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We previously discussed the benefits of equity incentives. When it comes to compensating a start-up’s key people, equity incentives are often the best way to align interests with the founders.  Sometimes, however, non-equity incentives can be useful.

Non-equity incentives allow employers to compensate and incentivize key employees by enabling them to share in the success of the business without complicating the capitalization structure of the company, or where the capitalization structure of the startup doesn’t leave much value to the common stock and option plan.  For example, minority shareholders are entitled to certain rights and protections (e.g. a right to inspect the books and records of the corporation, protection from majority oppression, and the right to bring a derivative claim on behalf of the corporation).  These rights can sometimes hinder the efforts and decisions of directors and controlling shareholders, who may owe minority shareholders a fiduciary duty.  Employees under non-equity incentive plans, however, are owed no such duty.

Some other reasons a company might consider a non-equity incentive plan include:

  • The Company perceives a need to offer cash-based incentives;
  • The company cannot offer traditional equity plans because of corporate restrictions;
  • Other incentive plans are determined to be too restrictive or too costly; or
  • The Company’s preferred stock liquidation preference is unlikely to allow any value to flow to the common.

The following is a discussion of a few types of equity-like but ultimately non-equity incentives:  Phantom Stock, Stock Appreciation Rights, and Management Carve Outs.

Phantom Stock

Phantom stock, as the name suggests, is not real stock.  Rather, phantom stock is essentially a non-equity incentive that ties cash bonus payments to the value—perceived or otherwise—of a company’s stock at a particular point in time.  For example, under a phantom stock plan, an employee might be paid a bonus equal to a percentage of the corporation’s profits (however measured), the cash value that a specified number of shares in the company would have, or a percentage of the increase in the corporation’s equity value.  This bonus might be paid over a period of time (e.g., profit over the next 5 years), at a set point in time (e.g., every five years), or upon the occurrence of some triggering event (e.g., upon payment of dividends to stockholders, equity financing, sale of the company or an IPO).  For public companies, phantom stock is typically tied to the trading value of the stock, which is why (as we previously noted) phantom stock tied to a share value isn’t a great match for a non-publicly traded company.  Non-publicly traded companies can, however, structure phantom stock plans in other ways to incentivize overall increases in value of the company.

Much like any other cash bonus, phantom stock payments are taxed as ordinary income to the employee at the time received (vested) and are subject to withholding.  One advantage to employees is that, unlike the vesting of a stock grant, the employee receiving a phantom stock payment has cash to pay the tax.  For employees who receive actual shares in the company taxes are often imposed (unless an 83(b) election was made), notwithstanding the absence of a cash distribution to fund the tax obligation.   For the employer, phantom stock payments are treated as a currently deductible expense.

Phantom Stock plans are not “tax-qualified,” so they are not subject to the same rules as Employee Stock Ownership Plans (ESOPs) and 401(k) plans.  However, if a phantom stock plan covers a broad group of employees, it may be subject to the Employee Retirement Income Security Act (ERISA).  Employers should also be aware that there are certain accounting methods and principles that apply to phantom stock plans, which should be discussed with the company’s tax advisors.  In addition, the phantom stock arrangement may be subject to § 409A of the Internal Revenue Code and compliance with § 409A should be discussed with the company’s tax advisors.  Section 409A may apply if an employee has a legally binding right to compensation in one year that may be payable in a subsequent year.

Stock Appreciation Rights

Stock Appreciation Rights (“SARs”) are similar to stock options in that they may result in a payment tied to an increase in the value of stock over a certain period of time.  SARs can be paid in cash or in shares (the latter crossing over into equity incentive territory) and typically are subject to vesting and various external trigger events (such as a sale of the company).  Additionally, like phantom stock, SARs are taxed as ordinary income to the employee when the benefit is exercised and are a deductible expense to the employer.

Management Carve Out

Management Carve Outs are a bit different and usually come into play well after the start-up phase, when the company is ready to sell (or its investors are ready to have it sold).  Nevertheless, they are another kind of non-equity incentive that can be important for companies, including start-ups, to keep in mind as management works toward the company’s growth.

Simply put, a management carve out is a payment to key members of management out of the proceeds of a sale of the company (usually based on the purchase price), and ahead of the preferred stock liquidation preference in the waterfall.  When preferred holders have a liquidation preference that is very likely to result in the common stock and option plan being attributed no value in a sale, traditional equity incentives such as stock options are worthless to incentivize management.  For management who perceive themselves as having worked hard to make the company what it is, a carve out can be an incentive to get the company sold.  However, carve outs can be complicated, and, from the point of view of a lot of investors, are a red flag that the capitalization table is too heavy and needs to be cleaned up. Accordingly, the decision to implement a carve out, or any non-equity plan for that matter, requires a careful balancing of costs and benefits.