Profit and capital sharing in the partnership and LLP model

The flexibility inherent in the partnership and limited liability partnership (LLP) model is perhaps most prominently highlighted through the vast range of profit-sharing mechanisms available to its participants. Indeed, this is one of the key benefits of the use of an LLP over a limited company. Pretty much the only requirement is, in fact, that all partners/members must participate with a view to profit.

At its most basic level, profit sharing arrangements between partners/members are by reference to fixed percentages, which may or may not be equal. In a simple structure, often this revenue proportion will equal the respective equity proportion held by of each of the members, replicating a share ownership structure. This principle forms the basis of a traditional ‘lockstep’, a system of profit sharing historically prevalent amongst professional firms. Partners buy (generally funded through a partner loan facility with the partnership’s bank) points in the partnership (added to their capital accounts) and the annual profits are shared pro rata to the points held by each partner out of the aggregate points held by all of the partners. On retirement, the capital was repaid to the exiting partner (or used to repay the bank funding) without uplift, the investment return being made throughout the partnership tenure.

Variations of lockstep

In its purest form, lockstep creates a hierarchical firm, whereas many ambitious, younger partners were calling for a meritocracy, emulating an American style of profit sharing; and whilst that was not without its own drawbacks, the lockstep model fell out of favour. Most professional practices now operate a hybrid-lockstep model, with a graduated equity entitlement but with profits shared via a combination of a base profit entitlement (akin to a salary), a discretionary performance based additional profit share, and a share of the residual profits divided according to their equity interests.

However, neither of these models fully exploit the opportunity to delink profit from equity rights nor maximise the ability to craft bespoke entitlements for partners/members. Fund managers operating through an LLP may hold a similar equity interest in the business but will frequently be entitled to a share of the LLP’s annual profits equal to the profit generated by their internal book of business, taking into account turnover, expenses and trading losses attributable to their own activities.

Profit-sharing vs capital-sharing arrangements

Both partnerships and LLPs are tax transparent, meaning revenue profits and capital gains are taxed in the hands of the partner/member on a current year basis; this remains the case even if the profits are retained or reinvested in the business. It is common in a fund management LLP agreement to implement a method of profit retention for reinvestment in the underlying assets management by the LLP, which is used to create a system of carried interests which vest over time. An investor, particularly in the private equity sector, will be looking to generate an investment return with a profit share that replicates repayment of its original investment together with an annual return and exit strategy. This arrangement is likely to be entirely distinct of the profit-sharing arrangements between the other partner/members.

The same level of flexibility exists in relation to capital sharing arrangements. The capital in=capital out traditional structure is unlikely to be attractive to a PE investor and indeed in professional partnerships, this is looking increasingly outdated.

Professional services businesses are now worth more than the sum of individual partners – brand loyalty, investment in infrastructure (particularly lawtech products), and subsidiary businesses, all add to the value of the firm, and which the partners will wish to access on an exit or a sale. Synthetic goodwill and anti-embarrassment provisions, for example, are finding increasing favour with founding partners. Often complex, these types of provision remain a relative rarity, but partners and members are well advised to explore the benefits of these arrangements with their advisors.