The Competitive Edge:
Creating Attractive Incentive Compensation
Plans forPrivately Held Entities
Keith H. Berk, Jeffrey A. Hechtman, and Kenneth A. Goldstein[i]
A discussion of alternative incentive compensation plans and the
application of executive compensation plans in closely held businesses.
INTRODUCTION
As companies vie for executives with track records of proven success, executive compensation has taken on increased importance for businesses in today’s highly competitive job market. Executive compensation plans can make the difference in attracting and retaining the key personnel required to manage successful businesses.
For years, corporations have expended great time and effort to develop compensation packages for key personnel to balance management’s focus between short term and long term concerns and create a bond of common interest between shareholders and senior management. These compensation structures not only provide a means of attracting and retaining senior management but can also serve as an effective motivational device for focusing the executive’s interests to achieve specific corporate performance objectives. Incentive plans can also preserve working capital by splitting compensation into short term and long term components.
AVAILABLE ALTERNATIVES
Executive incentive plans can generally be separated into two classes: equity-based plans in which the executive has an actual or potential equity stake in the company and equity-like plans that give rise to cash payments but do not provide the executive actual equity ownership. Equity-based incentives include stock option plans, stock bonus plans, and stock purchase plans. Cash-based equity-like programs are comprised of stock appreciation right plans, phantom stock plans, and performance unit plans.
The principal distinctions between equity-based plans and cash-based equity-like plans are the benefits and burdens that accompany actual ownership in an entity. In equity-based plans, the executive, upon becoming a shareholder, is entitled to certain benefits including the rights to vote, receive notice of meetings, inspect the books and records, and hold directors, officers, and majority shareholders accountable as fiduciaries. On the other hand, equity-like plans are contractual obligations which, while subject to the implied covenants of good faith and fair dealing, do not subject the enterprise or the other shareholders to obligations owed to minority shareholders.
The company’s choice will be based on several factors such as ownership structure, business strategy, and the role of outside personnel in growing and managing the business. In general, closely held businesses prefer not to give actual equity ownership to executives unless the benefits are provided pursuant to a broad based plan for many executives, true equity will better motivate the executives than economic rewards, or the tax benefits of equity-based plans are superior to the tax consequences of equity-like plans.
Doc: 131219/1/HM&B
1248211/1/13541.000
The principal issues for the executive in connection with incentive plans will concern income tax treatment of the different plans and the psychological perception of true ownership versus a participation right in the company’s economic well being.
DESCRIPTION, COMMON FEATURES, AND TAX CONSIDERATIONS OF EQUITY-BASED PLANS
Stock Options
A stock option is not stock; it is the grant of a right to purchase stock at a specific price (the "exercise price") on or after a specified future date subject to specific terms. Options can be granted based upon a number of criteria, including position, tenure, past contributions, or the expectation of future performance. There are two basic types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). The primary differences between NSOs and ISOs lie in their relative flexibility and tax consequences.
Incentive Stock Options
ISOs are options granted to an employee to purchase stock which meet the following statutory requirements:[ii]
·Following exercise of the options the employee may not dispose of stock that is purchased within two years from the date that the options were granted or within one year after the options are exercised;
·The executive must be an employee of either the company, its parent, or a subsidiary at all times during the period from the date the options are granted until three months before the date of exercise;
·The options must be granted pursuant to a plan which states the aggregate number of shares that may be issued to the employees (or class of employees) eligible to receive the options and that is approved by the shareholders of the company within twelve months of the date the plan is adopted;
·The options must be granted within ten years from the date the plan is adopted or the date the plan is approved by the shareholders, whichever is earlier;
·The options must be exercisable within ten years from the date of grant;
·The option price may not be less than the fair market value of the stock at the time the option is granted;[iii]
·The options must be nontransferable other than at death and must be exercisable only by the employee during the employee’s lifetime;
·At the time the options are granted, the employee must not own more than 10 percent of the total combined voting power of all classes of stock of the company, its parent, or subsidiaries, either directly or by reason of attribution of stock;[iv] and
Doc: 131219/1/HM&B
1248211/1/13541.000
·The aggregate fair market value of stock that can be purchased by the employee pursuant to options exercisable for the first time during any calendar year under all plans of the company, its parent, and subsidiaries, may not exceed $100,000.[v] Fair market value for this purpose is determined at the time the options are granted, based on the order the options were granted.
