Performance and Incentive Plans in Closely-Held Companies

By:  Paul D. Creme, Esquire

Performance and Incentive Plans are compelling tools for business owners and managers seeking to assure long and effective performance from their employees that will lead to a more successful and profitable company.  In many companies, but especially in closely-held companies, the company’s greatest asset is their key employees.  Many of these key employees may have employment contracts, or at least non-compete or non-solicitation contracts.  These contracts, to the extent that they are enforceable, protect companies by limiting the employees’ incentive to leave.  But it is equally as important, to know how to reward and incentivize key employees to invest and grow with the company.  There is a wide range of these types of plans, and each may be conditioned on a vesting schedule, involve voting or non-voting equity, and/or be payable upon the happening of specified events, such as a sale of the business during the term of the employee’s employment (or during such term and for a limited period thereafter).

When trying to determine what type of performance or incentive plan to adopt, the owners of the company must first determine what is the primary goal?  Is it to reward performance with an immediate benefit or is the goal to retain employees and allow them to participate in the increased value of the company?   The former simply requires cash bonuses, or deferred compensation plans.  On the other hand, if the latter is the goal, the company may wish to consider one of the many types of equity plans available.  Equity plans require more planning because giving someone an ownership in a closely-held company provides the employee with a variety of rights that business owners may be unwilling to offer.

A brief description of some of the more common plans and issues to consider in connection with each is set forth below.[1] We also offer our comments on the advantages and disadvantages of each.  These comments are based on our many years of experience representing closely-held companies.

Types of Plans

I.      Cash Bonuses
II.    Equity “Tracking” Plans

(a)    Phantom Stock
(b)    Appreciation Rights

III.  Equity Plans

(a)    Stock Grants
(b)    Stock Option Plans
(c)    employee Stock Purchase Plans
(d)   employee Stock Ownership Plans

I.     Current or Deferred Cash Bonuses

Cash bonuses are the easiest to administer and the most common form of performance based awards.  Cash bonuses are usually paid at year-end and are tied to company and/or individual performance.  The measurements of both company and employee performance are varied and can be unique to each employee and company.  Regardless, they should be easily measured and understandable to the employees.  Individual goals should be part of a formal review process and should be done in writing.

Advantages: Cash bonus plans are easy and inexpensive to administer.  Payments are deductible by the company.  If it is a formulaic plan, the employee has comfort in knowing how well they will do based on their own performance.  Many companies have moved to deferred compensation plans that allow the employees to defer income.  This deferral can have a vesting component to it which ties the employee to the company.  In a cash bonus plan, the employee does not have any rights as a stockholder.

Disadvantages: Payments of cash bonuses may not increase employee retention or loyalty.  Too often, once they are paid, the employee believes they earned it for past performance, not future performance.  Deferring bonuses can tie employees to the company, but you must comply with the tax code, in particular, Internal Revenue Code Section 409A (“409A), which restricts deferred compensation plans to avoid tax problems.

II.     Equity “Tracking” Plans

Equity plans work best in companies where growth and a potential for acquisition or an IPO are part of the strategy.  Equity Tracking Plans are plans that allow employees to benefit from increases in the value of the equity of the business without ever actually owning equity. One of the great advantages of these plans is their flexibility.  They are individual or group contracts between the company and employees that grant rights to income based on equity rights, but without subjecting the company to the statutory requirements, or to grant the employee the statutory rights that follow actual equity ownership in a company.  Because they are so flexible, many decisions need to be made about who gets how much, vesting rules, liquidity concerns, restrictions on selling shares (when awards are settled in shares), eligibility, rights to interim distributions of earnings, and rights to participate in corporate governance (if any).

     (a)        Phantom Stock Plans

Unlike many of the other plans to be discussed here, a Phantom Stock Plan provides some of the benefits of an equity plan without creating shareholder issues such as information and/or voting rights.  The name “Phantom Stock” is somewhat misleading in that the employee never receives stock, but rather only receives a promise to pay a bonus that is equivalent to the value of the company’s shares at a set time.  For instance, a company could promise an employee that it would pay a bonus after five years (or upon the happening of a specified event) equal to the equity value of a certain number of the established shares of the company at that future time; or it could promise to pay an amount equal to the value of a fixed number of shares set at the time the promise is made.  Other equity or allocation formulas could be used as well.  The taxation of the bonus is much like any other cash bonus – it is taxed as ordinary income at the time it is received.

The issues with this type of plan are addressable at the planning stage.  First, care must be taken to avoid giving early participants too large a “portion” of the company’s stock and not leaving enough for later employees.  Second, the Phantom Stock must be valued in a defensible way.  Third, similar to cash plans outlined above, if funds are set aside to “fund” the payments to come due, they may need to be segregated into a “Rabbi Trust” to help avoid causing employees to pay tax on the benefit when it is promised rather than paid.  Finally, if the plan is intended to benefit more than key employees and defers some or all payment until after termination or retirement, it may be subject to 409A or be considered a de facto “ERISA” or retirement plan.

