Which long-term incentive plan is best for your business?

Once you’ve decided to put a long-term incentive plan (LTI) in place, it’s time to review the options and determine which one will be the best fit. Below we’ll outline the top types of LTIs for privately-held companies and their various pros and cons. We won’t address employee stock purchase plans, employee stock ownership plans (ESOPs), or dividend equivalent rights because those LTI vehicles are typically used only by public companies.

1. Stock Awards. A stock award is a grant by a corporation to an employee of shares of stock of the employer or its parent or subsidiary. Stock awards are usually subject to certain securities/transfer restrictions but do not have vesting conditions based on continued employment or performance goals. Thus stock awards are typically considered fully vested on grant.

Advantages: The principal benefit of a stock award to the recipient is that it grants them an immediate ownership interest in the corporation, and correlates their interests to those of other shareholders. The company will appreciate that stock awards don’t require a complex plan or administration. Another benefit to the company is that stock awards usually result in less dilution than option awards, because stock awards typically represent fewer shares than options, given their immediate value. Finally, stock awards are never “underwater,” which occurs when the fair market value of the stock underlying a stock option is less than the exercise price of the option.

Disadvantages: For the employee, the grant is taxed as ordinary income. For the company, some incentive for employee performance is relinquished due to a lack of vesting or other conditions based upon future performance.

2. Restricted Stock and Restricted Stock Units (RSUs). Restricted stock is a grant of stock to employees that is subject to certain restrictions. They are generally restricted in two different ways. First, the stock is forfeited if service requirements, performance goals or other vesting conditions are not met. Second, the participant’s ability to assign, sell or otherwise transfer the shares is limited. On the grant date, employees become the owners of record of the shares and have voting, dividend and other stockholder rights. However, the shares are non-transferable and subject to forfeiture until the restricted stock vests (meaning, until the restrictions lapse). And, if the vesting conditions are not satisfied, the shares are forfeited.

Restricted stock customarily vests when there is either:

a) completion of specific time-based employment service requirements (time-based vesting)

b) an achievement by the company and/or the employee of certain performance-based conditions, such as annual revenue or net income targets for the company (performance-based vesting); or

c) a combination of time-based and performance-based vesting.

Restricted Stock Units (RSUs) are awards that represent a promise to transfer shares of a company’s stock in the future if certain vesting criteria are met. RSUs ordinarily have no purchase or exercise price. After vesting, RSUs are customarily settled in stock but may also be settled in cash. They do not represent actual ownership interests in the underlying shares until vested and settled in stock.

Like restricted stock, RSUs are usually subject to time-based or performance-based vesting and are forfeited if the vesting conditions aren’t met. Because holders of RSUs are not the actual owners of the underlying shares, they are not entitled to dividends, voting or other stockholder rights until the RSUs vest and the shares are transferred to them. Some companies offer dividend-equivalent rights to holders of RSUs to give them an amount equal to the dividends they would have received if they owned the underlying shares.

Advantages: Shares of restricted stock and RSUs are issued in full at the time of the grant. Because the shares ordinarily have no purchase or exercise price, they provide immediate value to the grantee and have no risk of going “underwater.” Recipients will appreciate that because the grant of RSUs is the grant of a promise and not a grant of property, RSUs are not subject to taxation until the underlying shares vest and are delivered. RSUs can also be complemented with deferred compensation plans that may permit further long-term deferral of taxes owed upon vesting.

Disadvantages: The need for tax liquidity at vesting isn’t ideal. In addition, if the underlying shares are not transferred to the holder within a short time after vesting, the delayed transfer may subject the holder to adverse tax consequences.

3. Incentive Stock Options (ISO) are an option granted by a corporation to an employee to purchase stock of the employer or its parent or subsidiary. For an option to qualify as an ISO under the tax law, the plan providing for the grant of ISOs must be approved by shareholders within 12 months before or after it is adopted, must specify the aggregate number of shares of employer stock that are available for issuance under the plan, and must specify the employees or class of employees eligible to participate in the plan. Each option must be granted within ten years of the date that the plan is adopted or approved and must be exercisable only within ten years of the grant date.

The grantee of the ISO must be a full-time employee of either the corporation granting the option, a parent or subsidiary of the granting corporation, or a corporation that has assumed the options pursuant to a reorganization, or a parent or subsidiary thereof. The grantee must remain an employee of the corporation granting the ISO, or a parent or subsidiary thereof, from the time that the ISO is granted until three months before it is exercised (extended to one year in the case of an employee whose termination of employment is caused by disability, and with no time limit in the event of the employee’s death). The terms of the plan may specify shorter exercise periods. An ISO cannot be transferable, except at death, and must be exercisable, during the employee’s lifetime, only by the employee.

Advantages: The most significant benefit of ISOs to the recipient is that they receive special tax treatment under the Internal Revenue Code. If certain tax requirements are met, then there is no taxable income to the employee at the time of grant or timely exercise of an ISO.

