Methods of Motivation

As appeared in Financial Advisor 

Employers need good employee incentive plans so that the interests of their firms and companies are aligned with the needs and wants of their key people. That’s a reality supported not only by empirical studies but also by plain logic. And it’s true for both public and private concerns.

But at private companies, there’s less room for error when it comes to incentive plans. These businesses must not only compete with public companies for talent but often do so with fewer resources, including cash.

They are also having to assuage workers’ fears. Those seeking work at a private company sometimes worry about its long-term survival and fear they are taking on a greater risk by joining. Those concerns might be based more in perception than reality, but they can make a private company’s competition for talent more difficult.

Short-Term Incentive Plans

Employee incentive plans can generally be divided into short-term and long-term components. While public companies may be inclined to offer short-term incentives, focusing even on periods as brief as three months, a private company is more likely to think of entire fiscal years when structuring a short-term plan.

Regardless of the time horizons, short-term plans that are based on an employee’s objective, measurable performance targets are most effective and the least controversial to participants, management and shareholders. More subjective short-term plans are less likely to be effective, if only because employees are more apt to be focused on what can actually be measured.

An employee’s performance might be tied to the earnings, revenue or growth rates for the entire company or a particular business segment. It can even be tied to their achievement of milestones, such as when the company launches a new product or closes a major transaction. Or a short-term plan can be tied to individual performance metrics such as individual sales or customer ratings.

In some cases, a company may want its short-term plan to consider both an employee’s individual performance and the performance of a group. This approach, when deployed successfully, can mitigate concerns about individualism and foster greater teamwork while also promoting a culture of accountability.

Another common approach in structuring short-term plans is to create performance thresholds and targets. The threshold is the minimum level of performance required to be rewarded, while the target is the level of performance established as optimal by the entire company. For each component, the incentives increase as they exceed the threshold and approach the target, where they are sometimes capped. Some companies adopt a more entrepreneurial philosophy that avoids caps on performance-based compensation.

Short-term incentives are typically paid in cash, though, as we discuss later, they sometimes can be paid with equity. From a tax perspective, short-term plans are typically less helpful for participants, as cash awards are taxable upon receipt as ordinary compensation income. The company, on the other hand, can deduct the amounts paid, subject to various limitations. In some cases, a company can construct tax-deferral mechanisms for its short-term incentive plan participants, but these mechanisms create additional complexity and can even subject participants to the risk of losing their awards if the company runs into financial difficulties.

Long-Term Incentive Plans

While a well-structured short-term plan can be quite effective in aligning a company’s and employee’s shared short-term interests, there’s usually a meaningful difference when it comes to a person’s longer-term goals, making long-term plans necessary as well. A simplistic approach structures long-term plans the same as short-term ones—but with longer assessment periods. Yet it’s only when incentives begin to take the form of equity do most employees truly begin to think—and act—like owners. And there’s a big increase in productivity and retention when someone transforms from a well-paid employee into a highly motivated owner. For this reason, many long-term plans take the form of equity-incentive programs.

By effectively using equity incentives, a private company can achieve four main goals in its talent strategy:

1. The alignment of employees’ interests as owners;
2.  The preservation of a company’s current cash levels;
3. The creation of potentially large rewards for the risks inherent in the business; and
4. The hiring and retention of top employees.

The Importance of Context

Before we address the main types of equity incentives available to private companies, it is first necessary to speak about the context for granting them. Specifically, an equity-incentive program should not be developed without first answering three central questions:

1. What are the objectives of the program?

A private company must consider its objectives and how they might best be achieved through an equity-incentive program.

• What are the main purposes of granting equity awards?
•  How egalitarian does the company wish to be in making equity grants?
• Is the company worried about its cash position?
• How tax-sensitive is the company?
• Is the company focused on the financial accounting implications of its program?
• Is the company concerned about potential control issues?

2. How is the business organized and capitalized?

The legal structure of the business will also influence the composition of its equity-incentive program. Certain types of equity awards don’t work (or don’t work well) if, for example, the entity is structured as a limited liability company or some other partnership for tax purposes. Therefore, a key question will be whether the business has been organized into a C corporation, an S corporation, an LLC or other type of legal entity. Indeed, the initial choice of entity is often based in part on its flexibility in creating an equity-incentive program.

Along with legal structure, the company’s capital structure must also be considered. Investors often impose covenants for equity grants, and complex capital structures can themselves lead to restrictions on certain types of grants.

3. What is the business’s exit strategy?

Understanding a company’s exit strategy is also important in constructing a plan. Companies that are planning to create liquidity through a sale or public offering can use structures that generally assume the liquidity will be available within a shorter period of time. These structures will usually be laden with restrictive covenants designed to facilitate such an exit.

