Recently, there has been a surge of interest surrounding OpenAI’s viral employee compensation packages. These packages notably incorporate equity grants known as profit participation units (PPUs), and are sparking widespread curiosity across Silicon Valley. If you’re interested in learning more about PPUs and other types of equity grants more commonly seen at private companies in the tech world, and the distinctions that set them apart, this blog is for you.
Profits Interest Units (PIUs) and OpenAI’s Innovative Path
OpenAI’s PPUs are reportedly a type of equity grant more commonly referred to as profit interest units (PIUs). PIUs are generally granted by limited liability companies (LLCs) and limited partnerships (LPs), and are typically seen at firms structured or taxed as partnerships, but are less common at Silicon Valley’s tech companies. Why? Because VC-backed companies are generally set up as corporations and usually grant stock options or restricted stock units. PIUs also have many similarities to other types of equity grantable by LLCs and LPs, such as unit appreciation rights and phantom equity.
PIUs typically give the recipient a percentage of the value of the company upon liquidation, usually above a threshold level (sometimes called a hurdle). They may also be structured to provide the recipient with regular distributions of profit. As is common for many forms of equity grants, companies will typically attach a vesting schedule, often a four-year time-based schedule, as appears to be the case for offers at OpenAI. The issuer can also set terms around transferability, forfeiture, and voting rights. One benefit of PIUs is that the recipient does not have to exercise the grant or pay anything for the PIU. Additionally, these interests are generally not taxed as they vest, and any gains eventually realized will be taxed at capital gains rates, which are typically lower than ordinary income rates.1
A PIU can mean different things at different companies and the structure allows for customization. For instance, grants may entitle the recipient to value generated at the company prior to the grant date, or only profits generated after the grant or following an exit event, and may limit a recipient’s right to share in proceeds above a certain threshold. At OpenAI, which has been uniquely structured to cap profit distributable to equity holders and route additional value to the company’s original nonprofit arm2, the value of the PPUs is reportedly capped at 10X their original value.
PIUs can be complex and may not be as familiar to many investors, lawyers, and advisors as other types of equity grants. Companies considering granting PIUs, and their employees, should be careful to consider the tax and employment implications. For example, employees receiving PIUS should keep in mind that they’ll likely need to file an 83(b) election3 within 30 days of receiving a grant subject to vesting, in order to obtain favorable tax treatment.
The Varied Landscape of Equity Grants
The realm of equity grants is rich and diverse, with different types of grants that can offer employees a stake in their company’s success. Among the various forms, stock options stand out as a prominent and well-known type of equity grant.
Stock options give the holder a right to buy shares at a fixed “strike price,” which must be at least equal to the fair market value of the company’s shares, often known as the 409A value. Stock option holders have no obligation to exercise their stock options, but will only own the shares if they exercise. Option-holders lose the right to buy the underlying shares if the grant expires before they exercise. Stock options typically become exercisable or “vest” in accordance with predetermined periods set at grant (generally four years at most companies) and have a fixed time frame in which they can be exercised, often expiring within a set period after the employee leaves the company and always within ten years of the grant. There are two primary types of stock options, incentive stock options and non-qualified stock options.
- Incentive Stock Options (ISOs): ISOs can only be granted to employees and have certain benefits, namely that the difference between the strike price and the fair market value is not taxed upon exercise (unless the holder has AMT Tax, which is not uncommon for option recipients). Instead, if certain holding period requirements are met, the gain upon the subsequent sale of the stock is treated as a long-term capital gain, which is typically a lower rate. ISOs are subject to specific rules regarding exercise periods and holding periods to maintain the preferential tax treatment.
- Non-Qualified Stock Options (NSOs): NSOs differ from ISOs in terms of both tax treatment and eligibility. NSOs can be granted to individuals other than employees, such as consultants. When an NSO is exercised, the gain between the fair market value at the time of exercise and the strike price is taxed as ordinary income. Assuming the shares are not sold in connection with the exercise, future gain between the exercise price and the price on a subsequent sale of the stock will be taxed at capital gains rates.
Diving into RSUs and Restricted Stock
While stock options used to be king in Silicon Valley, RSUs have grown in popularity in recent years. Restricted Stock Units (RSUs) entitle the recipient to receive shares of company stock at a future date, subject to vesting conditions. Unlike stock options, RSUs do not require the recipient to exercise or purchase the shares. Instead, upon vesting, the recipient receives the underlying shares and is taxed at ordinary income rates on the market value of the shares. In Silicon Valley, private companies typically grant double trigger RSUs, which vest upon completion of two triggers – a set period (typically four years) and a liquidity event, such as an IPO. Like stock options, RSUs typically carry an expiration date (frequently set at 7 years from grant), which has posed a challenge for many late-stage companies in recent years. RSUs are common at later-stage companies where the high fair market value of the company’s stock can make stock options prohibitively expensive for employees to exercise.
Restricted Stock (which is sometimes confused with RSUs) is typically only granted to founders or early employees, and is directly purchased by the recipient, typically at a very low price while the company is still in its early stages. These shares are issued outright, but are often subject to a vesting schedule and will be forfeited or can be repurchased by the company (often at the original purchase price) if the vesting period isn’t met or on certain conditions. Restricted Stock can be favorable from a tax perspective. If the recipient files an 83(b) election within 30 days of the grant, they can elect to be taxed on the shares at grant instead of vesting, saving substantial taxes, assuming that the shares increase in value over time.
The Future of Employee Equity Grants
Looking ahead, publicity around OpenAI and their PPU grants could encourage more companies to consider new structures, terms, and approaches when it comes to employee equity grants. One thing we don’t expect to change is the importance of understanding equity grants and handling them strategically. At Liquid Stock, we provide option-exercise and liquidity solutions that can help equity holders get the most out of their equity awards. Reach out to our expert team to learn more.
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