Disadvantages: ISOs must be held for one year after exercise to receive favorable tax treatment and must be exercised quickly after termination of employment. Additionally, if the options are underwater, the incentive and value of this LTI vehicle to the employee are eliminated. Lastly, the issuing company will not receive a deduction if the employee gets preferential capital gain treatment.

4. Non-Qualified Stock Options. NSOs are options that do not satisfy the Code requirements for ISOs and, as such, are not subject to specific tax eligibility conditions and do not qualify for the special tax treatment that is given to ISOs. Restrictions that apply to ISOs regarding option exercise price, plan and option periods, option transfers, and the number of options that may be granted do not apply to NSOs. In addition, unlike ISOs, both employees and non-employees (such as independent contractors and non-employee directors) may receive NSOs.

Advantages:  In general, there is no taxable income to the grantee of an NSO at the time of grant, unless the fair market value of the option is readily determinable, which is rare. However, the difference between the value of the stock at exercise and the exercise price is considered income to the grantee at the time of exercise.

Disadvantages: If the grantee is an employee or former employee of the company, the income recognized on exercise is taxed as ordinary income and, as such, is subject to income tax withholding and to employment taxes (which includes Social Security, Medicare and other payroll taxes). When the stock is later sold, the gain or loss is considered capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise). And, similar to ISOs, if the options are underwater, the incentive and value to the employee are eliminated.

5. Stock Appreciation Rights (SARs) SARs are a contractual right granted to an employee or service provider of a company that entitles the recipient to receive an amount equal to the appreciation in the value of the underlying company shares from the date the SAR is granted until the date the SAR is exercised. Because SARs are only a contractual right, the recipient has none of the rights of a stockholder.

SARs are customarily subject to a vesting period and, once vested, may be exercised at the employee’s election. Like stock options, a recipient’s ability to exercise the SAR is typically subject to the satisfaction of vesting requirements. SARs are most commonly settled in cash but may also be settled in shares. For SARs to be equitable for employees, it is crucial to establish a fair method of valuing the underlying stock. Available formulas to do so include the book value, the book value adjusted to reflect appreciation or depreciation of assets, multiples of earning standards, standards based on comparable companies, or a blend of these formulas.

Advantages:  SAR plans are flexible because they are not offered in order to receive special tax benefits. They tend to be more convenient for the holder and the company. Cash-settled SARs are non-dilutive, and stock-settled SARs are less dilutive than options because only the number of shares equal to spread value need to be issued at exercise.

Disadvantages: Recipients are taxed at ordinary income rates when the right to the benefit is exercised.

6. Phantom Stock. Phantom stock is similar to SARs, with a subtle variation. Phantom stock entitles the recipient to the full value of the shares at the time of vesting, rather than only the appreciation in value from grant to vesting. Additionally, phantom stock generally does not need to be exercised by the employee. Instead, it is settled on vesting without the need for exercise.

Phantom stock plans may be structured so that the holder of phantom stock receives payment upon the occurrence of different events. For example, a holder of phantom stock may receive dividends alongside actual shareholders as if the holder of phantom stock was a shareholder. Other plans provide for payment only upon a liquidity event, which is most often the sale of the company but could also be the sale of substantially all of its assets.

Advantages: Because phantom stock more commonly vests on a time basis rather than a performance basis and frequently vests on a sale of the company, it is an excellent LTI vehicle to motivate employees to help grow its value with the goal of a future sale. Phantom stock can be vested without triggering the need for tax liquidity (tax is delayed until the settlement is scheduled to occur at a future date following vesting date, other than Social Security and Medicare taxes, which apply at time of vesting). It also offers flexibility in design options—i.e., dividends/no dividends, liquidity events, etc.

Disadvantages: Phantom stock is taxable as ordinary income to the holder on vesting, or if payment is deferred, on actual payment. Additionally, if the phantom stock provides for a deferral of the cash or stock payment after vesting, the holder may be subject to adverse tax consequences.

7. Profit-sharing. Profit-sharing is a contractual right to receive a portion of the company’s net profits (as calculated by the company), typically quarterly. Payment is often conditioned on continued employment, which can provide an incentive to remain with the company.

Advantages: For the company, profit-sharing is easy to administer. For recipients, the certainty of regular additional income is appreciated.

Disadvantages Profits are taxed as ordinary income. Also, this LTI may not provide the incentive level to employees as other award types.

LTIs are an outstanding way to motivate and retain employees and can help drive company growth. However, before implementing a plan, business owners should educate themselves on the various vehicles, their advantages and disadvantages and consult with outside legal and tax professionals. These experts are well-versed in the different types of LTIs and can not only guide entrepreneurs towards the best choice but also assist with implementing and operating the plan to ensure tax and securities law compliance and help avoid expensive mistakes.