Advantages: Simple and inexpensive to administer; payments are deductible by the company.  No current income tax on the grant.  Employee does not have any rights as a stockholder.

Disadvantages: Payments of cash must be treated as ordinary income by the employees.  Some employees will not feel like “true owners” of the company and are not incentivized enough to stay in the company.

     (b)       Stock Appreciation Rights (SAR)

A stock appreciation right (SAR) is a form of phantom stock, except its value is always equal to the amount of an increase in the value of a specified number of the company’s shares over a specified period of time.

An SAR is normally paid out in cash, but it can be paid in shares.[2]  SARs may be constructed so that the Plan specifies when they will be paid, or they may provide that the company or the employee have the right to elect when they will be paid (the employee only after they vest).

Like Phantom Stock Plans, if drafted properly, employees are taxed on SAR Plans when the right to the benefit is received.  At that point, the value of the award minus any consideration paid for it (usually none) is taxed to the employee as ordinary income and is deductible to the company.

Advantages: Relatively simple and inexpensive to administer; payments are deductible by the company.  The employee does not have any rights as a stockholder.

Disadvantages:  The company must record a compensation charge on its income statement as the employee’s interest in the award vests or is no longer subject to forfeiture.  So from the time the grant is made until the award is paid out, the company expenses the value of the percentage of the promised shares or increase in the value of the shares, pro-rated over the term of the award.  In each year, the value is adjusted to reflect the additional pro-rata share of the award the employee has earned, plus or minus any adjustments to value arising from the rise or fall in share price.

III.       Equity Plans

Equity Plans, by definition, are intended to provide the employees with the opportunity to create wealth commensurate with the increased value of the company.  These plans provide strong incentives to employees to remain with the company to help achieve that growth.  The primary reason for employees to acquire equity in a closely-held company is to allow them to share in a liquidating event, such as the sale of the company or a public offering of the company’s stock.  The disadvantage that these plans share is that the employees will have rights as shareholders.  We recommend limiting those rights by using only non-voting stock, and by requiring the surrender or buy-back of the stock when the employee’s service to the company terminates, regardless of reason.  This can be accomplished through an employment contract and/or a stockholder agreement.

Generally, in designing an equity plan, companies need to consider carefully how much stock they are willing to make available, who will receive it and how much employment will grow so that the right number of shares is granted each year.  A common error is to grant too many shares or options too soon, leaving no room for additional options to future employees.  Questions that are crucial in defining specific plan characteristics include eligibility, allocation, vesting, valuation, holding periods and stock price.

Voting and non-voting stock

If your company elects to grant stock or options to purchase stock, or the stock is purchased by the employees as part of a stock purchase plan, the stock may be designated by the company as either voting or non-voting.  If the stock is voting, upon the grant and the removal of any restrictions, or in the case of the exercise of the option, upon payment of the purchase price, the person holding the stock has the same rights to information, receive dividend distributions and to vote, as any other stockholder.  If the stock is non-voting, the shareholder does not have the right to vote unless the right is granted for certain events, but the person holding non-voting stock still has the right to receive information and dividend payments equal to that of voting stockholders.

     (a)        Stock Grants

The company may grant stock to employees with or without restrictions.  These restrictions will determine when the employee will have to pay income taxes on the value received.  Most companies use restricted and non-voting stock.  While the fact that such restrictions may limit voting rights or vesting of the stock over time, the advantages are usually considered to outweigh these issues.

If the stock is subject to the possibility of forfeiture, or is not completely vested, then the stock is restricted and the tax is deferred until the vesting or forfeiture period ends unless the employee chooses to make an election under Section 83(b) of the Internal Revenue Code (an “83(b)” election).  If an 83(b) election is made, the employee pays taxes in the tax year in which he or she receives the stock based on its value in that year.  There are some issues with an 83(b) election. If the value of the stock does not increase after the election, taxes will still be payable even if the employee forfeits the stock after making the election.  In this case, the employee could deduct any amount actually paid for the stock (subject to capital loss limitations), but he or she would not get a deduction for the compensation income reported when the election was made.

Notwithstanding the potential costs, the 83(b) election may be appropriate if (i) the amount of income reported at the time of the election is small and the potential growth in value of the stock is great, or (ii) the employee expects reasonable growth in the value of the stock and the likelihood of forfeiture is very small.  The election form must be completed and filed within 30 days of the grant.

Advantages: Relatively simple and inexpensive to administer; grants are deductible by the company when the restrictions lapse.  The employee actually becomes an owner in the company and will receive the benefits and risks of ownership.

