Employee Incentive Compensation: What are the Options

By Team HRH | January 5, 2015

Attracting and retaining talent is difficult for any company, but particularly for start-ups that compete with larger,well-capitalized companies for top staff. Key employees expect to receive a compensation package consisting of salary, bonus and long-term incentive compensation.  Newer companies often believe that they can’t compete with mature companies in the area of incentive compensation due to lack of liquidity, difficulty in valuing equity, and concerns about loss of owner control.

Equity based compensation can provide a means for start-ups to attract and retain the talent that will drive company innovation and growth without loss of control.  There are many types of compensation plans and differing tax, legal and accounting issues that should be considered when reviewing each. A full discussion of the issues is beyond the scope of this article, but three common plan types are summarized below:

A Restricted Stock Plan can be advantageous for companies in early stages of development whose stock has little stock value.  In this plan, employees or even key vendors receive a grant of stock. The stock vests over a period of time or upon the occurrence of a future event (term of employment, performance goals, change of control, etc.).  There is very little cost to the company, no ownership dilution, and potentially minimal tax for the employee until the stock vests.  Employees can control the timing of income recognition (and employer tax deduction) by making an 83(b)election.  There is great upside potential for increases in value so this type of plan is a useful tool to motivate key employees through the vesting period.

A Stock Appreciation Right (SAR) or Phantom Stock Plan is useful for companies in the middle stage of development which may or may not stay private.  Phantom stock pays a future cash or share bonus equal to the value of a specified number of shares.  Stock appreciation rights provide the right to the increase in value of a designated number of shares.  The award vests over time and the employee can exercise after the vesting period. At exercise they can either receive the shares of stock or cash equal to the difference between the values at exercise versus grant.  Cash settled SARs have no dilutive effect on owners but reduce liquidity.  With this plan, the employer obtains a tax deduction at the time the employee recognizes ordinary (compensation) income.

Middle to later stage companies and those that plan to go public may benefit from offering a Stock Option Plan.  Employees are familiar with such plans and have come to expect this as part of a compensation package.  With such plans, the employee receives the right to purchase equity in the company at a fixed date in the future.  Option plans may be qualified (Incentive Stock Options/ISOs) which may only be granted to employees or non-qualified(NQOs).  Because the employee has to purchase shares at exercise, the company benefits from some liquidity, but these plans are typically more dilutive as more shares have to be issued to create value for the employee.  Employees only receive benefit if share prices increase. If options stay underwater for long periods of time, the plan can be detrimental to morale.  For NQO plans,the employer receives a tax deduction equal to the employee ordinary income at the date of exercise.  For ISO plans, the employer receives no tax deduction (and the employee has no ordinary income) at exercise.

When making choices about which plan to offer, the company will need a thorough understanding of employee and employer tax consequences,financial statement issues, the state and federal securities laws, and valuation issues applicable to the plan.

Equity based compensation is a valuable tool available to start-ups and private companies to attract and retain key personnel and to motivate key employees to build company value.

This information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice.  Any tax advice contained in this communication is not intended or written to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties. Please contact our office (603-627-3838) for more information on this subject and how it pertains to your specific tax or financial situation.  Howe, Riley & Howe, PLLC would be happy to answer your tax and financial questions regarding these issues or other matters that may be of interest to you or your business. 

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