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The purpose of an employee incentive plan, regardless of the specific type or form that it takes, is to more closely align a key employee’s financial interests with the company’s. The company owners’ challenge when developing and implementing an employee incentive plan is to strike the right balance between allowing key employees to share in the company’s upside success, while at the same time protecting the company’s downside risk in the event one or more of the key employees fails to deliver the anticipated value based on which the equity sharing is provided.
The following hypothetical scenario illustrates how selecting the right employee incentive plan can be a tricky process for a company’s owners. Three individuals (Owners) joined together and formed a company to perform government contracting work. The Owners have grown the company into a multi-million dollar annual revenue company. However, they believe the company has reached a plateau (at level “x”) and in order to take the company to the next level (level “y”), the company will have to attract new key employee talent with some form of equity sharing incentive (and, in fact, certain key employee candidates have signaled to the Owners that in order to join the company they would need a “piece of the pie”).
The company (1) is not in start-up but rather emerging growth mode; (2) is currently valued at $5 million; (3) has a strong contracts backlog and is positioned to realize significant profit and growth over the next three years; (4) is structured as an “S corporation” for tax purposes (which makes the company a pass-through entity but it can only have one class of stock); and (5) will award the equity sharing incentives to the key employees for current and future valuable services that the key employees will provide.
Because the Owners feel the need to provide real equity to these certain key employees, they intend to implement a restricted stock plan. Is this likely to work well for the company (and Owners)? Perhaps not, and let’s see why. The company has significant value today. The company would therefore be delivering to the key employees a valuable asset (restricted stock) which is likely to appreciate significantly over time. For certain tax efficiency reasons (which go beyond the scope of this blog post), the company presumably wants to allow the key employees to accelerate and minimize the amount of ordinary income tax on the receipt of the restricted stock (by making and filing an 83(b) election) and to lock in all future income recognition (provided certain requirements are met) at capital gains rates. (Note: Not allowing the Section 83(b) election could lead to even more challenging (tax) scenarios to the key employees going forward).
But, this would lead to some other potentially thorny and unintended consequences for the Company (and its Owners). First, if awarded restricted stock, the key employees would, at the time of a sale of the company event, share in the full value of the company (and not just the part tied to their efforts to take the company from level x to level y). Second, the Section 83(b) filing and payment of taxes would, for tax purposes, make the key employees full shareholders in the company right away; regardless, of the fact that they would not yet have vested to and therefore would not truly own any of the restricted stock.
Remember, the company is an S corporation and can only have one class of stock. This means that all stockholders must be treated the same and have the same financial/economic rights. The company, therefore, would not be able to treat the key employees any differently than the Owners. Any time the company would make pro rata tax or other distributions to the Owners, the company would have to make matching pro rata distributions to the key employees.
Moreover, any company efforts to condition the key employees’ receipt of discretionary distributions until having vested to the stock (for example, by way of depositing them into an escrow account and releasing upon vesting), could be viewed as the company having created a second class of stock, which could well jeopardize the company’s S corporation tax status. It is likely that some form of equity-linked plan (such as a SARs plan), as opposed to an equity plan, would better match to and achieve the company’s goals and objectives.
As you can see, choosing the wrong employee incentive plan could undermine a company’s goals and objectives and lead to other unfavorable consequences. So, choose wisely.