Disadvantages: Grants must be treated as ordinary income by the employee, or the employee must buy the stock.  The employee has rights as a stockholder.  These disadvantages can be limited by using non-voting stock and shareholder agreements.

     (b)       Options to Purchase Stock

Traditionally, stock option plans have been used as a way for companies to reward top management and “key” employees and link their interests with those of the company and other shareholders.  However, if the option plan allows employees to sell their shares within a short period after granting, it may not create long-term ownership vision and attitudes.

A stock option gives an employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years.  The price at which the option is provided is called the “grant” or “strike” price and now usually will be the market price at the time the option is granted.  There are two principal kinds of stock option programs: incentive stock options (“ISO”s) and non-qualified stock options (“NQO”s or “Non-Qual”s).

ISOs are a form of equity compensation that provides unique tax benefits, but also requires meeting certain statutory requirements.  There is no deduction for the company or income (other than AMT income) to report by the employee at the time of grant or at the time of exercise (unless the stock is sold within one year of purchase).  If the stock is held for one year or longer, any gain from the sale of the stock will be treated as long-term capital gain by the IRS.  Grants of ISOs must be made at fair market value (or higher) and the option may be held open only for a limited period of time (10 years).  It is very unusual for a closely-held company to grant ISOs rather than NSOs, because normally, neither the employee nor the company wants the employee to exercise the option unless there is a pending sale, thus the employee will not satisfy the holding period needed to obtain the tax benefits.  In addition, in most instances, the exercise of an ISO will subject the employee to the Alternative Minimum Tax in the year of exercise.

NSOs have two disadvantages compared to incentive stock options.  One is that the person receiving the option has to report taxable income on the difference between the exercise price and the value of the shares at the time the option is exercised, and the other is that the income received when the stock is sold is treated as compensation, which is taxed at higher rates than long-term capital gains.

Advantages: Options allow the employees to participate in the growth of the company and to feel that they have an equity participation, without having to pay for that right until exercise.

Disadvantages:  Once they exercise the option, employees will have rights as stockholder; sometimes complex to administer.

     (c)        Employee Stock Ownership Plans (ESOP)

In an ESOP, the company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares.  Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.

Shares in the trust are allocated to individual employee accounts.  Although there are some exceptions, generally all full-time employees over 21 years of age must participate in the plan.  Allocations are made either on the basis of relative pay or some more equal formula.  As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting.  Employees must be 100% vested within 3 to 6 years, depending on whether vesting is all at once (cliff vesting) or gradual.

When an employee leaves the company, the company must buy back the stock from his or her trust account at its fair market value (unless there is a public market for the shares).  This can be a major expense.  Private companies must have an annual outside valuation to determine the price of their shares.  In private companies, employees must be able to vote their allocated shares on major issues such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the Board of Directors) on other issues.  In public companies, employees must be able to vote all issues.

Advantages:  Issuance of shares is deductible by the company, creating a non-cash deduction.  The owners receive significant tax advantages.  Employees do not have any rights as a stockholder while the stock is in Trust.

Disadvantages:  The cost of setting up an ESOP is substantial.  It is also an ERISA Plan and therefore, much less favorable since you cannot discriminate in favor of key employees.  The costs of cashing out retiring employees can be high if the company has been profitable.  The plan does not reward performance and the cost may outweigh the values of providing the equity to employees.

     (d)       Employee Stock Purchase Plans (ESPP)

Under a typical Employee Stock Purchase Plan, employees are given an option to purchase company stock generally at a discounted price at the end of an offering period.  Although there are some exceptions, generally all full-time employees over 21 years of age must participate in the plan.  Employees who wish to participate indicate the percentage or dollar amount of compensation to be deducted from their payroll throughout the offering period.  The percentage or dollar amount employees are allowed to contribute varies by plan; however, the IRS limits the total purchase to $25,000 annually.

Advantages:  All employees have full participation in growth of company.

Disadvantages:  The biggest disadvantage with this type of plan is the lack of flexibility and the inability to treat certain groups of employees differently.  This type of plan is subject to ERISA requirements, therefore, preventing the company from discriminating in favor of key employees.  There is no differentiation for performance and rewarding performance.  These are complex to establish.  The employees have full rights as stockholders.

[1] Note:  for ease of discussion, all equity will be referred to as “stock” or “shares,” but all plans other than Incentive Stock Options are equally applicable to interests in limited liability companies or partnerships.

[2] In large companies, SARs may be granted in tandem with stock options (either ISOs or NSOs) to help finance the purchase of the options and/or pay tax if any is due upon exercise of the options.  If SARs are settled in shares, however, their accounting is somewhat different.  The company must use a formula to estimate the present value of the award at grant, making adjustments for expected forfeitures.