CASH… NOT ALWAYS KING: FIVE ALTERNATE EQUITY-BASED COMPENSATION PLANS FOR EMPLOYEES
When you hire talented employees, align their individual goals with the goals of the organization, and incentivize them to remain engaged and motivated, workforce productivity is hardly accidental. And while cash is almost always king for motivational purposes, it doesn’t always align the employees with organizational goals. Enter equity-based compensation plans whose purpose are to align employee compensation directly to company growth with little to no upfront cash from the company; and they offer the employee greater financial upside than a typical salary raise – not to mention a more favorable tax treatment. But equity-based plans come in different, and sometimes exotic, flavors. Begging the question: which plan offers the right financial and cultural fit for your company? This article considers five plans pointing out some pros and cons for each.
1) Non-Qualified Stock Options (“NQSO”)
NQSOs, commonly called “stock options.” Most people understand that a stock options is simply the right to buy a specific number of common stocks by a designated time and at a specified price (the “strike price”). The strike price locks in the price for the employee and remains the same even if the actual price of the stock has enjoyed a massive gain between the time of issuance and time of exercise. That’s the “upside.” For example:
- January 1, 2015 the company grants to employee 50,000 options for shares,
- The strike price is $0.20 per share (or $10,000 for all 50,000 shares),
- The option fully vest on June 1, 2020 (5 years)...
- Flash forward 5 years and at the time of vesting, the company’s stock has increased in value to $10 per share…
- When the employee exercises the option, he or she will pay $10,000 for stock that’s now worth $500,000.
This $490,000 gain illustrates the potential upside for employees participating in equity-based compensation plans. A gain that is totally acceptable, by the way, so long as the strike price was based on “fair market value” at the time of the grant. (see, I.R.C §409A to reference safe harbor valuation methods for calculating fair market value).
NQSOs are the most basic type of these stock-option plans (pay no mind to the awkward name, it’s a long story…). The upside to NQSOs is companies can issue them to nearly anyone: employees, board members, contractors, or anyone else providing perceptible value. And fortunately for the recipient, he or she does not recognize any taxable income at the time of the grant; taxes are only assessed at the time the employee exercises the option to buy. In addition, it does not require any cash outlays on the part of the company. So the company can grant them freely and often if it so desires. But there are some drawbacks to these options.
In the private-company context there may not be a market in which to sell the options, which in effect sticks the employee with a tax bill for exercising the options. This results in the employee paying cash for a stock that’s not liquid and owing taxes on the paper gains on it. Borrowing from the earlier example: if the employee elects to exercise his option to buy the stock for $10,000 after the option has vested, he or she would be required to shell out $10,000 to actually buy the stock and then on top of that pay taxes on $490,000 gain in stock value – even though none of that gain is in the form of cash.
To compound the issue, NQSOs do not enjoy the favorable long-term capital gain tax treatment, currently 20% Federally; this is true even if the employee has held onto the option for longer than one year. So the $490,000 gain from NQSO would be assessed at an ordinary income tax rate, which is approximately 39.5% at the upper bracket. This would a substantial bill for the employee to incur, especially if he or she had no way to make the stock liquid. Now, it is true that any increases to the stock value after exercising the option would get treated as a long-term capital gain – say for example the stock went from $10 in 2020 to $30 in 2025, the $20 increase is taxed at the lower long-term capital gain rate – but its difficult to project whether those rates will remain the same in that span of time. So it hardly seems like a fair concession.
Keeping those limitations in mind, the company may opt to “gross up” the employee by paying the tax on the employee’s behalf. In some cases the company may buy back some of the stock so the employee can pay the taxes him or herself. Of course, concerns about illiquidity should be allayed if a market into which the employee can sell the shares actually exists. Ultimately, NQSOs offer a solid alternative to straight cash compensation if the employees can avoid going out of pocket for tax expenses.
2) Incentive Stock Options (“ISO”)
The ISO is a type of stock option that operates largely in the same way as NQSOs; the company grants options at a designated strike price and the employee can exercise the option at the end of a vesting period. Like the NQSOs there is no tax assessed upon the grant of the stock option. But unlike the NQSOs, and one of the major advantages of the ISO is the employee is not taxed upon exercising the option; rather, he or she is only taxed at the time of ultimate sale. So the employee does not get stuck with a tax bill for a non-liquid gain (recall the tax on the $490,000 gain in stock price from our earlier example).
Furthermore, there is a potential that the entire difference between the strike price and the sale price is assessed at the more favorable long-term capital gain rate, rather than the ordinary income rate. This could prove substantial, considering the different between the two rates. Unfortunately, the ISOs are subject to the alternative minimum tax “AMT,” which will wipe out some, if not all, of the savings the employee received from the long-term capital gain treatment. This is especially true for employees realizing gains of less than $200,000. This notwithstanding, there is still a major advantage since employee must only pay tax upon sale of the stock (when he or she actually has cash) versus being required to pay tax immediately upon exercising the option as with the NQSO. For this reasons, many companies will elect the ISO if they can qualify for such treatment.
