Introduction
As the marketplace continues to grow more competitive, companies are often searching for creative ways to compensate their key people. By simply relying on base salary and an annual bonus to attract and retain critical employees, companies may find themselves at a competitive disadvantage in today's environment. This struggle to remain competitive, together with increasing recruiting costs, has prompted many companies to explore additional compensation methods. While there are many forms of incentive compensation available, this article will focus on equity based incentive compensation, both real equity (actual stock or stock options in the company) and phantom equity (a contractual right which mirrors real equity).
Real Equity
Although there are a variety of ways a company can grant real equity to key employees, the two most common forms are stock options and restricted stock. In many cases, the equity granted is non-voting, has the same dividend and distribution rights as the company's existing class of equity, and is often subject to repurchase by the company in the event the key employee's employment with the company is terminated.
Stock Options
Stock options provide the employee with the contractual right to purchase a certain number of shares of stock at a fixed price. The exercise price is typically equal to the value (either book value or fair market value) of the shares on the date of the grant. Employees are often required to hold the options for a period of time (five years from date of grant is common), although each individual company may determine its own set of parameters with respect to the vesting of its stock options. Once vested, the employee is free to exercise the options.
In the event the value of the company's stock increases after the options are granted, the employee can exercise the options at the lower stock price (the price on the date of the grant) and then sell the stock at the higher price on the exercise date. In many privately held companies, a key employee will not exercise the options until the company is sold because exercising the options will require an outlay of cash, and the employee will likely not want to part with cash unless he or she is assured that the stock can be sold. If the key employee exercises the options contemporaneously with a sale of the company, the employee will recognize a gain equivalent to the spread between the sale price of the stock and the exercise price. This spread is taxable to the key employee at the rates applicable to ordinary income.
A key employee may be inclined to exercise the options before the sale of the company if the stock is subject to an automatic repurchase by the company on a certain date in the future (usually in connection with the termination of the employee's employment). The promise of a buyback by the company will assure the key employee that their stock can be sold and, therefore, may entice the key employee to exercise the options early. At the time the key employee exercises the options, the key employee would be taxed (at ordinary income rates) on the spread between the value of the stock at the time of the exercise and the exercise price. Once the stock is sold, the spread between the sale price of the stock and the value of the stock upon exercise would be taxed at long-term capital gains rates, as long as the stock was held for more than one year from the date of exercise. As rates on long-term capital gains have recently declined to 15 percent, any key employee in a high tax bracket (e.g., 35 percent) would recognize significant tax savings.
It should be noted that there are two types of stock options available to companies: statutory and non-statutory. Statutory options are also referred to as "qualified stock options" or "incentive stock options" and are those options issued in compliance with the Internal Revenue Code. These options, although subject to a number of restrictions, offer potentially significant tax advantages to the option holder. The employee would not pay regular income tax upon the exercise of the statutory options, as tax liability is only incurred when the statutory options are sold in connection with other dispositions or transfers. If the employee holds the stock for two years from the grant date and one year from the exercise date, the increase in the value during that period is taxed at long-term capital gains rates. If the employee does not hold the stock for such requisite period, then the increase in the value during that period is taxed as ordinary income.
Companies often find it difficult or impracticable to implement a qualified stock option plan because of the many restrictions associated with this type of program, and therefore opt to issue non-statutory or "nonqualified" options. Non-statutory stock options differ from statutory stock options in that, upon the exercise of the options, the employee recognizes taxable ordinary income on the difference between the fair market value of the stock and the exercise price paid for the stock. If the employee sells the stock acquired in the option, the employee is taxed at capital gains rates on any increase in the stock price since the date of exercise (short-term rates if sold within one year from the date of exercise, and long-term rates if sold after one year from the date of exercise).
