- A unique set of challenges. Establishing an equity-based long-term incentive plan in private companies presents unique design and planning issues.
- Real equity award advantages. From a tax perspective, real equity awards are more favorable than other types of awards, because they typically support the taxation of all or a portion of the value realized from the award as capital gain versus ordinary income.
- Keeping control. Because phantom equity awards do not result in the transfer of equity to employees, company leadership will not need to cede any control or ownership to others and may continue to closely guard their financial data.
- Showing value. The advantage of full value awards is that they will have value even if the value of the company’s equity doesn’t appreciate. Because of this, they immediately have retentive value upon grant.
- The advantages and disadvantages of appreciation awards. The benefits of appreciation awards are converse to those of full value awards, in that they have no value unless the company’s value increases.
Establishing an equity-based long-term incentive plan in the private company context presents unique design and planning issues, especially where the private company is not owned by a private equity sponsor (PE fund). Let’s explore various alternatives for the design of equity compensation plans, discuss the pros and cons of each, describe the general tax impact, and highlight other issues that might influence a private company’s decision to implement one alternative over another, or whether to even offer a long-term equity compensation plan at all.
In developing an equity-based long-term incentive plan, the most significant decision to make initially is whether the plan will be based on real equity or phantom/synthetic equity. This single decision will determine the impact of the plan in many respects.
Real equity encompasses many different award types, including stock options, restricted stock and restricted stock units, performance awards, stock-settled stock appreciation rights (SARs) and partnership interests (including profits interests). Real equity awards ultimately result in the recipient receiving actual equity in the company.
From a tax perspective, real equity awards are more favorable than other types of awards, because in most cases they support the taxation of all or a portion of the value realized from the award as capital gain versus ordinary income, depending on the vehicle used. This is advantageous to the recipient, as the capital gains tax rate remains significantly lower than the highest marginal federal income tax rate.
Real equity awards, depending on the award vehicle utilized, also allow recipients to utilize the election procedure of IRC section 83(b), which can result in significantly more favorable tax treatment for a greater portion of the award value than would otherwise apply. This election is not available for phantom/synthetic equity awards.
Although real equity may support more favorable tax treatment, there are countervailing considerations. One issue that is more pronounced for private companies that are family-owned (as opposed to those that are owned by a PE fund) is the desire to keep the company’s equity held as closely as possible. Owners of closely held businesses have little appetite to cede control to others, or to share detailed financial information with minority shareholders.
From the recipient’s perspective, real equity may not be perceived as having much value if there is no exit plan or timeline for monetizing the business. For these reasons, real equity plans are not as common among private companies, other than those that are held by a PE fund.
Phantom/ Synthetic Equity
Phantom equity can also take many forms, including cash-settled SARs, phantom stock and performance units. Unlike real equity, which is settled in actual shares or other equity instruments, phantom equity awards are settled in cash.
Because phantom equity awards do not result in the transfer of equity to employees, some of the negative aspects of real equity designs are avoided; that is, the company owners will not need to cede any control or ownership to others and may continue to closely guard their financial data. Recipients will also see immediate value in the form of cash payments, eliminating the need for an exit plan or timeline for monetizing the business.
From a tax standpoint, however, it is not feasible to avoid ordinary income treatment of payments made under a phantom equity award. Accordingly, these awards are not as tax-efficient from the participant’s perspective. While the company receives a tax deduction for the payments (which may not always be available with respect to real equity awards), this is only advantageous if the company has positive taxable earnings. Because these awards are settled in cash, the company also must have sufficient cash flow to fund the payments.
Within each broader category of real and phantom/synthetic equity, a number of award vehicles are available. The type of organization that is establishing the plan — C-corporation, S-corporation, LLC, partnership, for example — will impact which award vehicles are applicable; thus, all vehicles may not be available to a given company. Each award vehicle has pros and cons and presents different tax and other issues.
Full Value Award Vehicles
Full value award vehicles are award vehicles that have value on the day they are granted. In other words, they have intrinsic value that exists without regard to appreciation in the value of the company’s equity. In the real equity context, full value awards include restricted stock (RS) or restricted stock units (RSUs).
The difference between RS and RSUs is that RSU awards do not result in the transfer of stock on the date granted. Rather, they constitute a promise to transfer equity in the future, either upon vesting or at a later date. RS, on the other hand, are shares that are actually transferred immediately, subject to restrictions that lapse over time, upon the achievement of performance criteria, or the occurrence of some event.
In the phantom/synthetic equity context, full value awards include phantom stock and performance shares or units. Phantom stock awards vest over time and promise a cash payment in the future based upon the value of the company’s equity at that time. Performance shares work like phantom stock, except vesting is tied to some predetermined performance criteria. Performance units work like performance shares, except the award value is a pre-determined cash amount that is not tied to the value of the company’s equity.
The advantage of full value awards is that they will have value even if the value of the company’s equity doesn’t appreciate. Because of this, they immediately have retentive value upon grant. Furthermore, they continue to have some value, even in down years when the company’s equity might lose some value.
The disadvantage of full value awards is that they are more expensive for the company. Additionally, while they have more value and better retentive effect from the participants’ perspective, they may not drive growth as effectively as appreciation awards, which only deliver value if the company’s equity value increases. Therefore, in determining whether to offer full value awards, a company should consider its goals and the reasons it is seeking to offer a long-term equity plan in the first place.
Unlike full value awards, appreciation awards only have value if the company’s value increases after the awards are granted. In the real equity context, appreciation awards include stock options (both qualified and nonqualified), as well as stock-settled SARs and profits interests. In the phantom/synthetic equity context, appreciation awards include cash-settled SARs.
The advantages and disadvantages of appreciation awards are converse to those of full value awards. These awards have no value unless the company’s value increases. Thus, upon grant, their retentive effect will be muted, pending an increase in the value of the company that leads to a buildup of the intrinsic value of the awards. Additionally, if the company experiences a decline in value after awards are granted, the awards could be perceived as worthless, having no retentive or motivational effect.
From the company’s perspective, if value growth is a primary goal, these types of awards would be more aligned with that goal. Additionally, appreciation awards are generally less costly to the company overall, and do not require any cash outlay if the company’s equity value does not increase.