Authored by Mark Lobb
Keeping key employees during turbulent economic times can be a difficult task. Over the past several years the job market has been difficult to navigate for companies. Wages have been driven up due to a number of factors and employees have either made lateral moves or opted to leave the job market. The Wall Street Journal recently reported that 40 million people quit their job in 2021 and either left the job market altogether or moved to another job. The situation is referred to as the “Great Resignation” or “Great Reshuffle.”
Economic uncertainty is causing another concern for employers. For the week ending May 20, 2022, the Dow Jones Industrial Average suffered its first eight-week losing streak since 1923. The S&P 500 dipped into bear market territory. Business survivors of the Great Recession know that having cash and minimal debt is imperative during economic turbulent periods. So, how can a company entice new hires, retain good employees, and incentivize employees without depleting cash?
Now more than ever, companies need to be strategic with employee compensation structures. Rushing to pay more than a competing company in base compensation with an unpredictable economy is not wise. At the same time, with inflation at a 40-year high, employees need to make more money and be well compensated. A great tool to consider as a part of the compensation structure is a non-qualified deferred compensation (NQDC) plan. This article will focus on stock appreciation rights plans (SAR(s)) and phantom stock.
Stock Appreciation Rights
Also referred to as value appreciation rights, SARs are a type of employee compensation linked to the company’s stock price during a predetermined period. The employee receives compensation based on the increase in the value of a portion of the company stock over a set period. Some of the important issues related to SARs are as follows:
- The employee does not pay tax on the SARs. Tax is not paid by the employee until the employee receives compensation tied to the SARs.
- Employees receive proceeds from stock price increases without having to buy stock.
- The company receives an expense deduction when the compensation is paid to the employee.
- The existence of the SARs does not dilute shareholder ownership, nor does it affect control of the company.
- In a down economy, employers need key employees to be motivated and tied to the success of the company. SARs accomplish this by rewarding the key employees for the success of the company.
It should be noted that SARs can be granted to not only employees, but recipients may also be directors, third-party vendors, or others. The plans are flexible and can be adjusted to the needs of the company. The following are some important elements of the plan:
- Grant Recipients: Normally employers use SARs for key employees and do not include all employees. Also, as stated above, non-employees can be included in a SAR plan to incentivize strategic partners.
- Valuation: A stock price value needs to be determined to set the base value of the stock for the plan; remember, the grant recipient will be entitled to the increase in the value of a portion of the stock from the date of the initiation of the plan otherwise referred to as the grant date.
- Vesting: The company determines whether the grant recipient will be required to “vest” into the plan. Generally, companies require a vesting schedule. This entices the employee to stay at the company in order to receive the full benefit of the plan.
- Taxes and Accounting: As discussed above, the company will receive an expense deduction once the SAR is paid to the employee. The employee pays ordinary income on SAR related compensation. The company books the vested SARs as a liability.
- Settlement Date: This is the date in which the employee is entitled to receive the benefit of the SAR. It can be a set date such as “seven years after the grant date,” or it can be subject to an event such as EBDITA reaching a certain level, the company being sold, annual profit reaching a certain level, etc.
The objectives are to motivate the grant recipient to help the company grow, retain the grant recipient, and provide additional compensation. These objectives need to be reflected in the details and maintenance of the plan.
Phantom stock is similar to SARs, but instead of the compensation is a factor of the increase in a base value of the stock over a period of time, the grant recipient is entitled to the value of the actual stock. As with SARs, the grant recipient pays no tax until receiving the compensation, the company gets an expense deduction upon paying the grant recipient, the company shareholders retain full ownership and control of the company, and the grant recipient is not out of pocket for the compensation entitlement.
The traditional compensation calculation for phantom stock is the market value of an equivalent number of shares of the corporation’s stock allocated to the grant recipient. Thus, the amount of the payout increases as the stock price rises and decrease if the stock price declines. For instance, if a one share of stock in the company is worth $5,000 on the day designated for the payout under the phantom stock plan and the employee has been allocated three phantom shares, the employee is entitled to $15,000.
Again, the concept is to tie the grant recipient into the success of the company without giving up actual ownership in the company.
For a closely held company, NQDC can be a powerful tool to motivate, retain and compensate employees and strategic partners. Likewise, for non-publicly traded companies, NQDC is superior to stock options. With a stock option, the following should be considered:
- Having minority owners creates additional legal complications for the majority owners.
- Employees may have to come out of pocket to purchase the shares.
- Without a mandatory dividend policy, the shares may be worthless to the employee if there is no market for the shares.
With NQDC, the owners of the company do not have to worry about control issues, fiduciary obligations, etc., and the value of the SARs or phantom stock is objective and tied to something real.
The following serves as a good checklist to review when planning an NQDC plan:
- What are the goals of the plan?
- Who will be responsible to over see the plan and evaluate whether the goals are being achieved and the behavior and performance levels are being enhanced because of the plan?
- Who will be allowed to participate in the plan?
- What percentage of the company’s value should be allocated to the plan?
- Should participants receive the growth above the base value of the stock or the value of stock units?
- Is the potential payment obligation under the plan in line with the company’s long-term compensation and business objectives?
- When will the SARs or phantom stock units vest?
- Will the value of the stock units under the plan be based on a formula or an appraisal?
- Will forfeiture provisions apply to compensation entitlement if the employee competes with the company or is terminated for cause?
- What is the Settlement Date for purposes of payout determination?
- If a change of control determines the Settlement Date, what is the definition of a change of control.
- Will the payment be made in a lump sum or in installments? If payments are to be made in installments, what are the installment terms?
The current employment and economic environment has created the perfect storm for implementation of a deferred compensation structure.