For companies that want to get stock into the hands of only one or a few employees, an ESOP isn’t the right tool for the job. There are other options (pun intended) that provide equity-based compensation to a small number of employees. Picking the equity-based plan that will do what you need it to do can be confusing. The key is to ask yourself these five questions.
1. “Real” or “Synthetic” Equity?
If you’re comfortable adding another shareholder to the roster and your employees place a high value on owning actual stock, then real equity is the way to go. But if you’re not ready to share ownership just yet or your employees are ambivalent about owning actual stock, synthetic equity (like phantom stock) is a good choice. Answering this real or synthetic equity question requires being on the same page with your employees who will participate in the plan.
2. Is Your Priority to Recruit, Retain, or Incentivize?
Think of this as a sliding scale of requirements or contingencies to meet or satisfy before employees earn the benefit. On one end of the scale is an outright bonus or grant of unrestricted stock. Issue a stock certificate in the employee’s name, add them to the share register, and include the value of the stock as compensation on their W-2. This can be effective for recruiting or retaining a valued employee. It doesn’t require any future performance. On the other end of the scale, you could adopt a stock appreciation rights (SARs) plan with a performance-based target for receiving the grant and a years-of-service requirement for being able to exercise the SAR and be paid. The SAR plan would incorporate recruiting, retention, and incentive features. Somewhere in the middle might be a grant of actual options or restricted stock with no cash payment or other requirement to receive the grant. Either might include a performance-based or time-based requirement to exercise or lift voting rights restrictions. Deciding what you want the plan to do will narrow the plan design choices significantly.
3. If You Select Real Equity, How Much “Freedom” Will the Employee Have with the Stock?
If you want to ensure continued control of the board, you may want to form a voting trust with a trustee holding the voting rights attached to the employee’s stock or non-voting common. If the company is a C corp and pays dividends, you may want to avoid paying dividends on stock held by employees by creating a second class of stock. See our article on tax-deductible dividends for more on that topic. If you don’t want the employee to sell their stock to a third party, you probably want a shareholder agreement that specifies to whom the employee can sell the stock, when, and at what price. By choosing real equity over synthetic, you’ve already decided that you’re willing to share ownership to some extent. Answering this question 3 will help you focus on how much control you’re willing to share to achieve the priority you identified in step 2 above.
4. If You Select Synthetic Equity, Do You Want to Reward Employees for Past and Future Performance or Only Future Performance?
SARs plans provide only a forward-looking benefit because the value is based on the increase in the stock value from the date the SARs are granted to the date they are exercised. Phantom stock is a benefit that looks backward and forward. The value of the benefit is based on the full value of the underlying stock, when the benefit is paid, not just the increase in the value from the date of the grant. The answer to this question may also be affected by how you prioritize the needs to recruit, retain, and incentivize.
5. How Much Real or Synthetic Equity Is Enough?
This is a challenging question. Some companies think in terms of percentages of the company. This measure is often not tailored enough for the company objectives or the right employee incentive. The starting point for the calculation is the value of the total employee compensation package needed to achieve the priority you determined in question 2. Think of it in terms of how much is meaningful as a benefit compared to the employee’s base compensation and career goals. If you don’t know what this number is or how to divide it up between base compensation and benefits, you may want to engage a compensation consultant familiar with your industry and market. Once you know the total compensation target and roughly what proportion should be base compensation versus bonus or equity-based compensation, you have the foundation for deciding the more detailed questions. For example, how much dilution, real or synthetic, are you comfortable with? How many employees will that cover? Do you want to grant all of it now or save some for future hires?
This article intentionally does not describe the features of each type of equity-based compensation tool, but you can find more resources on Equity and Executive Compensation here. In our experience, you will get a more satisfying result by first answering these five questions. You will achieve your plan design more efficiently than starting off scrolling through the internet to decipher the differences between phantom stock, restricted stock, incentive stock options, nonqualified stock options, and stock appreciation rights. Thoughtfully answering these questions will help make you select one or a combination of plans that will best meet your objectives. If you’re ready to design and implement an equity-based compensation plan or you need guidance for answering these questions, let’s start a conversation.