Many private business owners and CEOs live with regret. They bemoan sharing equity with one or more employees and feel like they opened a Pandora’s Box by doing so. “I didn’t want to lose this person and they wanted equity—so I gave them stock,” is the common rationale offered when explaining why they expanded the ownership pool. In other words, there was urgency to retain or attract a key person—and an assumption was made that they would lose that talent if they didn’t grant him or her shares. Expediency ruled the day.
So, why the regret? The source of their distress is usually one or more of the following issues:
- The level of employee or company performance (or both) doesn’t justify the dilution of equity.
- There is no effective means of buying out minority shareholders if equity sharing becomes no longer merited, viable or the employee leaves the company.
- Employees receive no payout unless there is a sale or termination of employment—making it difficult to provide financial incentive and recognition for meeting or exceeding periodic results thresholds.
- Employees are privy to financial information owners prefer not to share.
A large percentage of enterprise leaders who share stock with employees do so because they aren’t aware of a better alternative. They assume equity sharing is essentially a requirement for compensating certain positions or attracting high-level talent. And in some instances, that may be true. However, more often than not, when a current or potential key person is asking for stock, what they’re really requesting is a means of participating in the value they help create. In doing so, they too assume equity sharing is the only solution because no one is talking about another option. So the negotiation gets fixated on the subject of equity sharing.
In reality, there are alternatives to sharing stock that can be better for both company owners and employees. If you lead a private company, here are six LTIP strategies you should consider before deciding to give stock away:
A Profit Pool is the simplest of all long-term incentive plans. The sponsoring company selects a percentage of annual profits to contribute to a pool for employees. The percentage may reflect an amount above a minimum profit threshold. The pool contribution is then allocated among the participating employees. The company may be discretionary when determining the allocation formula. This process continues annually for several years. Let's assume it's a three year period. At the end of year three, the company would pay one-third of the accumulated value to each employee and carry the remaining two-thirds forward. The idea is that each employee's pool would grow as profits grow. Likewise, their annual payment (beginning after the third year) would also increase. When employees leave the company they would customarily forfeit any remaining amount. The pool may or may not be credited with interest.
Performance Unit Plan (PUP)
A Performance Unit Plan (PUP) allows the sponsoring company to select two or more financial metrics to be used to value units that are awarded to employees. The units will be converted to cash payments at a future time (commonly three or four years). For example, a company establishes a unit price of $100 (the determination of the starting value is completely arbitrary). Next, the company creates a table that illustrates targeted improvements in two important metrics - such as margin improvement and sales growth (any metrics will do - even department level ones). The table will show the employees how much the value of the PUPs would grow to if the specified metrics are achieved. The employees are rewarded for meeting the targets outlined. Commonly, the company will award new PUPs each year with either the same or different targets. Alternatively, new PUPs may be issued at the end of the first payment, thus beginning a new cycle.
Strategic Deferred Compensation
A Strategic Deferred Compensation Plan is a performance-based retirement program. Individual nonqualified retirement accounts are created for the plan participants (typically executives and senior managers). The company annually establishes performance targets which, if achieved, will lead to contributions to the participants' accounts. Better results lead to higher contributions. Once the contribution has been made, the employees are given the ability to self-direct their account allocation among a variety of investment options. The investments are handled in the same way as a standard deferred compensation plan and are subject to the same limitations and risks. Plan accounts are also typically subject to vesting schedules.
Full Value Phantom Stock
A Full Value Phantom Stock Plan is a deferred cash bonus program that creates a similar result as a restricted stock plan. The sponsoring company determines a phantom stock price through an internal or external valuation of the company. Employees are awarded some number of phantom shares that carry specific terms and conditions. At some point in time, active plan participants will receive a cash payment equaling the value of the original shares plus the appreciation thereon. For example, assume an employee receives 100 phantom stock with a starting price of $10. At a pre-determined future date, the company will calculate the value of the phantom stock price and pay the employee the full value. Assume, for our example, the share price grows to $18. The company will pay the employee $1,800. Phantom stock plans do not result in shareholder dilution because actual shares are not being transferred. Employees do not become owners. Instead, they are potential cash beneficiaries in the underlying company value. Phantom shares result in ordinary income taxation to the employees when they turn into an actual cash payment. Click here for comprehensive information on phantom stock.
Performance Phantom Stock
A Performance Phantom Share Plan contains two distinct performance-based elements. First, employees must achieve certain pre-determined performance targets. Should they do so they are awarded phantom shares. The number of shares may vary by employee and by the degree to which the targets were achieved. Financial targets might include such measures as company pre-tax Income or EBITDA. The second performance element relates to the potential improvement in value that may come through phantom stock value appreciation. Once awarded, the phantom shares may still remain subject to vesting schedules or other restrictions. The tax effect to employees is identical to that of phantom stock.
Phantom Stock Options
A Phantom Stock Option Plan is a deferred cash bonus program that creates a similar result as a stock option plan. The sponsoring company determines a phantom stock price through an internal or external valuation of the company. Employees are awarded some number of phantom options that carry specific terms and conditions. Should the company phantom stock appreciate over time, employees will receive a cash payment equaling the difference between the original price and the appreciated price. For example, assume an employee receives 100 phantom stock options (PSOs) with a starting price of $10. At a pre-determined future date the company will calculate the value of the phantom stock price and pay the employee any positive difference. Suppose, in this example, that the share price grows to $18. The company will pay the employee $800. Phantom options result in ordinary income taxation to the employees when they turn into an actual cash payment.
There certainly is no “one size fits all” when it comes to creating a plan that will encourage long-term value creation in a business and then effectively reward it. The primary role of any value-sharing approach is to define and give clarity to the stewardship an employee has for outcomes upon which sustained company performance depends. Therefore, if you start by identifying those roles and outcomes, the type of plan that will best reinforce them will become more apparent. If improved profits are the priority result, then perhaps a profit pool is the best solution. If you have senior people who need to drive the business model and strategy on multiple levels that in turn fuel the growth trajectory of the company, then some form of phantom stock might be most suitable. And so on.
The moral of the story is that if you are a CEO or private business owner, you don’t have to live with the regret that can come with sharing stock. There are other ways to share value with key contributors. More times than not, one or more of the six LTIP alternatives just discussed will work better for both shareholders and employees.