Aligning Incentives in an Employee-Owned Company: Synthetic Equity

By Chris Taylor

We know employee-owned (EO) companies enjoy strategic benefits: They outperform comparable non-EO companies, they take care of their employees, and they have increased financial stability. In other words, employee owners tend to be happy, healthy, and wealthy. After all, who doesn’t work hard for a company they own?

However, conventional or formal employee ownership, such as an ESOP, is only one of many tools that can be used to incentivize employees. You may want to increase rewards for your leadership team, or you may wish to employ a more surgical mechanism to recruit and retain talent, or maybe you are gearing up to sell the company. So, what are some options in those circumstances? Here, we look at the two most common forms of synthetic equity, why they may be better for an EO company than a traditional equity compensation program, and how to align your plan with business strategy.  

What is synthetic equity?

Synthetic equity is a broad term that encompasses a set of tools for employee compensation that confer the right to receive the value of equity, generally without actual ownership being transferred. Unlike most traditional equity compensation programs, synthetic equity programs are generally more flexible and tend to have fewer technical, securities law, accounting, and tax considerations in their design and execution. Thus, the company has increased freedom with plan design—from the vesting schedule to how value is determined—in a manner that best supports and aligns with the strategy the board is tasked with overseeing. Two of the most common types of synthetic equity in formal EO companies are phantom stock and stock appreciation rights (SARs).

Phantom stock generally functions similarly to a stock grant. Usually redeemed in cash at a fixed point in time, employees receive a cash payment equal to the value of company stock that is taxed to them as ordinary income, and therefore fully deductible by the company as a compensation expense when paid. For example, an executive may receive a block grant of phantom stock, the precise amount determined by quarterly performance metrics, which is then paid in cash two years from the issue date. Therefore, like traditional stock grants, phantom stock awards have some value regardless of firm performance from the time they are issued. Also, like stock grants, phantom stock awards are usually granted and utilized as a reward for previous performance, since they have value from the date they are awarded. Note, unlike many other forms of synthetic equity, phantom stock grants are subject to IRC Section 409A, nonqualified deferred compensation plan rules.

SARs generally function like stock options, where the value of the award is dependent on the increase in the price of the company stock. In other words, the recipient has the right to the stock appreciation over time, but not the total value of the stock. The value of an award is determined by the difference between the strike price at issue and the current fair market value (FMV) of the stock. At redemption, the cash award paid to the employee is deductible by the company. As a result, SARs may act as a better extrinsic motivator for growing company value over time, as they hold no value if the company stock price declines after the award date. Note, to qualify as 409A exempt, the strike price for SAR grants cannot be below fair market value.

Why use synthetic equity instead of more traditional equity programs?

To be clear, synthetic equity is not the right fit for all companies. However, it is an increasingly popular tool, and it can often be a great fit for formal EO (or soon-to-be EO) companies.

  • To provide equity without diluting ownership: Owners may wish to limit dispersion of actual shares to retain control. Not only does this preserve closely held value, but it also reduces complexity in future transactions (such as a future ESOP).
  • To preserve S corporation election: An S corporation is limited to 100 shareholders; it is also a pass-through entity that is required to issue a Schedule K-1 to each shareholder who then must report and pay their proportional share of corporate income on their personal tax returns. Therefore, utilizing synthetic equity does not threaten elected tax status and simplifies the tax situation of awardees.
  • To attract and retain key personnel: A 100 percent ESOP company is highly incentivized to protect the significant tax benefits afforded a 100 percent ESOP-owned S corporation by not issuing actual new shares, yet it competes for talent against non-ESOP owned firms. Thus, it may want to attract and or retain key personnel with an equity compensation program outside the ESOP. Synthetic equity fulfills similar goals of traditional equity compensation programs without impacting the tax advantages of the firm.
  • To manage cash flow: With greater control over vesting periods and exercise rights, a synthetic equity plan can be structured to produce more foreseeable redemption expenses. Furthermore, synthetic equity payments are deductible as payroll expenses.

Aligning equity compensation with company strategic objectives

How do you motivate employees to work hard in a manner that supports the ongoing strategic direction of the company? Equity compensation is one answer. Properly implemented, a compensation plan generates consistently high performance and encourages executives to think like an owner. However, it is not always easy to ensure your compensation plan incentivizes the individual and organizational behaviors you want.

Two primary factors should guide plan design: First, what is the purpose of the incentive? Plans to incentivize short-term sales should look different from attracting and retaining top talent, which should also look different from pursuing long-term objectives. Equity compensation is not a one-size-fits-all plan, and the future cash payouts to awardees need to be accurately tracked and estimated.  

Second, do the metrics accurately support the strategy, and what are the unintended consequences? In other words, do the measurable factors encompass the impact of the encouraged actions? For example, your director of B2B Business Development receives SARs based on customer acquisition rates. They push their team to increase sales volume, and you soon see client list growth. However, you also begin to see your churn rate climbing. What happened? Well, the sales-based metric encourages closing quickly, which could effectively disincentivize expending effort to build closer relationships with existing customers. It can be difficult to measure intangibles like customer satisfaction or relationship strength, but without a metric it is impossible to drive behavior equitably.

Again, synthetic equity is an incredibly malleable tool. Nonetheless, the most common model is pay-for-performance and tied to easy-to-define metrics. However, equity compensation should always be structured in a more deterministic manner—there should be legitimate motives for its structure, whether rewards are tied to individual, team, or company performance, or vesting occurs in two years vs. three years. Below are a few considerations for plan design:

  • How much control does the individual have over the outcome? Are results dependent on internal or external factors? Increased randomness means less motivation from contingent rewards, and a lack of control in a group setting may lead to free riding.
  • Could ambitious goals incentivize bad behavior? Aggressive goals can have unintended consequences (think about the recent Wells Fargo scandal).
  • Is there potential for internal conflict? Does the incentive create harmony between teams or drive a wedge?
  • What are the individual’s attitudes towards risk? For example, variable compensation may be far less attractive to the sole provider of a family than a single 24-year-old.

    A final consideration when aligning equity compensation with company strategy is employee perspective. At its core there should be transparency in goal alignment, and employees should understand how their metrics drive company strategic goals. Not only does this build stronger culture, but it also increases commitment to long-term performance.

    Closing thoughts

    Synthetic equity, like the traditional forms of equity, can be just as an effective tool in achieving short-term and long-term business goals through incentivizing employees. Although there are tax and additional benefits for EO companies, the principal question is whether the plan accurately supports the overall business strategy. Pros and cons exist for each design variable, but alignment is the key to success. 

Chris Taylor, 2019 Rady MBA candidate

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