Tax treatment of ISOs. An executive does not recognize income when an ISO is exercised.[vi] Upon the eventual sale of the underlying stock, the executive will recognize a capital gain based on the difference between the sales price and the exercise price. The company receives no deduction in connection with the granting or exercise of ISOs.
Advantages and disadvantages of ISOs. Gain on the sale of stock purchased pursuant to an ISO is taxed at capital gains rates. Given the new capital gains rates, which are as low as 20 percent and the ordinary income tax rates, which are as high as 39.6 percent, the executive not only receives a benefit from the company but also pays the historically lower rate applicable to capital gains. Although the company receives no corresponding deduction, it benefits by compensating the executive without a cash outlay and without paying the withholding taxes that accompany payment of regulatory compensation. Moreover, the holding period requirements create an incentive for the executive to remain with the company and to focus on long term growth and strategy.
The major disadvantages of ISO’s are the burdens of the strict ISO requirements. A company may not grant ISOs that have an exercise price that is less than the current fair market value of the stock; therefore, an ISO will not provide the executive any compensation unless the value of the company increases. The company may find that executives do not consider ISOs to be "compensation" because the options have no economic value when granted. As with all equity-based plans, the employee may become a shareholder, diluting the investment of existing shareholders and entitling the employee to hold majority shareholders, directors, and officers accountable as fiduciaries.
ISO requirements have several features that the employee may also find troublesome. The employee may pay for the stock only by certain statutorily prescribed methods.[vii] Also, holding period requirements prevent the employee from disposing of the underlying stock within two years from the date of grant or one year from the date of exercise of the ISO and can frustrate the employee’s ability to take advantage of market upswings. Furthermore, since ISOs cannot be transferred, the lack of transferability eliminates the employee’s ability to transfer the ISOs to descendants to reduce the employee’s estate for estate tax purposes. Finally, the employee may owe tax upon exercise to the extent he is subject to the AMT.
Non-Qualified Stock Options
NSOs are options that do not satisfy the statutory requirements of ISOs and because of their flexibility and tax advantage, are more typically used in closely held businesses.
Exercise price. NSOs may have a fixed exercise price, a variable exercise price, or an exercise price that has fixed and variable components. Because NSOs are not required to meet the stringent fair market requirements applicable to ISOs, the company has the flexibility of setting the exercise price above, below, or equal to the fair market value of the stock at the time of the grant. By using NSOs that are already "in the money," the company can use NSOS to provide an executive with a bonus for performance achievements while at the same time preserving cash and providing incentives for future achievements.
Doc: 131219/1/HM&B
1248211/1/13541.000
Variable exercise prices can be based on performance criteria such as sales, profits, earnings per share, or cost reductions. As the level of performance improves based on the measuring threshold, the variable exercise price can be adjusted to make the options more valuable, thereby aligning the executive’s incentives with specific goals of the company. However, the company should be careful in selecting measuring criteria that are meaningful to the executive’s performance and do not create a perception that the executive’s compensation is independent of performance.
Holding periods and vesting. Given that the features of the NSOs are not mandated by statute, no minimum period is prescribed for exercising options or holding stock purchased under an NSO plan. Consequently, a company has flexibility to establish restrictions that balance the executive’s desire for current compensation with its long term goals. Typically, NSOs provide for delayed exercise periods or establish minimum holding periods in order to create an incentive for the employees to remain with the company and take a long term view of the company’s success.
NSOs are frequently subject to vesting provisions that provide that the employee will not have an indefeasible right to the options or the underlying stock until the expiration of certain periods of time or the occurrence of specific events. The most common vesting methods involve vesting over a fixed period or "cliff vesting," which provides that all vesting occurs at a certain point in time. Of course, the two methods can be combined to tailor an option plan to the company’s and the employee’s desires. The company’s choice of a vesting schedule should focus on a time period that is sufficient to achieve the desired long term results from the executive.
Transferability. With recent changes in the Code making the transfer of NSOs possible, an executive may be able to substantially reduce federal estate and gift tax liability by making lifetime transfers of the NSOs. Typically, the most advantageous time to transfer NSOs is shortly after their grant. The executive may transfer the NSOs directly to family members, a trust for the benefit of family members, or, possibly, to a family limited partnership.