Restricted Stock
Restricted stock is "restricted" because it is subject to forfeiture if the key employee terminates his or her employment before the stock has vested. Restricted stock can be sold to the key employee for any price not exceeding its book or market value. The restricted stock could vest over any period (again, five years is common) and would be taxable to the employee upon vesting, unless a so-called 83(b) election is made at the time the restricted stock is granted. An "83(b) election" must be made within 30 days after the restricted stock is transferred to the key employee and, if made, the key employee must pay tax on the spread between the value of the restricted stock at the time of the grant and the price paid for the restricted stock. The effect of making an 83(b) election is that subsequent appreciation in the stock will be taxed only upon the sale of the stock (not upon vesting) and at long-term capital gains rates if the sale occurs more than one year from the date of the 83(b) election. Whenever the stock is sold, the value of the stock would be taxed to the key employee at long-term capital gains rates, assuming the sale occurs more than one year from the date of vesting or, if applicable, the date of the 83(b) election.
By implementing equity based plans, companies are able to compensate their key people competitively and can achieve a common goal of maximizing profitability and growth, while at the same time not requiring the company to immediately deploy cash. Increased morale among the employees is also achieved as key employees who hold the restricted stock or stock options view themselves more like owners, thus creating a stronger bond between themselves and the company. Finally, since equity ownership in the company would not be broad-based, an award of actual equity would likely be viewed by these employees as prestigious.
The principal disadvantage of offering equity to a key employee is that once the key employee is an equity holder, the key employee may be entitled to examine the books and records of the company, including the articles of incorporation, by-laws, accounting records, financial statements, tax returns, and the minutes of meetings of the board of directors. Another disadvantage of offering stock to key employees is that the other shareholders will suffer dilution when the additional stock is awarded, although the dilutive effect may be offset in large part if the awarded stock is non-voting and subject to a buyback.
Phantom Equity
Phantom equity plans allow key employees to receive theoretical equity that cannot be exercised until some time in the future. Phantom equity is not real equity; it is simply a contractual right to receive cash based on a stated formula created by the company ownership and/or management. Since it is a contractual right, it can be customized to accommodate almost any performance goal. In its most basic form, it can substantially replicate real equity, either in the form of an outright grant or subject to a vesting schedule, and once vested, it could give participants the right to receive year-over-year cash bonuses equivalent to the amount of dividends and distributions they would have received had they been real shareholders. These year-over-year cash bonuses can also be tied to the specific performance of a division or an operating unit of the company, rather than to the entire operation. If the company were sold, the phantom equity can even give the key employees the same portion of the sales proceeds they would have received had they held real equity. Most phantom equity plans provide for forfeiture of the phantom equity upon the termination of employment of the key employee.
One of the primary advantages of phantom equity is its flexibility. Phantom equity plans can be tailored to accommodate the objectives of both the company and the company's key employees. In addition, since phantom equity is a contractual right, holders will not have a legal right to inspect the books and records of the company. Finally, key employees are not required to make a cash outlay in connection with their award of phantom equity.
A significant disadvantage of phantom equity is that the participating key employees may not feel like they are true shareholders of the company. Some key employees place a great deal of importance on being a "shareholder" in the company and may not be satisfied with a grant of phantom equity. Another disadvantage is that from the key employee's standpoint, holders of phantom equity do not have voting rights as a true shareholder and all cash received, whether in the form of bonuses or sale proceeds, is treated as ordinary income rather than capital gains.
Conclusion
In today's competitive marketplace, it is important for companies to be proactive in their approach to attract and retain qualified employees. In many industries, both understanding and deploying appropriate incentive compensation programs can often mean the difference between success and failure. These programs range from standard company-wide retirement and profit sharing plans to specialized executive compensation arrangements structured to encourage and reward highly compensated and skilled executives. Equity based compensation programs, if implemented properly, provide a popular approach for companies to accomplish these goals. Regardless of the equity based incentive compensation method chosen, these key employees will be offered an incentive to work diligently, increase the company's performance and stock price, and remain with the company to participate in its success.
Published June 1, 2007.
