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For many companies, stock options, ESPPs, or ESOPs are not the only stock plans to consider. Instead, restricted stock awards, restricted stock units, phantom stock, stock appreciation rights (SARs), performance awards, and/or direct stock purchases are an essential part of their compensation strategies. The book includes eight chapters on what the plan alternatives are, how they work, how to combine them, and the legal and accounting issues they raise. The authors include leading authorities from law firms, other consulting firms, NASPP, the Beyster Institute, and the NCEO.
In the 20th edition (2023), chapters 2, 3, 4, and 6 were revised and updated, and minor changes were made to chapter 7.
Table of Contents
Basic Issues in Plan Design
Phantom Stock and Stock Appreciation Rights
Restricted Stock Awards, Units, and Purchases
Performance Award Plans
Selling Stock Directly to Employees in a Closely Held Company
ESOPs, ESPPs, 401(k) Plans, and Stock Options: When the Old Standbys Still Make Sense
A Tiered Approach to Equity Design with Multiple Equity Compensation Vehicles
About the Authors
About the NCEO
From Chapter 1, "Basic Issues in Plan Design"
The first question you must ask is how much stock will be available for employees or, if you have a phantom stock plan or SAR plan, how much equity value you will share. It may seem at first blush that if you are not actually giving up stock, then you are not really giving people equity value, but rather just a bonus based on equity performance. In fact, however, if you pay people out based on equity value, you are giving up an important part of ownership. The value of a company is, in most companies, a function of the present value of future cash flows or earnings. If you pay people based on equity value or appreciation, your future stock value is being reduced in exactly the same way as if you gave them shares or stock options (the realized value of an option to an employee is the same as SARs on an equivalent number of shares). So whatever kind of plan you have, if it is based on equity in any way, you should think of it in terms of sharing ownership or its equivalent. Deciding how much ownership to share is obviously an essential, if difficult, first step in setting up a plan.
Generally, companies approach this issue in one of two ways. The most common is to determine in advance some percentage of total shares or equity value that the existing owners are comfortable in sharing. Unless employees pay fair market value for the stock in a direct share purchase plan, sharing ownership or equity value dilutes the economic value of the ownership already held by dividing the claims on the company’s assets into more pieces. If employees have to purchase shares at a fair market value, however, this economic effect is offset by the infusion of cash, so all owners end up having a smaller share of a larger company. Any ownership plan that allows employees to vote their shares or their share equivalents (such as phantom stock), however, dilutes control rights.
Owners’ tolerance for stock or equity value dilution will depend in part on what they see as the alternatives. For instance, assume that owners are willing to share 10% of the stock or equity value of their company. What if this turns out to provide an insufficient incentive to attract, retain, and motivate those employees targeted by the plan? What else can be done? Will more current cash be needed to reward people, either with straight pay or bonuses? If more cash is spent, how will that affect future share price? Would it be better to share more of the company’s future growth through some form of ownership than to deplete current cash that can be used to help the company grow?
Other factors come into play as well, however. In companies listed on stock exchanges, there are often informal norms about how much dilution is acceptable, as well as formal rules requiring shareholder approval for dilution. For any particular company, the range of acceptable dilution will vary with industry norms, company performance, the makeup of shareholders (some institutional shareholders, for instance, are more opposed to dilution than others), and the distribution of ownership rights to employees (generally, shareholders are more tolerant of broadly distributed ownership rights than concentration of ownership rights among a few key people). Going beyond what shareholders or the broader market of potential stock buyers find acceptable may be a signal to investors that the company wastes too much of its assets on excessive compensation.
From Chapter 2, "Phantom Stock and Stock Appreciation Rights" (footnotes omitted)
A SAR program can be designed to be exempt from Section 409A, provided the program meets the following requirements:
- The SAR must be granted on what Section 409A calls “service recipient stock” (essentially, common stock of the entity benefiting from the employee’s service or a 50%-or-more-owned parent of such entity; special exceptions allow the 50% ownership interest to drop to 20% or more if it is due to legitimate business criteria).
