Stock-based compensation is a staple of senior executives and key management employees in privately held companies. In public companies it is typically broad based as well. In both publicly traded and privately held companies, employees are almost uniformly interested in a piece of the pie and a stake in their future. Shareholders and directors, on the other hand, seem to be more interested than ever in tying executive and employee compensation to the performance of the company. Whether a stock-based compensation strategy makes sense for your company or your client’s company will depend on a number of factors. This article surveys the factors that may help you make that decision.
There are many types of stock-based compensation arrangements other than making company stock available through a qualified retirement plan. These alternatives include the four true stock arrangements: nonqualified stock options, incentive stock options, employee stock purchase plans and restricted stock arrangements. There are also stock-related compensation strategies that do not, strictly speaking, provide employees with actual shares of stock, but rather provide them with cash compensation or other rights that are tied to or determined by the value of the company’s stock. These arrangements include stock appreciation rights, and phantom stock plans. Typically, stock compensation strategies include a combination of some, if not all, of the above arrangements with certain amounts of shares under the arrangements aimed at different groups of employees or directors.
The chart “Equity Option Plan Comparison,” compares the attributes of stock-based arrangements that involve issuance of actual stock with phantom stock. The chart “Equity Plan Comparison,” compares qualified retirement plans holding stock with restricted stock and phantom plans. You can use it to help determine if any of these arrangements might work for your company. Apart from the technicalities of these provisions, however, the following five basic criteria will help you determine which of these arrangements may work in any given situation.
Simply put, these are the most obvious of concerns. They include:
- Whether employees will be interested or willing to buy stock considering potential for appreciation, and the liquidity of the stock and repurchase issues.How the shares or options are to be valued, if they cannot readily be traded on an established market.
- Whether employees can afford to buy the stock, if, in fact, it is being offered for purchase.
- Whether employees can afford to pay tax on compensation that is not received in the form of cash.
- Whether the existing owners will be willing to suffer “dilution” of their holdings in the company.
Public Company Or Privately Held?
Whether a company and its shares are traded on an established securities market will fundamentally affect the range of alternatives available and whether any of the arrangements will be attractive to a company’s employees or directors. It almost goes without saying that if there is no market for a company’s stock, it is difficult to turn stock-based compensation into cash and realize a return from reinvestment. As a result, publicly traded companies, including those traded on a limited market, such as the Over-The-Counter Electronic Bulletin Board System sponsored by NASDAQ, have the entire universe of alternatives available to them while companies that are owned by only a few, or a limited, number of shareholders and who have not registered their shares for trading, must narrow the scope of their objectives.
The ability to resell stock is only one aspect of securities laws that must be considered. There are two other principal considerations:
- The ability to offer the stock for sale to employees in the first place under an option agreement.
- The fact that the options themselves may constitute a security subject to regulations.
Securities laws dictate what is necessary to permit shares of stock to be sold to individuals and specifies protections for potential buyers from fraud concerns. A discussion of how securities laws work to require offerings of shares to be registered or offered under a “permit” is beyond the scope of this article. However, in addition to these requirements, it is most important to remember that the fraud-prevention objectives of state and federal securities laws require extensive disclosure that the companies may be unwilling or unable to provide to nonkey executives or rank-and-file employees.
If the desire for broad-based ownership of company shares by employees or others is an objective that is high enough on the company’s list of priorities, then it may make sense, at some point, to set an objective to register the company’s securities and make them more marketable. Of course, whether this is desirable is driven primarily by the company’s business plan and secondarily by compensation strategies. However, as we know, in certain industries, such as high tech, the two strategies go hand-in-hand. High growth rates are anticipated and everybody wants to own stock. The ultimate goal in these companies is for the stock to become widely held and freely traded in the market so everyone can reap the results of the company’s success. In other companies in other industries, registration of the shares is unthinkable because of the nature of the company and the cost involved.
Of course, even closely held companies can make arrangements for the resale or repurchase of securities among shareholders. This is typically done through a buy-sell agreement among shareholders. These agreements are typically funded by the corporation or by insurance and offer very limited means for realizing a return on a stock-based compensation. For many companies, these types of agreements, are the “only way out” for owners of company stock. This indicates that in closely held companies, stock-based compensation is really aimed at key executives or principals who are ultimately going to succeed to ownership of the company. Stock-based compensation in these companies, therefore, is not aimed at a broad class of employees since it would be unsuitable for them to own stock that they cannot ultimately sell.
