► Paying Key Employees When You Can’t Show Them the Money
If you run one of the many companies struggling to keep cash flowing and the bottom line in the black, consider paying your executives in stock.
You’re conserving cash — and that’s especially important when your company finds you have less than usual and you’re having difficulty getting it.
- By using stock or phantom stock, you may still get a tax deduction based on the value of your stock, which helps your cash flow.
- Since the sale of the stock is restricted, it will help retain your key employees and even attract new ones.
What to consider:
- Standard restricted stock – the survival award. Give a restricted stock award, and the employee can’t sell this stock. It is stamped “Cannot be sold before a certain date.” That date usually is at least 5 years out in the future, but as long as you are still in the company 5 years from now, the stock is yours to do with as you wish.
- Restricted with performance-related conditions – Instead of five years, maybe the stock award is out for 8 years. If the company is able to achieve a compound average growth rate of earnings per share of 15% for 8 years, restrictions are off. They may never come off – the company may never get to the compound average. At the end of 8 years, it still belongs to the employee.
- True performance share plan – includes the first two restrictions but scales the award based on company performance. For example, the company might set an award target of 6,000 shares. For an individual to receive those 6,000 shares, the company will need to reach a certain business goal – such as 15% earnings-per-share growth – within a certain time frame. If it does, the shares are awarded. If it reaches only 12%, however, the individual might receive only 4,800 shares. Below the target, there should be a threshold award, which is the lowest award above zero. If 15% is the target, the threshold typically is set at about half that, 7.5%. Below that, the employee would not receive the reward. Also, the award could scale up. At the top end, it’s typically set at double the target, which would mean 12,000 shares, and that would probably mean a compound average of earnings per share of 30%.
- Phantom stock – a promise to pay a bonus in the form of the equivalent of either the value of company shares or the increase in that value over a period of time. For instance, a company could promise its new employee, that it would pay a bonus every five years equal to the increase in the equity value of the firm times some percentage of total payroll at that point. Or it could promise to pay an amount equal to the value of a fixed number of shares set at the time the promise is made. Other equity or allocation formulas could be used as well. The taxation of the bonus would be much like any other cash bonus–it is taxed as ordinary income at the time it is received.
- Stock appreciation right (SAR) – much like phantom stock, except it provides the right to the monetary equivalent of the increase in the value of a specified number of shares over a specified period of time. As with phantom stock, this is normally paid out in cash, but it could be paid in shares. SARs often can be exercised any time after they vest. SARs are often granted in tandem with stock options (either ISOs or NSOs) to help finance the purchase of the options and/or pay tax if any is due upon exercise of the options; these SARs sometimes are called “tandem SARs.” One of the great advantages of these plans is their flexibility. But that flexibility is also their greatest challenge. Because they can be designed in so many ways, many decisions need to be made about such issues as who gets how much, vesting rules, liquidity concerns, restrictions on selling shares (when awards are settled in shares), eligibility, rights to interim distributions of earnings, and rights to participate in corporate governance (if any).
- Tax Issues. For phantom stock, employees are taxed when the right to the benefit is exercised. At that point, the value of the award, minus any consideration paid for it (there usually is none) is taxed as ordinary income and is deductible to the employee. If the award is settled in shares (as might occur with a SAR), the amount of the gain is taxable at exercise, even if the shares are not sold. Any subsequent gain on the shares is taxable as capital gain.
- ERISA Issues. Phantom stock plans are not tax-qualified, so they are not subject to the same rules as ESOPs and 401(k) plans, provided they do not cover a broad group of employees. If they do, they could be subject to ERISA rules (see below). Unlike SARs, phantom stock may reflect dividends and stock splits. Phantom stock payments are usually made at a fixed, predetermined date.
- Valuation Issues. By having an independent valuation expert appraise the stock, the employer and its lawyer and accountant have shifted the responsibility of determining the fair value of the stock.