Employee Incentives – Part 2
The Anatomy of a Deal Newsletter November 22, 2019
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
Last month, we talked about some of the preliminary considerations in making an equity award. With those general principles in mind, this month we’ll talk about some of the most typical equity compensation alternatives that are available once you’ve decided to provide some sort of equity-based award. Of course, this isn’t everything, but it’s a good start.
So, let’s start with the “true equity” arrangements. And the most widely-recognized from of equity award is…
Options are the equity award with which people tend to be most familiar. Options are pretty simple. The recipient gets the right to buy equity at a future date using today’s price. So, as long as the equity appreciates in value over time, the recipient gets the benefit of buying the equity at a discounted price.
If the issuer is a corporation, there are two flavors of options available: incentive stock options (ISOs) or nonqualified stock options (NQSOs). Economically, both of these work the same way as described above, but they have very different tax treatments.
- ISOs are not taxable to the recipient at the time the option is granted, or at the time the option is exercised. Instead, the ISO becomes taxable only when the stock received upon exercise is ultimately sold. At the time of sale, the difference between what the recipient receives in the sale and the amount he or she paid for the stock by exercising the option will be taxed at the more-favorable capital gains rates (assuming the required holding periods are met).
- In contrast, NQSOs are taxed – at latest – at the time of the exercise of the option. And, to make things worse, they are taxed at the higher ordinary income rates. So, while the recipient still has the same economic benefit, the recipient suffers two distasteful tax impacts relative to the ISO: recognition of taxable income at a time when he or she may not have actually received any cash with which to pay it (the dreaded “phantom income”), and a tax rate that is higher. The silver lining is that, after the tax is paid at exercise as described above, subsequent appreciation occurring thereafter will be taxed upon ultimate sale at the capital gains rates.
So, why not only grant ISOs? Unfortunately, there are limits on who can receive ISOs, and how many ISOs they can receive. In some cases, awards are structured to grant as many ISOs as possible, but the excess (if any) will be NQSOs.
If your company is not taxed as a corporation, then the tax treatment of any type of option will follow that of the NQSO.
Although options are perhaps the most well-known form of equity award, they’re not nearly as common as they used to be. That’s because there are other alternatives that may be more attractive in many cases.
Straight equity grants are very simple. If I want you to own 5% of the equity of the company, I just issue you equity equal to 5% of the company’s outstanding stock.
The tax treatment of this award is equally simple. Whatever that equity is worth is immediately taxable to the recipient at the ordinary income rates. In our example, if the company is worth $1 million, then the 5% stock grant will result in taxable income of $50,000. This could be problematic because – like NQSOs – the recipient doesn’t actually have any cash with which to pay the tax (phantom income!).
Unfortunately, there’s no easy way around this problem. There is, however, an alternative that allows us to spread out the tax hit: restricted equity. If we take the same 5% equity grant but vest the award in 1% increments over 5 years, then only $10,000 is taxable in the first year, which is a little more manageable for the employee. This also provides a nice ancillary benefit to the employer because the employee forfeits the unvested equity if they leave prior to the vesting date – the much-celebrated “glue-in-the-seat.”
Spreading out the tax cost may make the pill a little easier to swallow in the short-term, but it could actually result in the employee paying more tax in total. Using the same example, if the company’s value grows steadily from $1 million in year 1 to $5 million in year 5, the employee will end up receiving taxable income as follows:
|Year||% Vested||Company Value||Taxable Income|
So while the employee would have paid taxes on only $50,000 of income if they had bit the bullet and recognized the entire tax in year 1, they end up paying 3 times as much in taxes by deferring the tax with restricted stock.
To complicate things, the employee has a decision to make at the time the stock is initially granted in year 1, because the tax code gives an employee who receives restricted stock the option to make a so-called 83(b) election. If the employee in our example had made the 83(b) election, they would pick up the $50,000 in taxable income on the full 5% equity grant in year 1, but then wouldn’t pay further taxes based on the increased appreciation between years 1 and 5. Instead, they will pay taxes – at the more-favorable capital gains rates – only if and when the stock is thereafter sold.
But the 83(b) election raises its own set of unique risks. For example, if the stock actually goes down in value, the employee would have paid less in taxes if they had waited and paid the tax only when each installment vests. Also, if they forfeit the stock by leaving the company, there’s no way to recover the “prepaid” taxes by making the 83(b) election. So, the 83(b) election is an interesting alternative, but unless the stock is worth very little in year 1, there’s a bit of a gamble involved with making the election. On the other hand, when the stock’s value is very low in year 1 – such as may be the case in a brand-new start-up – an 83(b) election may be a no-brainer.
And, as noted in last month’s installment, the 83(b) election requires quick action and the rules are unforgiving. So, if you receive an equity award and are thinking about an 83(b) election, you need to work with your tax advisors ASAP to make a decision and file. If you miss the deadline, you’re stuck.
The profits interest is a very popular equity compensation structure but is only available to companies that are taxed as a partnership (including LLCs that are taxed as partnerships). Economically, the profits interest works like an option, but benefits from more efficient tax treatment, and doesn’t require the employee to pay anything for the equity.
