It's commonplace for newly hired executives to expect (or request) equity when joining a company. This is true regardless of whether the company is privately held or publicly traded. At one time, such equity was reserved for unique circumstances such as turn-around situations or when attempting to attract a uniquely talented individual who could add special value to the business (e.g., an inventor with a special patent or an executive from a key competitor with unusually valuable contacts or relationships). In such instances, it was easy to see why the new executive should join as a "partner." Over the years, these practices have become commonplace and in all but the smallest businesses it is customary for executive compensation plans to include some form of equity.
In general, I am opposed to granting equity to new executives because I see no need for the owners to give away hard-earned value to someone whose future contribution is uncertain. Remember, on their first day every new employee is considered a star (or they wouldn't have been hired), yet three years later half of them are gone. Others would argue that granting equity to executives ensures that they will have the best interest of owners in mind (since equity makes them an owner themselves). The advisability (or lack thereof) of granting any form of equity to employees is a worthy topic for a future posting, but for now I am going to assume that you have already decided to grant equity and are considering what type of equity to grant.
WHAT'S THE DIFFERENCE?
Tangible Equity (also referred to as Incentive Stock Options ISO or Stock Grants) is actual legal ownership of some portion of the business.
Synthetic Equity (also referred to as Phantom Equity or Stock Appreciation Rights SARs) simulates the cash value of tangible equity but entitles the holder to none of the rights of legal ownership.
When considering which ownership vehicle is right for you, it is helpful to view them separately from the viewpoint of the employee and the employer.
LET'S SIMPLIFY MATTERS
Any Internet search involving tangible equity will reveal a labyrinth of arcane tax treatments and legal considerations. At the end of the day, they are all designed to ensure that the employee and the employer pay their fair share of taxes. This generates an elaborate dance with each party trying to outsmart the others. If half as much energy and intelligence went into trying to increase the value of the business as goes into trying to minimize taxes, so much money would be made that paying taxes would not be inconsequential.
Which brings us to the key issue. With Synthetic Equity all payouts will be taxed as ordinary income (this is not always true, but let's take it as a given since it is true in the vast majority of cases). From the point of view of the employee, this can be viewed as a non-starter. From the point of view of the company, Synthetic Equity payments must be paid out of cash flow and/or retained earnings. Neither of which seem particularly desirable. Let's look at an example.
Consider an executive who has been granted SARs (stock appreciate rights) worth 5% of the business' increase in value over three years. Let's assume the company was valued by an independent appraiser at $20 million on day one. Fast forward ahead three years, and let's say that appraisal values the company at $28 million. The three-year increase in value amounted to $8 million of which the executive holding SARs worth 5% would be due $400,000 (5% of $8 million = $400k). That $400k would be taxable as ordinary income. So the good news is the executive would get around $250k of that after taxes. The bad news from the point of view of the employee is that Uncle Same would get the other $150k. The bad news from the point of view of the company is that they will have to cought up $400k in cash at that point (unless they have negotiated payout terms which is often the case).
Now if this same executive is granted 5% tangible equity in the business, in the scenario described above, there are only three points in time when the executive will ever see any money:
- When the company is sold.
- When the executive leaves
- When the majority owners choose to buy him out.
Unlike Synthetic Equity where the executive usually has access to cash within a specified timeframe, with Tangible Equity the executive cannot count on ever seeing any cash. This is usually considered as desirable from the vantage point of the company since they don't have to come up with any real dollars unless they choose to do so.
Most companies and executives seem to be enamored with the idea of tangible equity. Executive like the idea of "owning something" and companies like the idea of not having to pay anything until it suits them. I look at it differently. I am a huge fan of synthetic equity. From the point of view of the executive, it means real cash in a reasonable timeframe. From the point of view of the employer is it is much simpler to set up, easier to administer, and less costly in the long run considering the legal and accounting fees associated with tangible equity.
THE PERFECT PAY PLAN
In addition to your well designed base salary and annual incentive plans, consider adding SARs to your executive pay plans. They are an excellent tool for simulating ownership and improving focus on increasing the value of the business.