Employee Incentives – Part 1

The Anatomy of a Deal Newsletter

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.

One of the challenges faced by many start-up and early growth stage businesses is how to attract and retain the talent needed to fuel growth when cash is scarce. Many of these companies use “equity-based incentives” as a tool to bridge this gap.

In theory, these incentives – if properly designed – align your key employees’ interests with your interests as an owner. Therefore, these types of incentives can be a useful tool, but they’re also ripe with opportunities to royally screw things up. So, before even broaching the topic with a current or future employee, it’s important to get educated about exactly what you’re offering.

And the menu is extensive, depending on the company and the circumstances, including: equity grants, restricted equity, restricted equity units, incentive stock options, nonqualified stock options, profits interests, phantom equity, stock appreciation or unit appreciation rights, and more!

There are so many considerations that go into this that we couldn’t possibly attempt to cover them all here. Each decision has consequences on (1) employee behavior, (2) company operations and decision-making, and (3) tax treatment, among other things.

While we’ll only be scratching the surface, let’s start to look at some of the key considerations.

To Give Equity, or Not to Give Equity: That is the Question

If you’ve already decided to provide some kind of equity-based incentive, the first question is whether to give actual equity or something that mimics equity. Actual equity would include the actual stock (in the case of a corporation) or membership interests (in the case of an LLC). The simplest strategy is just to give the employee actual equity in the company and call it a day.

But giving actual equity isn’t always the best answer. Equity owners have certain rights by law – some of which can be modified and some of which cannot. For example, while you can usually create equity interests that have no voting rights and that may have more limited rights to profit distributions, you should create these terms before promising the equity to your employee. On the other hand, certain rights of equity owners cannot be completely waived, including the right to access certain company information and the right to institute a claim for breach of fiduciary duties.

An even more significant potential complication is the need to get that equity back from the employee if things don’t go as planned. At best, negotiating contracts to require the employee to sell – or potentially forfeit – their equity if they’re no longer with your company can be difficult, expensive, and time-consuming. At worst, certain contractual restrictions may be difficult to enforce, leaving you with a partner that is no longer working with your company.

For these reasons, many companies are reluctant to give actual equity to employees but still want to compensate employees for growth in the company’s value. Enter the impressive-sounding category of “synthetic equity.” Notwithstanding the fancy name, synthetic equity is just a contract that gives the employee rights to payments tied to the equity value (or growth in equity value) of the company.

Unlike actual equity, synthetic equity gives the employee no rights of an equity owner, except those rights you give them by contract. The company’s owner doesn’t owe fiduciary duties to holders of synthetic equity, nor do synthetic equity holders have rights to company information, unless you decide to give them that information by contract.

Common types of phantom equity include phantom stock (just in time for Halloween!) and stock appreciation/unit appreciation rights (sometimes called SARs – not the disease).

The trade-off (you knew there had to be a trade-off) is that synthetic equity is treated just like any other compensation for tax purposes. So, it will be taxed to the employee as wage income at the generally-higher “ordinary income” tax rates. By contrast, actual equity is a capital asset, and subsequent gains on the equity are generally taxed at the more-favorable “capital gains” tax rates, subject to…

I've Got 83 Problems

Taxation of equity awards is – in a word – complicated. You can thank Internal Revenue Code Sections 83 and 409A (described below) for that.

Section 83 has been around for a long time and says that property received in connection with the performance of services is taxed to the recipient at the time the property is no longer subject to a substantial risk of forfeiture. That is, of course, unless you elect to have it taxed earlier by making the so-called Section 83(b) election. Huh?

So why do I care about any of this? Simply stated, most equity-based incentives will need to be structured carefully to achieve the right tax result and to avoid problems for the company and the employee.

For example, let’s say you decide to give a key employee 10% of your company as an outright equity grant. Under Section 83, the employee is taxed at “ordinary income” rates when the stock is “no longer subject to a substantial risk of forfeiture” (whatever that means).

So if you just give 10% of the stock of your company and the total company value is $1,000,000, then your employee gets taxed on $100,000 of ordinary income. This, of course, presents a big problem for the employee because he/she has $100,000 of taxable income but doesn’t actually receive cash to pay the tax. Many employees would find this result to be disagreeable.

