Performance and Incentive Plans are compelling tools for business owners and managers seeking to assure long and effective performance from their employees.. In many companies but especially in closely-held companies, the company’s greatest asset is their key employees. Many of these key employees have employment contracts or at least non-compete or non-solicitation contracts. These contracts, to the extent that they are enforceable, protect companies by limiting the employees’ incentive to leave. To know how to reward and incentivize key employees to invest and grow with the company is equally important. There is a wide range of the types of incentive plans. Each may be conditioned on a vesting schedule, involve voting or non-voting equity, and/or be payable upon the happening of specified events, such as a sale of the business during the term of the employee’s employment (or during such term and for a limited period thereafter).
When trying to determine what type of performance or incentive plan to adopt, the owners of the company must first determine what the primary goal is. Is it to reward performance with an immediate benefit or is the goal to retain employees and allow them to participate in the increased value of the company? The former simply requires cash bonuses or deferred compensation plans. On the other hand, if the latter is the goal, the company may wish to consider one of the many types of equity plans available. Equity plans require more planning because giving someone an ownership share in a closely-held company provides the employee with a variety of rights that business owners may be unwilling to offer.
A brief description of some of the more common plans and issues to consider in connection with each is set forth in this article and the following one: (For ease of discussion, all equity will be referred to as “stock or “shares”, but all plans other than Incentive Stock Options are equally applicable to interests in limited liability companies or partnerships). We also offer our comments on the advantages and disadvantages of each. These comments are based on our many years of experience representing closely-held companies.
Types of Plans:
1. Cash Bonuses.
2. Equity “Tracking” Plans.
(a) Phantom Stock
(b) Appreciation Rights
3. Equity Plans
(a) Stock Grants
(b) Stock Option Plans
(c) employee Stock Purchase Plans
(d) employee Stock Ownership Plans
Current or Deferred Cash Bonuses.
Cash bonuses are the easiest to administer and the most common form of performance based awards. Cash bonuses are usually paid at year-end and are tied to company and/or individual performance. The measurements of both company and employee performance are varied and can be unique to each employee and company. Regardless, they should be easily measured and clear to the employees. Individual goals should be part of a formal review process and should be done in writing.
Advantages: Cash bonus plans are easy and inexpensive to administer. Payments are deductible by the company. If it is a formulaic plan, the employee has comfort in knowing how well they will do based on their own performance. Many companies have moved to deferred compensation plans that allow the employees to defer income. This deferral can have a vesting component to it which ties the employee to the company. In a cash bonus plan, the employee does not have any rights as a stockholder.
Disadvantages: Payments of cash bonuses may not increase employee retention or loyalty. Too often, once the bonus is paid, the employee believes it was earned for past performance, not future performance. Deferring bonuses can tie employees to the company, but you must comply with the tax code, in particular Internal Revenue Code Section 409A (“409A”), which restricts deferred compensation plans to avoid tax problems.
Equity “Tracking” Plans.
Equity plans work best in companies where growth and a potential for acquisition or an IPO are part of the strategy. Equity Tracking Plans are plans that allow employees to benefit from increases in the value of the equity of the business without ever actually owning equity. One of the great advantages of these plans is their flexibility. They are individual or group contracts between the company and employees that grant rights to income based on equity rights, but without subjecting the company to the statutory requirements or granting the employee the statutory rights that follow actual equity ownership in a company. Because they are so flexible, many decisions need to be made about who gets how much, vesting rules, liquidity concerns, restrictions on selling shares (when awards are settled in shares), eligibility, rights to interim distributions of earnings, and rights to participate in corporate governance (if any).
(a) Phantom Stock Plans.
Unlike many of the other plans to be discussed here, a Phantom Stock Plan provides some of the benefits of an equity plan without creating shareholder issues such as information and/or voting rights. The name “Phantom Stock” is somewhat misleading in that the employee never receives stock, but rather only receives a promise to pay a bonus that is equivalent to the value of the company’s shares at a set time. For instance, a company could promise an employee that it would pay a bonus after five years (or upon the occurrence of a specified event) equal to the equity value of a certain number of the established shares of the company at that future time or it could promise to pay an amount equal to the value of a fixed number of shares set at the time the promise is made. Other equity or allocation formulas could be used as well. The taxation of the bonus is much like that of any other cash bonus – it is taxed as ordinary income at the time it is received.
The issues with this type of plan are addressed at the planning stage. First, care must be taken to avoid giving early participants too large a “portion” of the company’s stock and not leaving enough for later employees. Second, the Phantom Stock must be valued in a defensible way. Third, similar to cash plans outlined above, if funds are set aside to “fund” the payments to come due, they may need to be segregated into a “Rabbi Trust” to help avoid causing employees to pay tax on the benefit when it is promised rather than paid. Finally, if the plan is intended to benefit more than key employees and defers some or all payment until after termination or retirement, it may be subject to 409A or be considered a de facto “ERISA” or retirement plan.
Advantages: Simple and inexpensive to administer; payments are deductible by the company. No current income tax on the grant. Employee does not have any rights as a stockholder.
Disadvantages: Payments of cash must be treated as ordinary income by the employees. Some employees will not feel like “true owners” of the company and are not incentivized enough to stay in the company.
(b) Stock Appreciation Rights (SAR).
A stock appreciation right (SAR) is a form of phantom stock, except its value is always equal to the amount of an increase in the value of a specified number of the company’s shares over a specified period of time.
An SAR is normally paid out in cash, but it can be paid in shares. SARs may be constructed so that the Plan specifies when they will be paid, or they may provide that the company or the employee have the right to elect when they will be paid (the employee only after they vest).
Like Phantom Stock Plans, if drafted properly, employees are taxed on SAR Plans when the right to the benefit is received. At that point, the value of the award minus any consideration paid for it (usually none) is taxed to the employee as ordinary income and is deductible to the company.
Advantages: Relatively simple and inexpensive to administer; payments are deductible by the company. The employee does not have any rights as a stockholder.
Disadvantages: The company must record a compensation charge on its income statement as the employee’s interest in the award vests or is no longer subject to forfeiture. So from the time the grant is made until the award is paid out, the company expenses the value of the percentage of the promised shares or increase in the value of the shares, pro-rated over the term of the award. In each year, the value is adjusted to reflect the additional pro-rata share of the award the employee has earned, plus or minus any adjustments to value arising from the rise or fall in share price.
 In large companies, SARs may be granted in tandem with stock options (either ISOs or NSOs) to help finance the purchase of the options and/or pay tax if any is due upon exercise of the options. If SARs are settled in shares, however, their accounting is somewhat different. The company must use a formula to estimate the present value of the award at grant, making adjustments for expected forfeitures.
Paul D. Creme is an attorney with Hamblett & Kerrigan PA. His practice is focused on business and corporate law. Of particular interest are the areas of software and emerging technologies. You can reach Attorney Creme at [email protected].