Executive compensation: Besides stock options, what else is there?

02 Apr Executive compensation: Besides stock options, what else is there?

Madison, Wis. – Most of us have a rough understanding of stock options and how they work: they give someone the opportunity to buy stock at a given price somewhere down the road. In previous columns, we have examined some of the benefits of statutory and non-statutory stock options. Stock options, however, are not the only game in town. There are other ways to allow individuals to share in the success of a company. Let’s take a quick look at a few alternatives to the more common stock option.
So, what else is out there? There are several alternatives, including restricted stock plans, phantom stock, stock appreciation rights, and employee stock ownership plans. Each of these plans is an alternative to the stock option, and some do not involve stock ownership at all. Even more so than previous columns, please keep in mind that this is only a quick introduction to these less-typical arrangements. Section 409A may be implicated in these plans, and a trusted advisor is needed to ensure that the plan works as intended.
Why might companies be looking for an alternative to stock options? There are lots of reasons, not least of which are the statutory and tax restrictions and limitations placed on options. Sometimes companies may already have a stock option plan, but would like to supplement that plan with something else. More commonly in smaller, start-up companies, this might be the only plan the company has, and this often arises out of a concern that stock options will ultimately result in employees owning straight equity in the company. Or, perhaps, the company is not a corporation that can issue incentive stock options. These and other reasons lead many companies to consider one of the alternatives.
Restricted stock plans
A restricted stock plan is similar to a stock option plan, except that stock is often granted outright, with restrictions. These restrictions typically mean that the recipient will not be taxed on the restrictions unless and until the restrictions lapse. So, for example, the stock could vest over a number of years, with the recipient recognizing income as her interest in the stock vests. This type of plan can avoid the complexities of an incentive stock plan, but note that it still results in stock ownership by the participants.
Stock appreciation rights
A stock appreciation right, or SAR, is a very different animal. Instead of necessarily resulting in stock for the participant, a SAR often results in a right to cash. The basic concept is that the holder of a SAR receives a right to an amount equal to the appreciation of the stock of the company between the date the SAR is granted and the date it is exercised by the participant. For example, if a participant were granted a SAR when the company’s stock is worth $10/share, and the stock grows in value to $20/share, the participant would receive $10/share (the actual amount that the participant would receive depends on the number of SARs the participant is granted). Although these often are paid in cash, this is not required: a SAR can be paid in cash, stock, or any combination. SARs can even be issued in tandem with an incentive stock option to provide maximum flexibility to the participant.
Phantom stock
Similar to SARs, a phantom stock plan gives participants a right to enjoy the benefits of the appreciation of the underlying stock of a company. The basic concept is that the phantom stock issued to the participant is meant to act like the stock of the company, but instead of getting actual equity of the company, the “phantom” stock only mirrors the performance of the company’s stock. Typically, participants who receive phantom stock are entitled to the “value” of the phantom stock, not just the appreciation from the date of grant (like SARs). Like SARs, they can be paid out in cash or stock.
Employee stock ownership plan
The ESOP is yet another way to get employees ownership in the company, but it is a significantly more drastic and regulated means to that end. Nevertheless, there are significant benefits for some companies. An ESOP is an employee benefit plan governed by the Employee Retirement Income Security Act (ERISA), which adds an imposing regulatory framework. The ESOP is a sort of collective of employees that purchases (or is granted) stock of the company. Trustees who look out for the best interests of the employees must run the ESOP. Unlike other alternative plans, ESOPs cannot discriminate among employees in favor of the executives of the company.
An ESOP often is used as a way for the owner of a company to exit the company: the ESOP borrows money, which it uses to purchase the owner’s stock, and the result can be very tax advantageous for all parties involved. Since subchapter S corporations have been allowed to have ESOPs as shareholders, the planning opportunities have expanded to many small businesses and can ultimately result in companies that owe little if any tax. ESOPs, as you might imagine, are complex animals and require significant up-front and operational expenses.
Maximizing company value
This is just an introduction to some alternative ways to develop employee ownership or incentives that approximate share value. If they work well, participants will have incentives to maximize the company’s value, and everyone benefits.
For a great resource with more information about these types of plans, stock options, and other forms of employee ownership or participation in the company, check the National Center for Employee Ownership.
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