By: Tom Decosimo and Mike Costello

Many of our clients struggle with the question of how to compensate and appropriately incentivize key employees. One solution relied on by the compensation committees of many public companies is to grant equity securities, such as shares of stock or stock options, to key employees. This strategy aligns the economic interests of owners and managers, because the employees benefit from an increase in the value of the underlying enterprise.

While the granting of equity securities to incentivize managers is a practical solution in a publicly traded company, the vast majority of businesses are not publicly traded. The nonmarketable minority interests of privately held businesses present a number of complications when used as incentive securities. For example, options of a Subchapter S corporation may be treated by the IRS as a second class of stock, causing the S election to be lost. Further, securities of any pass-through entity (such as an S corporation, partnership, or LLC) issued to incentivize employees may complicate the tax situation of both the employee and the employer.

For these and other reasons, when we help our clients design and implement a stock incentive plan, we often advise them not to issue ownership interests in the underlying business, but rather to create a Stock Incentive Plan (SIP). SIPs reward key executives and employees for building value of the company over time, and they require that the company be appraised on a periodic basis. A focus on building the value of the company obviously helps both owners and managers. A well thought out SIP rewards managers for increasing the value of the owner’s investment without the tax, governance, and other issues associated with issuing equity securities outside the current ownership group.

Three key variables in such plans are the number of incentive units involved, the baseline value, and the date of payment. The baseline value is the minimum value that the company’s equity must have for any payment to be made. When the payment date comes, the baseline is subtracted from the value at that date, and the difference is multiplied by the number of units to determine the amount to be paid.

These plans are known by a number of names, most commonly phantom stock plans or stock appreciation right plans. Typically, a phantom stock plan involves the payment of bonuses based either on the value of the company or on the change in value over time. These bonuses are typically paid at predetermined dates, and they are treated for income tax purposes just like any other bonus; the employer deducts the amount of the bonus and the recipient is taxed at ordinary income rates.

A stock appreciation right is similar, but it is typically structured as a payment equal to the increase in the value of a certain number of shares of the company’s stock over a period of time.  Stock appreciation rights (SAR) plans provide payouts similar to call options, and plans vary widely in terms of when the SARs can be exercised. From the point of view of the recipient of a stock appreciation right, a value just short of the baseline is no better than a severe drop in value. This creates two key drawbacks:

• It encourages managers to run the risk of major losses in the hope of large gains.
• It does not reward a manager who limits the loss in value from difficult external conditions, while over-rewarding improvements that are from outside the company in good times.

The baseline and the number of units can be set in many different ways to customize the particular incentives that the company wishes to set before its management. In addition, the timing of awards may vary. Some plans call for annual payments, others allow the recipient to choose when to receive payment, and others are triggered only by a change of control.

This flexibility is both a key advantage and a major challenge of these plans. Many decisions need to be made about who participates, how may units will be granted, vesting and forfeiture, funding of payments, rights to interim distributions, and rights to participate in corporate governance (if any).

In addition, decisions must be made about valuation. Is the valuation to be prepared on a controlling interest basis or a minority interest basis? Should the appraiser consider a discount for lack of marketability? Should the valuation consider the dilutive impact of the plan itself? If the company owns nonoperating assets, should they be included? To measure the amount of value that has been created (or diminished as the case may be), a valuation must be conducted as of the date of grant (if that value is to be used in setting the baseline) and at each payment date. While valuation procedures and methods may change over time, it is important that the periodic valuations are not inappropriately inconsistent in their basic assumptions regarding standard of value, level of value, and similar defining elements of the appraisal.

To avoid inconsistency, we work with our clients to help owners and management understand the principles of valuation. We stress the three major inputs of valuation—the money you make, the risk you take, and the capital you stake. Prior to the preparation of a periodic valuation, we meet with concerned parties to review the approaches, methods, and inputs. We find that when everyone understands these critical inputs and how changing them can affect value, owners and management work together to ensure the valuation will be of high quality.

We are passionate about the valuation process and the benefits of incentive stock plans. Contact Decosimo Advisory Services for more information.   

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