Alternatives for Equity Incentive Programs
Following is a general summary of common equity incentives offered by companies to compensate management and/or consultants. While we have referred to “stock” in this alert, these alternatives should be similarly available for non-corporate entities, except incentive stock options which may be issued only by corporations and only to employees.
I. Stock Options
Gives the worker an opportunity, once the option vests, to elect to purchase company stock at a price equal to the stock’s fair market value at date of grant. Tax consequences depend on whether the option is statutory (also known as incentive stock options) (ISO) or nonstatutory (NSO).
A. Advantages
- Provides the opportunity to become an owner, thus aligning the worker’s interests with the interests of the company.
- Can require worker cash investment, so worker has more incentive to not lose stock value.
- Facilitates succession planning, if combined with a shareholders’ agreement providing buyout rights.
- No voting rights or right to dividends before exercise (underlying stock can also be made non-voting).
- Can be structured as a retention tool, with vesting after a given period of time or upon achievement of certain performance targets, or a combination of both. Thus, if a worker who holds options resigns before the end of the vesting period, he typically forfeits his right to all or a portion of the options.
- Vesting can encourage workers to focus on long-term rather than short-term goals.
- Incentive stock options (ISOs) are taxed as capital gains to employee upon eventual sale of stock (NSOs are taxed as ordinary income on the spread between exercise price and FMV at exercise)
Company:
- NSOs are tax deductible when exercised by the holder (ISOs are not tax deductible).
- For ISOs, no FICA or FUTA taxes.
- No company cash outlay required.
B. Disadvantages
- Upon workers’ exercise of options, workers are given the same rights as owners, such as the right to an accounting, the right to review the company’s records, etc….
- Can become valueless during a down market.
- Worker cash investment required to exercise (unless cashless exercise offered). Worker must also pay related income taxes upon exercise of NSO.
- Company must periodically (usually annually) value its stock, which typically requires obtaining a third-party valuation.
- If the worker terminates employment, either the company is now left with a non-employee shareholder (who may not be friendly) or the company may have to produce the cash to re-purchase the shares.
- ISOs are only available to employees (NSOs are available to all service providers).
- ISOs are not tax deductible to the company unless they lose their ISO status (e.g. upon a disqualifying disposition) (NSOs are deductible upon exercise).
II. Restricted Stock
Gives the worker an immediate ownership interest in the company, subject to certain forfeiture or transferability restrictions for a specified period of time or until certain performance targets are met, or both (known as the restriction or vesting period). Usually issued at nominal or no cost, or in return for a promissory note.
A. Advantages
- Makes the worker an owner, thus aligning the worker’s interests with the interests of the company.
- Facilitates succession planning, if combined with a shareholders’ agreement providing buyout rights.
- Can provide for no voting rights or right to dividends before restrictions lapse (vest) (can be made non-voting even after vesting).
- Can be structured as a retention tool, with restrictions lapsing (vesting) after a given period of time or upon achievement of certain performance targets, or a combination of both. Thus if an employee who holds restricted stock resigns before the end of the vesting period, he typically forfeits his right to all or a portion of the stock.
- Vesting can encourage workers to focus on long-term rather than short‑term goals.
- No worker investment required.
- Worker has opportunity to accelerate taxation (which is likely to be advantageous if stock is expected to significantly increase in value prior to vesting) by filing a Section 83(b) election and convert future growth to capital gains.
- No annual valuation of company stock is needed, except near vesting dates. Third-party valuation may not be required.
Company
- Tax deductible upon lapse of restrictions or filing of Section 83(b) election.
- No company cash outlay required.
B. Disadvantages
- Upon grant, workers typically have the same rights as shareholders, such as the right to an accounting, the right to review the company’s records, etc….
- If the worker terminates employment and holds vested shares, either the company is now left with a non-employee shareholder (who may not be friendly) or the company may have to produce cash to re-purchase the shares (shareholders agreement recommended).
- Workers normally taxed on the value of shares when restrictions lapse (vest), which may create a cash drain or exceed the workers’ current pay (a Section 83(b) election may avoid this problem).
III. Stock Appreciation Rights/Phantom Stock
Both phantom stock and stock appreciation rights (SARs) provide the worker a future cash or stock payment based on the value or increase in value of a set number of shares over a set period of time. SARs generally provide the right to the increase in value of a specified number of shares when the worker chooses to exercise the SAR. Phantom stock provides the right to the value of a specified number of shares upon a certain date that can not be controlled by the worker.
A. Advantages
- Aligns interest of workers with those of the company without having to share ownership of the company or shareholder rights.
- Can give company future discretion at time of payment to decide between cash or stock payment.
- No dilution of ownership, unless stock is used for payment.
- Greater flexibility - company does not have to base value on a share of stock - can modify the calculation (for a SAR, this may trigger more limited payout choices).
- Can be structured as a retention tool, with vesting after a given period of time or upon achievement of certain performance targets, or a combination of both. Thus if an employee who holds SARs or phantom stock resigns before the end of the vesting period, he typically forfeits his right to all or a portion of this benefit.
- Vesting can encourage employees to focus on long-term rather than short-term goals.
- No worker cash investment required.
- Annual valuation of company stock not needed for most phantom stock grants, except near payment dates (third-party valuation usually not required).
Company
- Company gets tax deduction on payment.
B. Disadvantages
- Can result in cash outlay by company.
- SARs can become valueless during a down market.
- SARs require company to periodically (usually annually) value its stock, which typically requires a third-party valuation.
- If the worker terminates employment, unless awards provide otherwise, the company may have to make cash payments, re-purchase stock (if any was issued), or provide stock as payment to a non-employee (who may not be friendly).
- Taxed as ordinary income to worker, and subject to FICA and FUTA, upon payment.