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Designing Executive Compensation in an ESOP Environment

Part 3: Equity Incentive Plans for ESOP Companies

Anthony Mathews

November 1996

In this last installment on executive compensation, I'm not going to tell you specifically what sort of equity compensation programs to implement at your ESOP company. After spending a couple of thousand words over the first and second installments telling you how individual you are, that would be pretty silly. But we can discuss some of the many approaches available and give you a few pros and cons for each.

The Role of Equity-Based Compensation

For all the reasons previously cited, most ESOP companies will come up with a management compensation and incentive program that will include some equity-based compensation features. After all, equity-based compensation is in the very nature of ESOP companies, so why should that not be the case at the highest levels within the companies? Under current law, there are several recognized types of plans, in addition to ESOPs, that are available for employees to acquire stock. These fall into four basic categories: bonus plans, purchase plans, "net effect" plans, and option plans; a specific company might sponsor a plan with some features of each.

Bonus Plans: Under a non-qualified stock bonus plan, employees are simply given stock as a "bonus" at such times and to such employees and with such restrictions as the board of directors may determine. Under this type of plan, employees have taxable income for stock once it becomes non-forfeitable and the company gets a tax deduction as compensation expense. The criteria for stock bonuses can be anything the company decides, including absolutely discretionary.
Purchase Plans: Under a non-qualified stock purchase plan, the general concept is similar except that because purchases are being made from employees' funds, there is no real incentive for the company to restrict participation and there is no additional tax deduction for the company.
Many plans integrate both purchase and bonus features by matching employees purchases on some basis. Again, since this is a non-qualified arrangement, the matching formula can be virtually anything, including cash to match the tax. In whatever form, employees have current tax on any bonus or excess discount. In most companies, including a provision allowing employees to sell part of their stock or providing other non-stock matching can provide cash for the taxes due.
Net Effect Plans: "Net effect" plans are those in which the employees receive the "net effect" of stock ownership; such plans are generally classed as "phantom stock" or "stock appreciation rights" plans. These are similar to stock bonus and purchase plans without the actual issuance of shares. In a phantom stock plan, employees are granted units each year based on some criteria. Each unit represents the value of a share of stock. Units are tracked, and after termination of service, units are "cashed in" for the value of an equivalent number of shares of stock. In stock appreciation rights plans, the same principle is followed except that the value to the employee is the difference between the value of a share on the date the unit was granted and the value of a share on the date it is cashed in.
Option Plans: Finally in this area, there are various types of option plans. The most basic non-qualified stock option can be as selective or broad-based as you like in terms of granting (e.g., a non-qualified stock option plan could be set up to offer options to all employees with 1 year of service equal to the number of whole shares nearest to 5% of their pay, or 100 shares per year of service from date of hire, or virtually anything else) and can be structured with virtually any terms. Vesting provisions and other elements to assist employee retention are possible.
When options are exercised, employees will be fully taxed on the difference between the cost and their then-fair market value, and employers are required to withhold the tax (or collect the amount of withholding from the employee) as if the spread were direct compensation. It can be set up so some of the shares in the option are applied to withholding, or coupled with a cash bonus program or other mechanism to deal with this problem. The company generally gets a tax deduction for the same amount as the employees' taxable income.

Until 1986, incentive stock options (which can be very selectively granted) and section 423 stock options (which must be granted to a broad range of employees) were popular because they offered a mechanism that created ordinary business expense deductions to the company and taxable capital gains to employees. In order to qualify for this treatment, the plans are required to meet many restrictions and follow specific guidelines (e.g., there are limits on the amount of grant in a given year, owners of certain percentages of employer stock are more restricted than other employees, and holding periods and exercise periods must meet guidelines). Since the tax rates on capital gains have been made closer to the maximum corporate rates, much of the attraction of these plans has been lost.

Stock Sales to Employees and Securities-Related Issues

It will usually occur to someone to just offer to let employees buy company stock on their own, and this certainly makes some sense. The most basic (and, at least from an ERISA perspective, the least regulated) methods of creating stock ownership opportunities for employees are in the category of non-qualified stock purchase plans.

These plans can be designed in virtually any configuration and can be as broad or as narrow in target population as one might wish. And from the perspective of employee benefit plan rules, these plans only need to meet some very basic requirements:

If stock is to be sold to employees on a discounted basis, any amount in excess of a 15% discount from fair market value will be taxable to the employees.
Formation of the plan may create securities issues if the employees involved exceed a certain number or are not sophisticated investors.
In some states (California, for example), mandatory stock purchases as a condition of employment are not allowed. (In many states, they are.)

Beyond that, the offer to sell stock (or options) can be made to any or all employees and can even be coupled with cash bonuses or loans to assist in the purchase. The term non-qualified when referring to these simple programs refers only to the fact that they provide no extraordinary tax advantages to either employees or employers. Basically, with few exceptions, for every tax deduction generated for the employer, there is an equal and offsetting taxable event for the employee.

Usually, for closely held corporations, the prohibitive stumbling block to installing these plans is the incredible body of securities laws and regulations that must be strictly followed. There are exemptions from registration requirements that are very likely applicable to sales to the highest-level employees, but sales to individuals who are not covered by these exemptions are usually prohibited absent a complete registration of the shares offered. The penalty for failure to follow these rules (usually referred to as blue-sky laws) are burdensome and unquestionably worth avoiding. In fact, federal and state control over the offering and sale of securities is such that unless your company's stock is already publicly traded, it is probably not cost-effective to create a stock purchase plan for a broad base of employees. Sales to a few sophisticated, high-level executives, however, can be effectively used in some situations.

Finally

Designing compensation strategies in ESOP companies is more complicated than in non-ESOP equivalent circumstances, to be sure, but the issues are exactly the same. The complication comes, just as in many other areas of corporate life, from the special relationship that is developed among employees, management and shareholders in ESOP companies. Like so many of the special problems ESOPs face, the difficulty involved in designing and implementing both prudent and incentivising compensation programs comes directly from the very features that give them extraordinary strength. An appropriate program is achievable safely, however, if ESOP trustees and other fiduciaries follow a few fairly straightforward guidelines:

Deal with compensation issues objectively and as early as possible in the process.
Recognize the contributions of key management employees (specifically where their compensation, benefits and equity have been compromised by the establishment of the plan), and design a program accordingly.
Make liberal use of outside directors and consultants to demonstrate due diligence.
Use the benchmark approach to validate program designs.
Document the decision-making process and, as closely as possible, foster what amounts to a negotiation of terms.

As with any company, ESOP companies rely on the good faith and incentive of employees at all levels. So, even in the arena of executive compensation, we can, and should, strive for a "win-win" outcome for all concerned.

Biography and list of other "Administrator's Notebook" installments

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