The value of a gift of NSOs will be equal to the fair market value of the NSOs on the date of the gift. Typically, this value will be substantially less than the value of the stock when the NSOs are exercised. Following the gift, any further appreciation in either the value of the options or the underlying stock will not be subject to additional estate or gift tax. However, there is a risk that the underlying stock price may never reach the exercise price. In such case, the Code does not permit the employee to reclaim the lost exemption or recover any gift tax that was paid. The gift of the NSOs should not create any income tax liability and does not affect the income tax consequences to the executive upon exercise of the NSOs by the family member.
Tax treatment of NSOs. NSOs result in immediate taxation if at the time of grant the options have a "readily ascertainable fair market value."[8] If the NSOs have a readily ascertainable fair market value, the employee has ordinary income equal to the difference between the fair market value of the NSOS less the exercise price, and the company receives a corresponding deduction. While the difference between fair market value and the exercise price is taxed at ordinary income rates, any future appreciation in the value of the NSOs or the underlying stock is taxed at the capital gains rates.[9] In closely held businesses, the granting of NSOs seldom results in immediate recognition of taxable income because the options will not have a readily ascertainable fair market value.1[0]
Doc: 131219/1/HM&B
1248211/1/13541.000
If the NSOs have no readily ascertainable fair market value on the date of grant, the executive will recognize income equal to the difference between the fair market value of the underlying stock and the exercise price of the options on the date the NSOs are exercised and the underlying stock is not subject to a substantial risk of forfeiture.1[1] A substantial risk of forfeiture exists if the options are subject to or dependent on a future event or condition that would result in termination of the NSOs by payment of less than fair market value. However, restrictions that never lapse, such as a requirement that the underlying stock be sold to the company at a predetermined price or a formula price on the executive’s termination, are ignored for determining the time for income recognition.
The company is entitled to a business expense deduction when the executive is required to declare ordinary income, which is limited to an amount equal to the ordinary income declared by the executive.1[2] The deduction will only be allowed to the extent that the executive’s total compensation is "reasonable".1[3] Moreover, the company is also subject to withholding requirements applicable to employee compensation. When the executive eventually sells the stock, the excess of the sales price over the sum of the exercise price and ordinary income previously recognized is taxed at the capital gains rate to the employee. No further deduction is available to the company on sale of the stock.
Advantages and disadvantages of NSOs. Since there are few specific legal requirements for NSOs, their range of features is quite broad. NSOs are advantageous because the company does not directly pay for the benefit realized by the executive.1[4] This feature is particularly attractive to early growth stage businesses for which compensation of talent must be balanced with the need for capital. The tremendous wealth-building potential offered by NSOs is especially effective in attracting executive talent that is willing to sacrifice short term compensation for a chance to participate in the company’s upside. Moreover, NSOS provide a non-cash method of awarding bonuses for attaining goals and motivation for continued performance. NSOS also allow companies to compensate individuals who do not qualify as common law employees,1[5] such as directors and strategic third parties. Finally, vesting and holding periods result in capital investment by executives in the company, further linking shareholder and management goals. Overall, the flexibility in pricing, holding periods, permissible participants, and times and methods of exercise make NSOs more useful vehicles than ISOs for tailoring a plan to a company’s needs to attract, retain, and provide incentives for employees.
Notwithstanding these benefits, NSOs impose costs that both the closely held business and its owners must bear. The exercise of the NSOs provides the executive with all of the rights of a minority shareholder and results in the dilution of the interests of the other shareholders. Moreover, the benefit ultimately provided is not directly related to the executive’s performance, but to the company’s performance as a whole. Consequently, the executive may become disenchanted upon realization that his performance may not result in a commensurate benefit. The executive generally recognizes ordinary income on the date of exercise and, if he only receives stock on the exercise of the option, the executive may not have the funds to pay the resulting tax. This hardship may be alleviated by combining NSOs with stock appreciation rights or a grossed up cash bonus that enables the executive to pay the resulting taxes. Moreover, the company is required to withhold taxes from the executive, but may not have a source of the executive’s funds from which to withhold.
Stock Bonus Plans
A stock bonus plan involves the outright grant of stock to the executive. The grant may be based on factors that include the executive’s role and position in the company, the company’s performance, the performance of the executive’s division, or the executive’s job performance. Generally, the closely held business will subject the executive’s stock to a substantial risk of forfeiture that lapses on vesting and to restrictions on transferability that never lapse.