The Basics of Incentive Compensation

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To the extent that a business wishes to provide future key employees with an incentive to grow the business, there are a  number of ways of doing so short of giving a membership interest. For example, you could create a phantom stock plan or  a stock appreciation plan – where you give the employees something that is the equivalent of an equity interest from an  economic perspective without non-economic rights (such as management and voting rights, and the right to inspect the  financial records). It is essentially a promise to pay the employee the equivalent of firm value or firm value appreciation in the  future. 

Stock Appreciation Rights.  

Stock Appreciation Rights (SAR) are a type of employee compensation linked to the company’s stock price during a  pre-determined period. SARs are profitable for employees when a company’s stock price (i.e., valuation) rises, which makes  them similar to employee stock options (ESOs), however, employees do not have to pay the exercise price with SARS. Instead,  they receive the sum of the increase in stock or cash. The primary benefit of SARs is that employees can receive proceeds from  stock price increase without having to buy stock – they don’t own any assets or contract. SARs are beneficial to owners since  they do not have to dilute share price by issuing additional shares. 

Synthetic Stock/Synthetic Equity Plans 

Synthetic (or Phantom) Equity Plans are a concept that is unfamiliar to many business owners. Synthetic stock can be a very  powerful and cost-effective way to motivate key employees so that they work to increase the value of the company using the  “motivation of ownership”. Instead of giving employees regular units, a synthetic equity program gives the employee something  that looks and feels like member stock but is not. Instead, the employee is awarded synthetic stock, which has many of the  attractive features of ownership without some of the drawbacks.  

Many business Owners prefer synthetic plans because they allow employees to participate in the financial rewards of  ownership without having a direct ownership interest and without the complications associated with having additional  Shareholders involved in the company. 

In addition, from the business owner’s perspective, synthetic plans are often preferred over traditional equity plans because  they can be subject to vesting requirements, they can be forfeited upon an employee’s termination or departure, and they can  be repurchased using payment schedules. Unlike traditional equity that need to be repurchased under the terms of a buy-sell  agreement when an employee departs or is terminated, synthetic units can “disappear” based on certain triggering events. 

Synthetic shares can also be valued using any formula that an owner deems appropriate. For example, synthetic shares may be  valued based on the value of the firm over and above the value of the business when the synthetic equity program was started.  That way, employees only participate in the additional value that they help to deliver and do not participate in the value that  already existed. 

Synthetic equity programs also have several significant tax advantages that are attractive to both business owners and  employees. First, when an employee receives shares under the firm’s synthetic equity program, the IRS does not recognize that  receipt as taxable income to the employee until he or she actually receives the money. This usually occurs when the firm is sold  or when the employee retires and is cashed out (assuming the employee’s synthetic shares are vested). This is very attractive  considering that regular shares are taxed as ordinary income and the employee basically has to pay the associated tax even  though he or she didn’t receive any cash. 

When the synthetic shares are redeemed, the employee would receive ordinary income (rather than capital gains) tax  treatment on any amounts received for his or her synthetic shares. However, keep in mind that the employee was not taxed  while employed by the firm, meaning that employee can effectively defer payment of taxes on this benefit until a liquidity event  occurs. The time value of deferring these taxes can be significant. 

Second, when the firm pays a key employee to redeem synthetic shares, the company can treat it as an expense rather than a  repurchase of shares and the company receives a tax deduction. If the company were redeeming traditional shares, the event  would have no tax benefits to the firm.  

Example: Assume your firm is valued at $5,000,000 and you reward two key executives with synthetic shares each yielding 5% of the  growth going forward. If the firm’s value rises to $6,000,000 next year, each is entitled to $50,000 (5% of the $1,000,000) appreciation  in firm value. This is just an example – amounts and percentages are based upon the objectives and comfort level of the owner.  