Where a stock cannot readily be traded, the issue of valuation needs to be addressed. The Internal Revenue Code imposes only a bare minimum requirement on certain stock option plans that the board of directors make a reasonable good faith effort at determining the fair market value of the underlying shares on the date that they grant certain types of options. In a closely held company, this could mean the board of directors’ using a formula approach or a value derived by the company’s certified public accountant or an outside appraiser. As advisers to these companies, we typically recommend that our clients use the services of a competent stock appraisal firm for two reasons. First, it provides some assurance to the investing employees as to the relative worth of the stock and the objectiveness of the price at which the stock is being offered. Second, it helps the board of directors identify what increases or decreases the stock’s value. This is often critical information for the board to receive as feedback when evaluating or re-evaluating its business plan. Since competent stock valuation professionals identify risk factors, earning assumptions, and performance and margins of comparable companies in their research and analysis, this gives the board (which often involves outsiders who are not involved in the day-to-day operations of the company) a valid reference point for determining how the company is performing. This is typically not the type of analysis the company CPA can render.
Employees’ capability to purchase stock is a pervasive concern for companies considering stock-based compensation. In closely held companies, often only executives or key employees are willing to part with savings or other bonus compensation to purchase shares in the companies they help control. Even in these cases, the company usually implements one of the ancillary rights mentioned at the beginning of this article to help the executives pay for the exercise of the options or stock. These ancillary rights typically pay a bonus or director’s fees to help fund the purchase of the stock. The bonus is often paid in tandem with the exercise of the stock. The bonus is measured by the value of the shares being purchased or the appreciation in the shares being purchased. Hence, the name stock appreciation rights. Typically, the cash being paid also needs to be enough to help the executive pay the tax on the stock being purchased if there is a taxable event at exercise. Sometimes, however, a company prefers that the employee at least be invested to the extent of the tax cost of purchasing the options.
In publicly traded companies where the shares have a readily ascertainable value and there is “light at the end of the tunnel” for an employee’s investment, employees will often purchase shares with payroll withholding arrangements and budget a portion of their savings for investment in the company stock. Indeed, the tabloids and periodicals are replete with articles about how pervasive these types of arrangements have become and the high participation rate of employees, at all levels of certain companies. Even employees of certain fast-food chains have become ardent participants in stock purchase plans and option arrangements.
The issue of dilution usually rears its head in the most closely held companies and in start-up or high growth companies where certain investors need to have their positions in the company protected. In more closely held companies where control is prized and hard-earned, certain percentages are determined and locked up with company buy-sell agreements and, potentially, board positions to determine who will have a say and who will be treated as an owner. In start-up or growth companies, certain critical start-up investors or mezzanine financing investors will not want to see a stock compensation strategy or stock purchase plan that makes stock available to employees that is not commensurate with growth. Some recently published compensation studies indicate that percentage ownership is often cast at or below 20 percent of a company’s outstanding shares for all stock incentive and participation arrangements, assuming that all shares and options are exercised and purchased. Therefore, the aggregate position in the company for all participants in such arrangements is usually below 20 percent of a company’s shares.
Of course, for publicly traded or dividend-paying companies, dilution affecting earnings per share is another important consideration for the board and the shareholders so the stock continues to be well-received in the market and is respected as an investment with a good return.
Whether a stock-based arrangement will be well-received by employees comes down to a broad number of factors, including how the company is run and how the employees are treated. If management is respected, growth is steady, and there is a mechanism for liquidating the investment at some point in the future, employees may be easily motivated to invest in their employer. However, employees need to see a relationship between investment and potential return. Alternatively, there must be a relationship between investment and participation in the operation of the company for a stock arrangement to be successful. Recent studies indicate that ownership plus involvement equals increased productivity at companies that implement these types of programs. However, if a company’s management mind-set is not progressive enough to implement participatory management structures, then the prospect of investment by employees in the company may be dim unless the stock has a high potential for return.
What To Do?
First, consider what objectives you are trying achieve by implementing a stock-based compensation strategy. Are you trying to tie directors and officers to the company’s fortunes? Are you trying to justify an additional layer of compensation for key executives and directors and, therefore, wish to compensate with equity rather than cash? Are you trying to encourage more than a narrow class of employees to think like owners? Are you generally trying to tie compensation to company performance? Are you trying to perpetuate ownership of a business?
Consider who you are trying to benefit with this type of arrangement and whether they are likely to make use of and appreciate it. Consider the cash flow and tax implications of your preferred choice of stock-based compensation arrangement. If your company is not publicly traded, is the cost of obtaining regular valuations of the company’s stock worth the time and expense?
Finally, consider what regulatory hurdles may lie in the way of achieving your goals. Is it appropriate for your targeted employees or directors to invest in the company? How do you feel about disclosure of company operations and the basis for valuing the stock? Have you discussed the regulatory burdens and risks with your corporate/securities counsel?
If you have addressed these issues, then consider the types of arrangements listed in the accompanying chart. Then you have the beginnings of a decision. For additional information about which types of arrangements or combinations of arrangements might be most suitable for your company, you can contact either our office or other independent associations that focus on this area, such as the National Center for Employee Ownership (http://www.nceo.org) and the American Compensation Association.