Equity Incentive Compensation 101: A Primer for Privately-Held Companies

10.05.2018

Incentive compensation, based on the overall performance of a business, aims to attract and reward employees who perform well. Equity incentives are an effective way to honor long-time performance and retain employees.

What are equity incentives?

Equity incentives are ownership interests. For a corporation, this includes the company’s stock, and for a limited liability company it includes membership interests. There are also phantom stock interests – contractual rights that are the economic equivalent of stock.

What are the benefits of creating equity incentives?

Equity incentives can serve as an alternative to a high salary, reducing the cash drain on a company. They also are an opportunity for employees to benefit with company growth, and they offer a long-term incentive to keep employees loyal.

What are different types of incentive compensation plans?

• Equity-based plans: These involve actual ownership. There are Qualified Incentive Stock Options (ISOs), which have strict requirements and preferred tax treatment. Conversely, non-Qualified Stock Options (NSOs) do not carry statutory requirements but also do not have preferred tax treatment. Another equity-based plan is a restricted stock or stock bonus plan, in which a company sets aside predetermined shares to grant to select employees as a bonus. When assessing these alternatives consider how number of shares, exercise price, vesting schedule and tax consequences will affect employees and the company.
• Synthetic equity plans: These involve no “real” ownership. An example is a Stock Appreciation Rights (SAR) plan, where value is based on appreciation in the value of the employer’s stock between a specified starting level and exercise date. Another example of a synthetic equity plan is a phantom stock, which follows price movement of the company's actual stock. Synthetic equity plans avoid the potential pitfalls of minority shareholders, including inspections and appraisal rights, and, provide great flexibility to address tax issues.  

What are key considerations in designing incentive plans?

• Compensation philosophy: Does the company want employees to be shareholders?
• Minority ownership: How much of the company will be made available?
• Participation and eligibility: Which employees will be eligible to participate? Should employees be required to make a capital investment? 
• Employee payout: What level of time versus performance must employees complete to earn a vested benefit? When and how should employees be paid under the plan? What benchmarks should form the basis of determining the amount of compensation?
• Tax consequences: What are the tax consequences to employees and the company?
• Transfer restrictions: What restrictions are necessary to prevent shares of the company stock being held by potentially adverse parties? 
• Financial obligation: How will the company pay for it and manage its financial obligation?

Keep in mind that while a successful incentive compensation plan can be highly effective, a poorly designed one can have a high cost on both a company’s profits and employee talent. Consult an experienced attorney to ensure you are making the right decisions when designing your incentive plans.