In contrast, companies that rely on internal succession are more apt to rely on grants that produce current income for the employee and can easily be cashed out by the company, either upon vesting or when the employee retires or is terminated. These structures will also incorporate restrictive covenants, ones designed to ensure continuous control and ownership within a select group of owners.

A Comprehensive Selection

With a complete understanding of the context for granting equity incentives, we can identify the most appropriate structures for the company.

1. Equity grants

Perhaps most simplistically, a company may grant straight equity interests—usually stock or LLC interests—to its employees subject to a vesting schedule. This structure offers the immediate sharing of interests, with the recipients becoming equity holders upon grant as long as they remain at the company throughout the vesting period.

The company may require recipients of these “restricted” grants to purchase the equity at its fair market value as of the grant date. For tax purposes, the holders generally recognize ordinary compensation income at the time of vesting equal to the value at that time, less any purchase price paid. A tax election, however, is available to recognize any compensation income at the time of grant, thereby allowing future appreciation to be subject to capital gains treatment. In most cases, the company will get a tax deduction for any compensation income recognized by an employee.

2. Restricted stock units (RSUs)

Restricted stock units have become increasingly common over the past several years. They provide for future grants of stock as vesting occurs. Before the units vest, their holders are not treated as shareholders, though dividend equivalents can be paid or accrued during the vesting period. From a tax perspective, RSUs create ordinary compensation income at the time of payment/vesting, which can lead to issues for holders in private companies who may not be able to sell enough stock to pay their taxes. Some plans offer opportunities for tax-deferral, though these features come with costs, including complexity.

3. Performance shares

Performance shares work like RSUs, but the recipient is granted the right to receive vested or unvested stock only upon achieving certain performance-related goals.

4. Profits interests

Profits interests are available in entities that are taxed as partnerships. A profits interest generally entitles the holder to future appreciation and income but not to any value as of the date of grant. For this reason, they typically are not taxable at the time of granting and only create tax consequences at the time of sale and as future income and losses are allocated to them. Like straight equity grants, profits interests can be subjected to vesting.

5. Stock appreciation rights (SARs)

Stock appreciation rights allow their holders to receive cash equal to the amount of appreciation in a share of stock over a certain period. In this sense, they are “synthetic” equity awards, as the recipients never acquire actual equity. They work well for companies not willing to use actual equity in their programs. Despite their name, SARs can also be used with LLC interests and are almost always subject to vesting, at which time the holder will recognize ordinary compensation income for tax purposes.

6. Phantom shares

Phantom shares are similar to stock appreciation rights, but they also entitle the grantee to any dividends or other income generated by the underlying equity.

7. Non-qualified options (NQOs)

These options allow grantees to acquire stock or other equity at a fixed price, usually the value as of the grant date, upon vesting. Holders generally recognize ordinary compensation income at the time of exercise equal to the value of the equity at that time less the purchase price. Because the resulting taxes can be substantial, non-qualified options are best used by companies whose equity offers liquidity through a sale or redemption so that the holder has sufficient cash to pay the taxes.

8. Incentive stock options (ISOs)

Unlike non-qualified options, incentive stock options can only be issued by corporations. They are subject to a variety of legal restrictions, but when properly issued they offer recipients opportunities for substantial tax benefits. Specifically, if the stock acquired upon exercise is held for at least two years from the grant date and one year from the exercise date, then all of the appreciation generally will be taxable as a capital gain, subject to potential alternative minimum taxes. On the downside, companies cannot deduct amounts that are taxable to recipients as capital gains.

9. Employee stock ownership plans (ESOPs)

ESOPs enable private companies to make contributions into tax-deferred stock ownership plans for their employees. The plans can be used to purchase shares from existing owners, sometimes with tax deferral, and can even borrow funds to do so. They offer substantial, albeit different, tax advantages to C corporations and S corporations, but they are regulated as retirement plans under ERISA and are subject to many legal requirements, including broad employee participation subject to vesting.

Vesting And Other Considerations

Both short- and long-term incentive plans that are settleable in cash often require that a participant satisfy certain requirements, including continued employment through the date of payment, to receive an award. As for equity-based awards, vesting is usually tied to the length of an employee’s time with the company, though it can sometimes be linked to key performance indicators. Awards often vest in annual, quarterly or monthly increments, though sometimes no vesting occurs until after the first or last year. Performance-based vesting is usually tied to measurable targets such as sales numbers.

Employers must also take other things into account, such as what happens to an award if an employee dies, becomes disabled or is terminated, or if there are changes in share control. They must also consider what kinds of restrictive covenants should be included. Each of these things must be addressed in the context of the company’s specific objectives.

Settling on the right incentive strategy for a private company involves complex decision-making starting with “why” and ultimately moving into “what” and “how.” Nonetheless, private companies have great flexibility in creating incentives to align, motivate and retain the workforce they need to achieve their goals.