On the bright side, however, if the company is sold more than a year later for $10,000,000, the employee will now have a tax basis of $100,000 in the stock, and the $900,000 gain (i.e., [$10,000,000 total company value x 10% employee share] - $100,000 employee tax basis) will be taxed at the more favorable long-term capital gains rate.

Now, if we wanted to lessen the tax hit to the employee on the front end, we could use something called restricted stock to spread the tax hit. Let’s say we give our employee the same 10%, but it vests in equal annual installments of 2% each over a period of 5 years. If the employee leaves the company before the vesting date for any installment, the unvested installments are forfeited.

In year 1, when the first 2% vests and the company is worth $1,000,000, the employee only picks up taxable income on the vested portion, which is $20,000 (i.e., $1,000,000 total company value x 2% employee share that is vested). Still not ideal, but less of a burden on the employee and perhaps something that the company could help to cover through loans or additional cash bonuses (which bonuses are taxable as well).

The downside, however, is that if the company continues to increase in value, the total tax impact will exceed that which would have existed if the full 10% was taxed at the time of the initial grant. In our example, if the company is worth $2,000,000 in year 2, the 2% block that vests in year 2 will now result in taxable income of $40,000 (i.e., $2,000,000 total company value x 2% employee share that is vested). As you can see, when the company grows in value – which, after all, is the point – the total tax impact of the restricted stock grant is greater.

This is where the so-called Section 83(b) election becomes a consideration. This allows the employee who receives restricted stock or other unvested property to ignore the vesting restrictions and take the full value of the total equity grant into taxable income in year 1 even though it vests over time. The downside is that if the full grant doesn’t vest or if the company doesn’t appreciate in value, the employee may end up paying more tax than if he/she hadn’t made the Section 83(b) election. It’s very much a roll of the dice except in situations where the value is so low at the time of initial grant that it’s a no-brainer.

Due to the many complications involved, the Section 83(b) election is beyond the scope of this article. That said, the important thing to remember is that you must make a Section 83(b) election in writing within 30 days after the initial grant. No exceptions. So you need to get good advice on whether it makes sense to make the election and take the appropriate steps as soon as the grant is made.

The moral of the story is that Section 83 may result in a significant impact on both the employee and the company. Speaking of which…

Clean-Up Make Bigger Messes with Formula 409A 

Enough tax talk, right? I wish.

Section 83 only applies to property received in connection with services. Equity is property; synthetic equity is not. So, we don’t have any tax issues if we grant synthetic equity, right?

Enter Section 409A, which was added in the days after the Enron debacle as a way to punish the largesse of public company executives who liked to use deferred compensation plans to avoid taxation, but then could simply take the money and run at the first sign of trouble. While much different from the problem that Section 409A arguably intended to correct, Section 409A impacts the structure of both true equity and synthetic equity awards.

The problem with Section 409A is that – as is all too common when Congress actually attempts to fix a problem – it uses the sledgehammer rather than the scalpel. Section 409A applies to all companies: big and small, public and private.

While super-complicated, at its core, Section 409A requires any compensation plan that provides for actual or potential payments in future years to be in writing at the time the compensation right is granted, to limit when and how the compensation may be paid, and to restrict the employee from thereafter changing when and how these amounts will be paid.

And the cost of non-compliance is steep. Failure to comply with Section 409A may result in immediate taxation even if the compensation will not be paid for several years, a 20% penalty on the full amount of compensation that is subject to Section 409A, and interest. Another disagreeable result.

I’m not going to go any further into Section 409A here because there are literally hundreds of pages of mind-numbing regulations that include rules, exceptions, and exceptions-to-the-exceptions. Suffice to say that it’s important that you get professional advice on how Section 409A might affect your incentive program to avoid a very bad surprise later.

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So the executive summary is that equity-based incentive programs are complicated and require a lot of thought, planning, and expert advice to implement correctly. Failure to do so could have catastrophic effects.

For example – and to show that I’m not simply being hyperbolic – in a transaction we worked on several years ago, the target company (which we didn’t represent) had a SAR plan drafted for certain key employees. The only problem is that the way it was drafted gave the SAR participants 100% of the company’s value. Not exactly what the actual owner had in mind.

Having set the stage – and made you wish that you had pushed the “Report Spam” button when this message hit your inbox – we’ll dig into the different “options” (pun intended) for equity-based incentives in next month’s piece.


Next Month: Employee Incentives - Part 2

Read last month’s piece: Representation + Warranty Insurance