Attracting Top Talent Through Equity Based Compensation Plans

By Team HRH | September 8, 2017
Jason Gagnon and Court Klein

By: Jason Gagnon, CPA and Court Klein, CPA

With New Hampshire’s unemployment rates at historically low levels and competition from Massachusetts businesses, companies in New Hampshire are struggling to attract and retain top talent. A tool that has been popular as a means to accomplish the goal of bringing top talent to an organization has been the use of equity based compensation plans. Frequently used in the technology industry to align the goals of employees with the goals of shareholders, equity based compensation can be an attractive perk that draws top talent to an organization and reduces the risk of employees abandoning the organization.

Before deciding if equity based compensation is right for your organization, it’s important to understand why an employee would find it attractive. Employees view the opportunity to financially share in the growth success of an organization in a positive light. It makes them feel as if they are truly a part of the organization and not just an employee. They enjoy the idea that the effort they put into the organization can be compensated by the growth of the organization and therefore an increase in the value of the equity they received. With that said, if an organization is not in a position to see growth, then equity based compensation is not as attractive and other methods should be considered.

Equity based compensation comes in many forms and selecting the right one for your organization depends on several factors. The most common questions we receive around structuring these plans include:

What is the impact on liquidity of the organization?
Will this dilute my ownership?
What are the initial and ongoing costs of structuring these plans?

Answers to these questions depends on the type of equity based compensation that is used. Some of the more common and useful forms of equity based compensation are stock options, restricted stock, and phantom stock.

Stock options:

Most have heard the term “stock options” before, but some may not know exactly what they are. A stock option is a right to purchase stock in a company at a future date at a set price. This form of equity based compensation provides the employee with value only if the value of the stock exceeds the price that they are required to pay for the stock. Many plans require that the price to be paid upon the exercise of the stock option (the price to obtain the stock) to be equal to the fair market value of the stock on the date that the options are granted to the employee.

Restricted stock:

Restricted stock is an award of stock or the opportunity to purchase stock (often at a reduced, fixed price) that is typically subject to a vesting requirement. If the recipient fails to vest, they must return any unvested stock. The most common vesting requirement is time. For instance, a restricted stock award might vest over a three-year period with the recipient earning the right to keep the awarded shares if they maintain employment for the entire period or they may earn portions of the total award over each of the three years. Vesting requirements can be widely defined and there is significant flexibility in determining the appropriate vesting requirement.

Phantom stock:

Phantom stock is a right to receive a future cash or stock payment based on a measurement of the increase in the value of the company’s stock. In short, this is a form of bonus plan that is directly tied to the increase in the value of the stock. The date or events that trigger payment is completely up to the company. Many of these plans typically tie the payment to an event, such as a business sale or an initial public offering. Since these are bonus plans, they are very flexible and have little regulation. Another benefit to these plans for the company is that should the triggering event not happen before the termination of the relationship with the employee, often no payment is required. The goal is to keep key employees with the organization through the date of a major event so that they may help grow the business and still allow them to share in the success. Phantom stock plans take many forms and include plans such as restricted stock units or stock appreciation rights.

Answers to the most common questions listed above are:

What is the impact on liquidity of the organization?

  • Stock options – Liquidity is increased since the employee is often required to pay for the stock when they exercise the option.
  • Restricted stock – Typically there is little to no effect on the liquidity since minimal amounts of cash are involved. Usually the discount on the right to purchase the stock is so insignificant that it would not be a significant factor in the decision making process.
  • Phantom stock – Since these are bonus plans, unless they are paid fully in stock, the organizations liquidity will decrease as a result of these plans since cash will need to be paid out to settle the liability.

Will this dilute my ownership?

  • Stock options – When the option is exercised (thereby obtaining the stock), the employee becomes an owner in the organization. As a result, the owners of record immediately before the exercise are diluted by the new owners.
  • Restricted stock – Yes, as the recipient vests, their ownership rights typically equate those of the other shareholders.
  • Phantom stock – No, unless they are settled in stock. These plans typically are bonus plans that are tied to the value of the stock rather than granting ownership in the organization. As a result, there is no dilution.

What are the initial and ongoing costs of structuring these plans?

  • Stock options – From a financial standpoint, these types of plans generally are the most expensive. Initially the legal costs to implement the plan can be significant since these plans can be complex. On an ongoing basis, the organization will need to have valuations performed to determine the fair market value of the stock if an option holder exercises their option into stock. We typically see stock option plans implemented when startups obtain their first significant seed or Series A funding round or when a more mature company (with liquidity) wants to provide a more traditional compensation plan to employees for recruiting purposes.
  • Restricted stock – Like stock options, these plans can be very complex and as a result can have legal expenses associated with the startup of the plan. However, on an ongoing basis, the plan can be structured in a way that reduces the financial burden of having multiple valuations done. Additionally, if the recipient of the stock makes an election under IRC section 83(b), the need for ongoing valuations is significantly reduced. After the initial setup of the plan, the ongoing costs are significantly less than stock options. We typically see startups with a very low initial valuation use restricted stock to attract and retain the first few key employees.
  • Phantom stock – Typically the costs associated with this type of plan are very low as they may only require an initial cost to structure the plan and if they are tied to a triggering event such as a sale or initial public offering, a valuation would not be necessary since the value would already be established. Due to their flexibility, simplicity and non-dilutive features, we’ve seen phantom stock plans in many different types of organizations from startups to mature companies.

Additionally, it’s important to consider the issues that can result from having additional owners in your organization. Many businesses that are owned and operated by a single individual will find themselves having new responsibilities and obligations when additional owners are added. In the event of a sale or merger, additional owners can make it difficult for transactions to be completed.

There are many other issues and considerations that need to be considered in determining if equity based compensation is right for your organization and in selecting the appropriate form. It is extremely important to consult your tax professional and your attorney before attempting to establish any of these plans to weigh all the advantages and disadvantages.

Have additional questions? Contact us. We’d be happy to help.

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