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.
Michael J. Nathanson, JD, LLM, is chairman and chief executive officer of The Colony Group. Nadine Gordon Lee is Managing Director, Metro NY Offices & President, Colony Group Family Office.