A profits interest gives the recipient participation in a percentage of the future appreciation in the company’s value. The profits interest holder does not share in any of the existing value of the company at the time the profits interest is granted.
So, if the company is valued at $10 million, grants a 5% profits interest, and later sells for $20 million, the math would work like this:
- The first $10 million goes entirely to the original owner(s) of the company because the holder of the profits interest cannot participate in the existing company value.
- The next $10 million goes 95% to the original owner(s) and 5% to the profits interest holder.
- So the original owner(s) gets $19.5 million of the total proceeds, and the profits interest holder gets $500,000.
The good news, though, is that the profits interest has the following tax benefits to the recipient:
- The profits interest holder does not pay any tax at the time the profits interest is granted. Although the profits interest is a true equity award (like an equity grant described above), the structure of the profits interest is such that it has no value at the time of grant. That’s because if the company liquidated immediately after the grant, all of the existing value goes back to the original owner(s).
- Also, because the profits interest is real equity, the ultimate sale of the profits interest results in capital gains income to the holder, rather than ordinary income.
So, the profits interest avoids the phantom income that we get on the front end with a straight equity grant, but still gets the benefit of capital gains treatment upon sale. Not too shabby!
The trade-off, of course, is that the recipient doesn’t get anything for the existing company value, like they would in an equity grant. But if the idea is to compensate the recipient for contributing to the future growth of the company, then it seems appropriate that they would only participate in a portion of that future growth.
Now we veer into the world of synthetic equity. While there are many different types of synthetic equity, the two most common are as follows:
Phantom stock (not to be confused with the dreaded phantom income) is really just a compensation plan that pays the employee based on the value of the company’s stock. Because the employee doesn’t have actual equity, there’s less risk of complications with phantom stock (e.g., voting rights, fiduciary duties, buying back the equity, etc.), but the tax situation can be problematic to the employee.
Phantom equity differs from the equity appreciation right (described below) because phantom equity is tied to the value of the entire share of stock, not just the future appreciation on that stock. So, it’s essentially the synthetic equivalent of the straight equity grant.
The good news to the employee with phantom stock is that there is no tax until the phantom stock becomes payable. Oddly – and happily – enough, phantom stock (if structured properly) won’t result in phantom income. Go figure! The bad news, though, is that, when the phantom stock is finally paid, the employee gets taxed at the higher ordinary income rates.
For example, if we give our employee 5% phantom stock in the company that pays upon the employee’s death, disability, or change of control, nothing happens until the employee gets paid. But when the company is sold in year 5 for $10,000,000, the employee gets $500,000 in cash, all of which is taxable at the ordinary income rates.
Unfortunately, phantom stock arrangements are generally treated as “deferred compensation” programs for purposes of Section 409A of the Internal Revenue Code (as was mentioned last month). So, you have to be very careful about how you structure the phantom stock arrangement; once established, it may be difficult to change.
Also, keep in mind that if you agree to pay out the phantom stock on events, other than changes of control or other liquidity events, you’ll need to figure out both (1) how to value the stock, and (2) a way to fund these payment obligations when cash may or may not be available to the company. All of this will need to be carefully planned at the outset.
Equity Appreciation Rights
Equity appreciation rights are a mix between phantom equity and the profits interest. Like phantom equity, the equity appreciation right is a right to compensation that is tied to the value of the company’s equity. Like the profits interest, the employee gets compensated based only on a percentage of the future growth of the company. But unlike the profits interest, the proceeds from the equity appreciation right are taxed at the higher ordinary income rates.
So, if we use our same example as included in the discussion of the profits interest, our employee still gets the same $500,000, but pays taxes at the higher ordinary rates.
Section 409A also has an impact on equity appreciation rights. Generally, the equity appreciation right will need to be structured to limit the employee’s compensation to the difference between the value of the underlying equity on the date of grant, and the value of that same equity at the time of exit. There are also restrictions on including additional features that will further defer when the payment gets made. So, again, it’s important to be careful in setting up an equity appreciation arrangement.
Keep in mind that this is only a high-level summary. We didn’t even try to delve into the details about how these programs must be structured in order to comply with applicable legal and tax requirements. Suffice to say, there are countless traps for the unwary with each of these programs.
There are many related considerations that need to be weighed in terms of economics, employee retention, and behavior. As an owner, you need to be thoughtful about how you structure, and ultimately present, an equity-based compensation arrangement.
You won’t be surprised to hear that there are no “one-size-fits-all” solutions here, and equity-based compensation programs clearly aren’t for everyone. There may be other ways to achieve the same goals without causing some of the complications that go along with these programs, such as transaction bonus arrangements, incentive plans based on various financial metrics, etc. But, armed with some of this basic knowledge, you can start to assess where and how these programs might fit in your business.
“Now you know. And knowing is half the battle.” – G.I. Joe
Next Month: Interactions with Third Parties
Read last month’s piece: Employee Incentives - Part 1