As we start the new year, I’ve been receiving a lot of questions about how companies can differentiate themselves in compensation planning. This afternoon I’ll be presenting a series of creative techniques to the Private Directors Association, the only national association dedicated to using governance strategies as a means of growing and sustaining private companies’ success. In the spirit of that talk, I’d like to outline a few of the techniques I’ll be discussing later today. Each of these has its strategic merits, and it’s important that any company understand the benefits and drawbacks of these compensation tools.
Phantom Stock Plan: Designed to give certain employees (typically senior management) the benefits of a stock ownership plan without actually giving them company stock, these plans are sometimes referred to as shadow stock. This compensation benefit involves giving out “fake stock,” crafted to follow the price movements of the company’s actual stock, thereby paying out the resulting profits. Phantom stock allows private businesses to incentivize employees while minimizing the number of actual shareholders, preventing the dilution of equity that giving out actual stock would create. However, these payments are taxed as ordinary income for the recipient, rather than capital gains, and may disrupt a company’s cash flow if proper planning isn’t in place.
Stock Appreciation Rights: Also known as SARs, this benefit is similar to phantom stock, in that it links compensation to a company’s stock price without conferring actual shares on an employee. The primary difference is that it defines a predetermined period of time for when the requisite appreciation will be deemed payable. Unlike employee stock options, SARs do not require the payment of an exercise price, meaning the employee can receive the increased sum either in stock or in cash. Similar to phantom stock, private companies often utilize this option to connect performance with pay, while not diluting equity.
Profits Interest: A type of equity right, profits interests are based on the future value of a partnership, typically given to individuals as an award for their service to the entity. It involves giving an employee a percentage of profits, without requiring the employee to put up capital. This tool is typically used when funds are limited, such as with a start-up LLC, as a means of incentivizing employees.
Actual Ownership: Stock options allow employees to purchase a specified number of company shares at a fixed price, also known as the grant price. These options are typically separated into incentive stock options and non-qualified stock options. The former involves favorable tax treatment by the IRS, with the value neither taxed to the employee nor deducted by the employer. The latter is typically used to reward key employees, since there are no statutory limits on this option, and they can be granted to anyone who provides services to the business, including non-employees like independent contractors, advisors, and members of the board of directors. Both of these options involve serious tax planning on the front end prior to electing them as compensation benefits.
Restricted Stock Ownership: This type of stock is issued through a vesting plan and distribution schedule, after a select employee has hit certain performance or tenure milestones. There is no value to this ownership until vesting has occurred, at which point they are assigned a fair market value. Taxably, they are considered income after vesting, and so a portion of the shares is withheld from payout in order to fund the necessary tax, with the employee receiving the leftover shares and all such selling rights to them.
Voting v. Non-Voting Shares: As you can probably guess, these forms of compensation hinge on whether a shareholder-employee has a say in shaping the board of directors or other special business issues. Voting stock gives a holder the ability, but not the obligation, to chime in. However, depending on the proxy form involved, an election to abstain from a vote may result in a default choice. A non-voting share is exactly that: one that does not grant any right or ability to weigh in on any issue. It’s important to note that neither type of share grants a holder the ability to vote on day-to-day operations.
Employee Stock Ownership Plan: Also known as ESOPs, these qualified plans grant workers an ownership interest in the form of stock, and they are often used as a corporate-financing strategy to synchronize employee motivations with shareholders’ interests. They provide several tax benefits for the company, and organizations typically tie plan distributions to vesting periods. While the reasons for electing an ESOP vary tremendously, we often see them as a way to make succession planning easier in a closely held company, as they are set up as trust funds and can be funded in a number of different ways. Should you elect an ESOP, it’s critical that you understand the nuances of the formation and its subsequent strategic advantages and disadvantages.
Deferred Compensation: This type of compensation usually includes retirement plans, pension plans, and stock-option plans. Unlike immediate compensation tools, deferred compensation sets aside a pot of money to be paid at a later date, thereby deferring income tax on it until it’s paid out. Deferred compensation, separated into qualifying and non-qualifying options, requires financial planning on the part of the employee, as a number of tax-related factors can influence whether it makes sense to elect such plans.
While there are certainly many more options – both well-established and ones that your legal advisors can craft based on your specific needs and goals – it’s important to remember that employee compensation is not a one-size-fits-all approach. It requires careful planning, methodical execution, and a series of trusted advisors to guide you along the way. As always, if you’re interested in any of these options or just want to learn more about what they are and how they could impact your organization, let’s set up a time to connect.