The first sugar substitutes, like saccharine, became commonly used during the First World War when real sugar became scarce. They weren’t a way to lose weight. They were a way to replace what was no longer available—real sugar.
Synthetic equity is the same: It’s becoming more and more common as the real equity is becoming more and more scarce and more expensive. This is perhaps great for the advisory industry. After all, sugar substitutes are thousands of times sweeter and may even have some surprising advantages. Perhaps the same is true with synthetic equity—it seems to have its place and we badly need it.
Why? It’s a way for people to share ownership of advisory firms at a time that selling employees pieces of equity has become expensive.
What Is Synthetic Equity?
Ownership in a legal sense is a bit like being married. There is no gray area. You’re either married or not, and you’re either the owner of a company or you’re not. Any instruments that simulate the financial or emotional or legal effects of ownership—but aren’t really ownership—are by definition synthetic.
The characteristics of equity ownership usually include the right to income, the right to vote and the right to appreciation of value. If I own 10% of a company, I am likely entitled to 10% of the profits, 10% of the voting shares (when votes on company decisions are needed) and 10% of the proceeds from the sale if we sell the firm. You can think of synthetic equity as something that loses you one or more of the three primary rights of shareholders (when other rights are emphasized):
No vote. You might have non-voting shares for people who participate in a company’s profit and the proceeds from its sale but have no voice in the company’s decisions. This may be a way for the original owners to expand ownership of their company and raise capital without surrendering control.
No income. There could be shareholders who aren’t entitled to profit distributions and only participate in the sale of the company. There can also be phantom stock or stock appreciation units that participate in the value of the company but not in the vote or profits.
No value. There can also be a class of contributors who receive a percentage of the profit of the firm but do not vote and do not receive a percentage of the value if the firm is sold. Sometimes these are called “income partners,” but this is essentially a bonus plan if you think about it.
Some of these instruments are worth describing:
Non-voting shares. These can be used with both S corporations and LLCs filing taxes as partnerships; they simply preserve control of decision-making in the hands of the original shareholders. This is an instrument often used by family businesses.
Phantom shares. These offer the right to a percentage of the proceeds of the company during a sale … if it’s sold. For example, I can own the right to 5% of the proceeds from the sale of the company if it’s sold. If it isn’t, my right is not worth much, but if it is, let’s say for $10 million, then I will receive 5% of $10 million, or $500,000. This instrument is usually used by companies whose sale is somewhat expected—perhaps it is only a matter of time—but the business needs to retain key people until that day comes. This is usually an instrument used in companies where succession is imminent—in other words, the founders are aging.
Stock appreciation rights (SARs). These are very similar to phantom shares, but they have a specific date of exercise. For example, stock appreciation rights are granted to me equal to 5% of the appreciation of the company between now and December 31, 2027. If the company appreciates in value from, say, $8 million to $10 million, then I will receive in cash 5% of the $2 million in appreciation (from $8 million to $10 million) or $100,000. Notice that SARs do not require the company to be sold, so they can be used to share the appreciation of a firm that is not expected to sell. They will, however, require the company to spend quite a bit of cash on the exercise day.
Stock options. These allow someone to purchase shares in the future at a predetermined price (usually today’s price). This is a valuable right: If the stock appreciates, then the difference between today’s price and the future price is pure profit. If the price doesn’t increase, the owner of the options can simply forfeit them without exercising. In essence, the owner of the options captures the appreciation in the stock—even if he or she doesn’t have the rights of an owner until the exercise date. These options are often used as recruiting instruments to entice professionals to a firm where their efforts will contribute to its increase in value.
Restricted stock units. These are shares not fully owned until a restriction (usually years of service) lapses. This allows a company to use the shares for recruiting but lock the recipient into a contract for a time; if the employee leaves, they would forfeit the shares. Restricted stock unit holders don’t usually get dividends while the shares are still subject to vesting. Just like options, RSUs delay the timing of the ownership rights. But unlike options, they have value even if the stock does not appreciate. For example, if I had regular options to purchase 1,000 units at the price of $1,000 per share and the price appreciated to $1,200 per share, I have a gain of $200,000 (1,000 x $200 appreciation). If I owned 1,000 RSUs, my gain would be equivalent—1,000 units would appreciate by $200 apiece. However, with regular options, any shares that did not appreciate at all means the $1,000 of options would be worthless—no gain to be had. But the restricted stock units are still worth 1,000 x $1,000 = $1 million.