Ownership portions (shares) or options should be components of the Operating Agreement. How and when ownership  portions are distributed to employees should be spelled out in exacting terms in the Plan Document and Operating Agreement.  Also, be specific about how and when ownership portions are deemed and how and when options may be executed. Spell  out the implications of poor employee performance, termination with cause, termination without cause, and divorce in the  Operating Agreement and Employment Agreement. Rather than stating a percentage of the firm, we would suggest that you  be specific in the number of ownership portions issued or optioned to the employee since there is ample ambiguity regarding  what constitutes a percentage of the company.  

Rolling Vesting Plan  

If a key employee elects not to participate in or does not qualify for ownership of the firm but still wishes to share in the  long-term growth of profits, a plan can be developed that will incentivize, motivate, and retain these employees above and  beyond their compensation for their respective individual duties and responsibilities. Under a Rolling Vesting Plan, participants  share in distributions that the owner takes on the theory that if they were true owners, they too would receive distributions.  Performance-based plans promise employees a cash bonus in the future for time-based or performance goals.  

For example, under this plan, an annual pool of dollars is structured so each participant is awarded an incentive based upon  attainment of firm or individual goals. Typically, the goals are tied to the firm’s gross revenue, net income before executive  salaries, or the compensation of the employee. Each year this award is credited to an interest-bearing account. A certain number  of years [usually three (3) or five (5)] after the allocation is made, the account “vests”. Upon retirement, the participant is entitled  to all “vested” amounts or can “cash them out” when each allocation is fully vested (see example in following paragraph). 

Example: Let’s say, a firm generates $1,000,000 of profit before owner’s compensation in 2021 (expenses cover the salaries, bonuses,  and benefits of the existing management). If the firm generates $1,500,000 of profit in 2022 before owner’s compensation, then  $500,000 will be considered “overage”. You can then share a percentage of this overage with employees (key executives, for example)  in the individual percentages you deem appropriate. When fully vested, participants can take the bonus as cash or choose to purchase  units in the firm, if available. You also reserve the right to add or remove participants as appropriate. Under this plan, you are not  affecting current compensation of the management team and those executives who choose to buy units truly want to be owners. Also,  since the contributions are based on firm profits, management has an incentive to increase profits over the long term. The contributions  can also be based on the profits generated by individual cost centers. 

In addition, in order to mimic ownership in the company, a triggering event for the plan could be added in order to pay an equity  type benefit should there be a third party-sale (the “triggering event”). Upon either of these events, the plan would reward the  executive with a percentage of the value of the company much like a Member would receive upon such an event. Typically, we  recommend that the executive benefit be a fixed percentage of the proceeds of the transaction in excess of some floor. The  executive benefit should then be based on a fixed percentage of the company subject to the attainment of defined performance  objectives set by you. Any amounts due to the executive upon the triggering event will be offset against any amounts  previously paid under The Rolling Vesting Plan. 

The executive is taxed on the compensation when it is actually or “constructively” received by him or her. The employer is  entitled to a tax deduction when the compensation is taxed to the employee. 

Deferred Compensation 

An alternative to unit-based plans is a deferred compensation plan which is classified for federal income tax purposes as either  a qualified or non-qualified plan. Qualified plans defer compensation until retirement for a broad range of employees. However,  since these plans must be offered to a broad range of employees because of ERISA requirements, they are not usually  considered a viable option as incentives developed especially for key employees. Therefore, the most common alternatives are  Non-qualified plans. Non-qualified plans typically defer compensation only for key executives and management personnel. In a  non-qualified deferred compensation plan, the employee’s receipt of a portion of his compensation is deferred to a future year.  The amount deferred can be a specified amount or a formula amount such as a percentage of the employee’s compensation or  a percentage of corporate profits.  

A deferred compensation plan can be looked upon as a bonus arrangement which is not paid at the time of determination but  rather is deposited in a deferral account in the key employee’s name. The employee is entitled to receive the balance in the  account upon the occurrence of a specified event such as retirement, death, or after a specified number of years. In addition,  the company can impose vesting requirements, for example, all or a portion of the deferred benefits are forfeited if the  employee voluntarily terminates his employment within five years of the creation of the account. These requirements can be  used to entice an employee to stay with the company. The income tax treatment of the compensation will also be deferred if  there is a substantial risk of forfeiture.  

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