most circumstances, vesting is “straight-line,” meaning that employees are granted a percentage of their equity in equal installments over a period of time as long as they continue to work for the firm. In some circumstances, equity grants may be subject to “cliff vesting,” where employees receive all of the equity granted at a single point of time in the future. Time-based vesting encourages employees to stay with the firm, fostering long-term commitment. Time-vesting arrangements are relatively straightforward to implement and administer, as vesting occurs automatically upon certain milestone dates. However, time-vesting arrangements do not take into account performance of the employee – only continued employment of the employee with the firm. However, the company can always terminate an employee in the event of underperformance, thus causing employees to leave unvested equity on the table.
Performance-based vesting requires employees to meet specific performance criteria or targets before earning equity or profits interests. These criteria can include financial metrics, client acquisition goals, or other performance-related benchmarks. Performance-based vesting aligns equity compensation with the firm’s strategic objectives. Performance-based vesting links ownership to performance, motivating employees to achieve strategic goals. Such arrangements also encourage employees to prioritize activities that benefit the firm’s growth and profitability. However, developing and monitoring performance criteria can be complex and may require ongoing assessment. Additionally, determining whether performance goals are met can sometimes be subjective and lead to disputes with employees.
Whether equity or profits interest vest over time or based on achievement of performance based targets, firms and employees should be aware that employees may be taxed on the fair market value of the grant of equity or profits interests either at the date of grant or vesting, and so it’s vital for employees to understand the difference and to make appropriate tax elections, if so desired, based on advice of their financial advisors or accountants.
In addition to vesting terms, equity compensation plans often include provisions detailing what happens to an employee’s vested equity or profits interests upon departure from the firm based on whether the employee departed for “good reasons” or was terminated for “cause.” As noted above, unvested equity or profits interests are typically forfeited by employees, regardless of the reason for the departure.
Employees will typically not be required to forfeit their vested equity or profits interests if they depart for “good reasons.” Common “good reasons” could include a departure due to a significant reduction in the employee’s responsibilities or compensation or a relocation of the employee far from the employee’s original place of work.
It’s vital for firms to carefully define “good reasons” as proving “good reasons” can be complex and subject to interpretation, leading to potential disputes down the road where employees desire to fight to keep their vested equity upon departure from the firm.
On the other hand, employees that depart or are terminated for “cause” typically forfeit their vested equity or profits interests. “Cause terminations” refer to circumstances under which an employee’s equity or profits interests are forfeited upon departure for reasons such as misconduct, violation of non-compete agreements, or breach of fiduciary duties.
Equity compensation tools are powerful instruments for investment advisers seeking to retain key employees and align their interests with those of the firm. Whether through equity or profits interests, investment advisers can create a mutually beneficial relationship that encourages long-term commitment and motivates employees to drive the firm’s success.
Understanding the pros and cons of these compensation tools, the tax considerations, vesting options, and forfeiture provisions is essential for structuring effective equity compensation plans. Careful planning and clear communication are key to creating equity compensation programs that benefit both the firm and its dedicated employees, ultimately contributing to the growth and sustainability of the investment advisory business.
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