Notice that synthetic equity can be created by changing the timing of ownership. For example, restricted stock units may make someone an owner, but this ownership can be forfeited if the person leaves before the units vest. And a stock option that delays the buying decision into the future creates a Schrödinger’s box of ownership—the person may or may not be an owner. We’ll only find out when we open the box on exercise day.
Some ownership may also be earned within a compensation program where the employee is subject to other restrictions—for instance, that they can’t leave and solicit clients.
Finally, these days we also see many firms allow their best professionals to buy shares in a parent company or a pool of equity created by acquisitions. These are not synthetic instruments, per se. They just function differently, since they are connected to the performance of many firms rather than one.
Does It Work?
To evaluate how well synthetic equity works or doesn’t work, we would need to look at what real equity does, and therefore what effect we’re trying to simulate. In my experience, businesses use equity compensation (or the right to purchase equity) to do a few things:
• Create a better alignment of interests between the firm and its key people;
• Recruit more effort from people eager to contribute to something they control and derive the fruits of;
• Protect the business by discouraging the departure of key people, doing so with both rewards and restrictions; and
• Promote a long-term focus in decision-making and discourage short-term profiteering or the taking of risks that might harm a firm’s reputation.
If we evaluate synthetic equity options we will find that they mostly achieve the alignment of interest very well, especially if the right instrument is used for the right situation (for example, phantom shares are best only when they’re used in a company that’s likely going to sell).
The one challenge for synthetic equity is that it does not seem to always generate the same kind of effort as the real thing.
Another advantage of real equity, of course, is that it’s subject to capital gains tax rates, something that makes it more attractive than cash compensation. This is important to note, since the tax treatment of some synthetic alternatives is different from that of real equity. For example, if I have 5% of the shares of a firm sold for $10 million, I will likely pay capital gains taxes of 20% (assuming I am in the highest tax bracket for that tax) on $500,000 or $100,000. On the other hand, if I had 5% phantom shares, I still get my share equal to $500,000 but now I will likely pay ordinary income taxes of 37% (assuming again I’m in the highest tax bracket) or $184,000. This tax “inefficiency” will be a drawback to phantom stock, stock appreciation rights and “income partnerships.”
In other words, synthetic equity works well but, just like saccharine, it is not a perfect substitute.
The Real Thing?
In my experience, employees who receive synthetic equity are much more likely to ask questions such as these:
• I was offered a higher compensation package at another firm by a recruiter. Why should I stay?
• I understand other advisors at my level get at least 30% of the revenue they manage. How come my salary is such and such?
• I account for 20% of the new clients in the firm but I am only a 5% owner. Is that fair?
Somehow, with synthetic equity there is always a strong sense that it is not the real thing, which means it will be subject to haggling. There is something about it that seems to say, “It’s a contract, it’s not love,” and thus it’s more subject to negotiation. After all, if you are selling an employee non-voting shares, they will remember that you don’t want them talking when decisions are made. When you give them phantom shares, they will remember that these shares are somewhat imaginary when they are making their personal career decisions. The only drawback of synthetic equity is that it is not the real thing.
That said, if it were me, I would rather have synthetic equity than no equity at all. The traditional path of working in a company and earning the right to buy some percentage of the shares may be near extinction. That said, if I am building something, I want to own at least a percent of it, and there are many ways to participate in the building of a business. It may be time to embrace synthetic equity. After all, we may not have a lot of the real thing left.
Philip Palaveev is the CEO of The Ensemble Practice, the leading business consultants to the financial advisory industry, and founder of the G2 Leadership Institute, a leadership program that trains the next generation of leaders.