Editor’s Note: Deana A. Labriola is a member of the Business and Technology Practice Groups at Ward and Smith, P.A., where she focuses primarily on business matters related to technology-based companies.
Let’s face it – times are tough. Businesses and individuals alike are feeling the pinch. Not so long ago, my phone rang off the hook about available investments, increased capital, and new ideas. Today, the phone calls are about cost cutting and workforce reduction. All businesses, both bricks and mortar and the cyber varieties, are trying to trim costs and ride out the current economy.
To accomplish that goal, businesses need to get serious about being creative. Employee compensation, for example, has long been thought of by many businesses as a fixed cost. However, it’s time to look beyond the fixed cost lens and think outside the box. If you’re confident that your company will survive this tough economy and live to see another more successful day, non-cash compensation options may be a consideration.
Technology and other high-growth companies have long known the virtues of paying employees in non-cash compensation. In fact, high-growth companies perfectly fit the model for it. After all, if you pay employees in promises for the future, those promises better have a potential high rate of return. Therefore, as many companies get back to basics in trying to retain their talent despite a lack of cash, lessons can be learned from the technology company model.
Two basic mechanisms companies can use to pay employees with non-cash compensation are stock options and phantom stock. While many employees and employers may be familiar with stock options, fewer know about, let alone understand, phantom stock.
A stock option is an option for an employee to purchase an ownership interest in the employer at a particular price that is set by the employer. The employee generally has several years in which to exercise the right to purchase the ownership interest. While options are used most commonly by corporations whose ownership is evidenced by stock (thus the common name "stock option"), an analogous concept exists for buying ownership interests in limited liability companies and other entities. In this article, the terms "stock option," "stock," "shares," and "shareholders" refer to the right to purchase an ownership interest in the employer, the resulting ownership interest, and the owners of the company, respectively, regardless of the employer’s form of entity.
A stock option can be either a non-qualified stock option or an incentive stock option. The basic difference between the two options is that incentive stock options may be issued only to employees of the company. In contrast, non-qualified stock options may be issued to employees, consultants, independent contractors, or vendors of the company in lieu of, or as partial payment of, compensation for services.
Stock options are not exercisable for the remainder of the holder’s life, but rather are exercisable by the holder for some specified period of time, as dictated by law or an agreement between the holder and the company.
The biggest advantages of stock options are: (a) once exercised, the holder has an ownership interest in the company, thereby making the employee, consultant, or vendor vested in the success of the company and helping to retain talent and/or the willingness to service the company’s needs; and (b) there is no cash outlay at any time by the company. Despite giving up some ownership interest, stock options are a nice way to build company loyalty without having to use cash to pay for it.
The disadvantages of stock options are: (a) unless the option is structured otherwise, the percentage of the company owned by current shareholders is diluted and, if voting shares are issued, the control of the company by the current shareholders also is diluted; (b) when an option is exercised, the holder pays either capital gains or ordinary income tax on the amount the stock has appreciated since the grant date, dependent upon the type of option and how long the option was held; and (c) the holder may not have the cash to pay for the shares or to pay the taxes associated with the exercise of the options. With respect to the third disadvantage, cashless exercise options can be used so that the holder does not have to pay cash for such shares. However, cashless options may not always be practical if there is limited growth in the price of the shares or a small number of shares are at stake.
Phantom stock can be a difficult concept to understand. While phantom stock may be given to non-employees such as non-employee directors of a company, it is given often to employees. In this article, the person to whom phantom stock is given is called the "holder," whether or not that person is an employee. At its most basic level, phantom stock involves giving the holder only the economic benefits the holder would enjoy if the holder owned a certain number of shares of the company, without the company actually issuing any shares (thus the name "phantom stock"). The holder gets no stock and holds no voting rights, and, thus, the ownership interests of the current company shareholders are not diluted. Like stock options, phantom stock vests over a specified period of time and, upon the grant of a phantom stock option, the company sets the target price for the "stock."
By way of an example, assume the following facts:
In 2009, Company A grants an employee 100 shares of phantom stock valued at the grant date at $10 per share. The phantom stock vests at a rate of 20 shares per year over five years, and the employee’s rights in the phantom stock terminate upon the employee’s death, retirement, or termination from the company.
Now consider two scenarios:
In 2012, the employee retires. Since the phantom stock vested at a rate of 20 shares per year, the employee is vested in 60 shares of phantom stock at the time of retirement. In 2012, the actual stock of Company A is worth $20 per share, and the employee receives the difference in the grant price versus the 2012 price as follows:
$20 Company A stock price in 2012
– $10 Value of Company A stock at 2009 grant date
x 60 Number of shares vested in 2012
TOTAL $600 Owed to the employee
In 2014, the employee still is employed by Company A. The employee is vested in all 100 shares of phantom stock. If the price of the actual stock of Company A in 2014 is $30 per share, the employee will receive the difference in the grant price versus the 2014 price as follows:
$30 Company A stock price in 2014
– $10 Value of Company A stock at 2009 grant date
x 100 Number of shares vested in 2014
TOTAL $2,000 Owed to the employee
While the above examples tie the receipt of phantom stock funds to continued employment with Company A, the phantom stock concept is flexible. Receipt of the economic advantages of phantom stock can be tied to the performance of the holder, sales goals reached by the company, sale of the company, or some other factor to determine payout, as the company chooses.
The advantages of phantom stock are: (a) any amounts paid to the holder by the company are deductible as an ordinary expense by the company; and (b) it is an easy way to provide an economic incentive to the holder without the company laying out cash initially or giving voting rights to the holder.
The disadvantages to phantom stock are: (a) when the cash is paid to the holder, the holder is taxed on the payment at the higher ordinary income rate (like wages); and (b) the company may not have cash available to pay the holder when payment on the phantom stock is due.
Technology and high-growth companies are used to arranging creative and innovative compensation structures to keep talent. While stock options and phantom stock have been utilized for years, they should not be used merely to defer compensation expected by talented employees. These tools should be considered only by businesses that intend and expect to grow in the near future, yet want to preserve cash while retaining use of the talent necessary to do so. Once in place, such strategies may help a struggling business of today to become a big business of tomorrow.
© 2009, Ward and Smith, P.A.
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Deana A. Labriola practices in the firm’s Technology and Business Practice Groups. Comments or questions may be sent to firstname.lastname@example.org.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.