Incentives for Key Employees
Key employees are often asked by newly formed companies to work for less salary than they can command in the marketplace. They do so in order to participate in the upside potential of the company. The form of that participation may vary depending on the circumstances of the employee and the company, and it can include incentive stock options, nonqualified stock options, phantom stock and grants of restricted stock.
Incentive Stock Options
Incentive Stock Options are options to purchase the stock of the employer. Incentive options are the most common form of equity sharing. They have the advantage of tax simplicity. The key employee pays no tax as a result of receiving the option until he or she exercises it and sells the stock acquired. The price to be paid for this simplicity comes in two forms: first, the option must have an exercise price not less than the fair market value of the stock at the time of the grant. The option is thus “out of the money” when it is granted. Second, the appreciation in the underlying stock that occurs between the time that the option is granted and when it is exercised is eventually taxed at ordinary income tax rates.
Nonqualified Stock Options
Nonqualified Stock Option can avoid the problems inherent in incentive stock options, but at the cost of greater tax complexity. The holder of a nonqualified stock option incurs taxable income when he or she exercises the option. If the exercise is followed quickly by a sale of the stock, the problem is minimized. If the option must be exercised (lest it expire) before there is a market for the stock, the option holder faces a cash squeeze. For that reason, executives frequently seek nonqualified stock options with a long term. Companies, however, typically want to avoid having too many options outstanding in order to avoid cluttering up their capital structures.
Phantom Stock
Phantom Stock can be offered where the founders do not want to dilute their equity ownership, but want to provide key employees with incentives tied to bottom-line performance. Phantom stock does not involve the issuance of actual stock, but is rather a system of paying bonuses based upon increases in the company’s value. This value can be established in the phantom stock plan at the book value of the company, some multiple of earnings or a combination of the two.
Grants of Restricted Stock
Grants of Restricted Stock can be particularly effective if there is a public market for the company’s shares. Restricted stock is a term of art that includes stock acquired from a company in a private transaction rather than a public offering. The SEC has reduced the period of time that a holder of restricted stock must hold the stock before being able to resell it without potential liability under the Securities Act of 1933 for persons who are deemed not to be part of the “control” group of the company.
Grants of restricted stock have the same potential tax problem that nonqualified options have: a tax liability may arise before the key executive can sell any of the shares. There are tax planning measures available to address this problem in some circumstances. They may involve subjecting the stock to restrictions on transfer and a risk of forfeiture so as to defer the deemed receipt of income, or having the company pay a cash bonus to the employee to help pay the tax bill. The appropriateness of these techniques will vary depending on the circumstances of the employee and the company.