To be eligible to receive the more favorable ISO the company must adhere to the following:
- The exercise price must be at least equal to fair market value of the company’s common stock at the time of the grant (note: if the grant is greater than 10% of the company’s stock the price must be set at 110% of fair market value at time of grant),
- ISOs must be granted to employees (e.g. consultants do not qualify),
- ISOs cannot be transferred by the employees,
- ISOs must have a vesting term of less that 10 years (less than 5 if employee holds 10% of the company stock),
- If terminated prior to end vesting period, employee exercise within three months of termination of employment (where applicable),
- Not provide more than $100,000 in stock value to vest in any single calendar year,
- The company must not disavow its ISO status at the time of the grant,
- ISOs must be granted pursuant to a written plan adopted by the board of directors.
If the company can meet all of these qualifications, ISOs are a very good solution.
3) Restricted Stock
A restricted-stock grant provides employees with the same upside growth potential as stock options, but operates differently – in somewhat reverse order. Instead of receiving an option to buy at the strike price in the future, employees buy the stock at the time of the grant. For startups, this does not pose any significant downside since the stock value early on is insignificant. But for existing companies desiring the issue restricted stock, employees would get burdened with having had to come up with the money on day one. Borrowing again from the previous example, the employee would have to come up with $10,000 (50,000 shares x $0.20 per share) on the January 1, 2015 grant date in order to take advantage of the offering.
The stocks would then immediately issue to the employee. But they are “restricted” because the company retains certain rights to repurchase the unvested potions of the stock grant. For example, if the employee purchases 50,000 restricted shares at $10,000 on a 4 year vesting schedule and then quits at year 1, or becomes terminated with cause, or otherwise acts in violation of the terms of the stock purchase agreement, the company would have the option of repurchasing the unvested portion stock (32,500 shares for $7,500). The first year’s worth of already vested stock (12,500 shares) are the employee’s free and clear.
There are several advantages to restricted-stock grants. Although the employee must pay for the restricted stock up front (or pay ordinary income tax if the shares are granted in exchange for services instead of for a cash purchase), any gain in value over time is treated as a long-term capital gain (again 20% Federally). And unlike the ISOs, restricted stockholders have no obligation to pay the alternative minimum tax. That means employees will pay significantly less in gains from restricted shares than either of the two stock-option alternatives.
In addition, as long as the stockholder makes his or her 83(b) election he or she is not taxed until the stocks are liquidated (when the employee actually has the money to pay the tax). It is no surprise then that because of the favorable tax treatment on restricted shares, they are often the most coveted by employees.
4) Employee Stock Purchase Plan ("ESPP")
ESPP works very different from stock options and restricted-stock grants. ESPPs allow employees to designate and accumulate a percentage of their post-tax earnings to either purchase company stock at a discount (usually 85% of face value) or to just receive the earnings in cash back (with no interest). Essentially it is a savings account that allows an employee to purchase stock at a discount; good for the company because it gets interest-free cash up front, good for the employee because he or she gets a discount on stock (assuming of course the opportunity cost of holding the money in an interest-free account is less than the stock discount).
There are a number of restrictions that limit both the amount of money transferrable within these plans and the people who may participate in them. As a result, ESPPs are limited in scope and used almost exclusively in publically traded companies. In short, ESPPs may supplement another plan, but are not a great candidate as a stand-alone.
5) Stock Appreciation Rights ("SAR") and Phantom Stock
Stock appreciation rights (“SAR”) and phantom stock are very similar plans. Both contractually obligate the company to pay employees based on the increased value of stock over a period of time. They are “phantom” because the stocks are not actually issued; rather, the stock price at the time of the issuance is used as a baseline to measure against the increase. For example, if a company’s stock is worth $10 at the time of issuance and increases to $35 at the end of the period, the employee is entitled to $25 in cash or stock depending on the plan. Note: the payout for SAR is usually paid in cash, whereas the payout for phantom stock is usually paid in stocks.
When the payouts are made, they are taxed as ordinary income to the employee, which, as discussed above is unfavorable to the employee but may be favorable to the company since ordinary income is deductible. But there is a more pressing concern: if the contractual rights for SAR or phantom stock is irrevocable, the IRS may require the employee to pay taxes before realizing any funds. One obvious way around this is to make the plan revocable. But if the plan is not guaranteed, it will likely affect the employee’s perceived value of the plan. And thereby appear less effective when recruiting talent.
On the bright side, phantom stock and SAR plans can be granted to anyone – employees, contractors, advisors and anyone else providing value to the company. But they should not be given toeveryone. If they are ubiquitously tendered to all employees, the IRS may consider them retirement plans or de facto ERISA plans, which are subject to a separate set of federal rules. So selectivity and diligence are critical if opting for this equity-based compensation.
As a final thought, employers confront wide range of choices in the market of equity-based compensation plans; each with its own unique package of value-adds and tax traps. Ultimately, a company must find the best plan to entice talented employees. Equally important is for the company to remain faithful to its own financial culture.