- The SAR must provide for payment not greater than the difference between the fair market value of the underlying common stock on the date of exercise and the fair market value of the underlying common stock on the date of grant. (See section 2.3.3 below for a discussion of the definition of “fair market value” under the final Section 409A regulations.)
- The “exercise price” cannot be less than the fair market value of the company’s common stock on the date of grant, and dividend equivalents cannot be accumulated in a manner that decreases the exercise price of the SAR. As discussed in section 2.3.3 of this chapter, ensuring the SARs are granted at fair market value can often be one of the most challenging issues for SARs that are intended to be exempt from 409A. See section 2.3.10 of this chapter for a discussion of dividends.
- The number of shares covered by the grant must be fixed at or before the date of grant.
- The SAR cannot provide for a deferral of income beyond the date the SAR is exercised. (This means that when the employee exercises the SAR, the employee must receive a lump-sum cash payment in that taxable year, as opposed to a promise from the employer to pay in installments over several years.)
This chapter refers to a SAR program that meets the above requirements as a “409A-exempt SAR.”
If the above requirements are not met, then SARs granted or vesting after 2004 must comply with the requirements of Section 409A both in form and in operation. Generally, this means that participants will not be permitted to exercise their SARs freely. Instead, the SAR grant will have to specify the applicable 409A-compliant payment events, which could include one or more of the following:
From Chapter 3, "Restricted Stock Awards, Units, and Purchases"
Vesting demarcates the period of time over which the award recipient must perform services to earn the award and provides an incentive for award recipients to continue working for the company. When deciding on a service-based vesting schedule, companies should consider the following factors:
- Over what period is it reasonable for the award to be earned, and over what period is the award intended to serve as compensation?
- Will the number of shares or units vesting in each vesting increment be meaningful to award recipients, such that each vesting increment provides an incentive for continued employment?
- Will the periods of time over which awards vest feel achievable to the award recipients? A disadvantage of cliff vesting over a period of several years is that the ultimate vesting date may seem so distant to award recipients that it causes the award to lose its motivational impact.
- What vesting schedules are common among the company’s peers, particularly those with whom the company competes for talent?
Where the number of shares or units earned on each vesting date is very small, e.g., less than five, this could make it difficult for employees to sell or tender shares to cover the tax withholding due at that time (and the number of shares employees are left with after covering their taxes may be so few as to be demotivational). This is one reason awards typically do not vest any more frequently than annually.
Under the ISS Equity Plan Scorecard (EPSC), points are awarded to plans that prohibit any portion of awards from vesting in less than one year, provided this prohibition applies to at least 95% of all awards granted under the plan. Another factor under the EPSC awards points to a plan if awards issued to the CEO do not fully vest in less than three years (partial vesting in less than three years is permissible).
Restricted awards can also vest upon the achievement of specified company performance goals (such as earnings per share, revenue, or profitability targets) or based on work unit, individual, departmental, or divisional performance goals. Where restricted awards are performance-based, the awards are most commonly issued in the form of restricted stock units. Because restricted stock purchases and restricted stock awards involve issuing the stock at grant and would require cancellation of the issued stock in the event that the performance goals are not achieved, it is administratively burdensome to attach performance-based vesting to these arrangements.
From Chapter 4, "Performance Award Plans"
The most common use of performance metrics is as a vesting modifier on full-value awards such as restricted stock shares and units. Full-value awards have no purchase cost to the participant, but some performance awards may require an initial investment. While there is no consistent naming convention used by all companies, most use some variation of “performance shares” or “performance units.” Equity is awarded in a manner similar to time-based awards, but the timing and/or amount of vesting is determined by pre-defined metrics. These awards usually allow for multiple levels of potential vesting. Common terminology includes the following: “Threshold” is the minimum performance level that must be met. “Target” is an acceptable middle payout. “Maximum” is the cap on the amount of equity that can be earned from the award. The terms used by companies vary widely; however, most external data use the above terms consistently.
Performance shares are restricted stock shares that are issued at the time of award and may be earned, vested, or paid out based on performance metrics. Performance units are split into two categories. The first category of performance units is generally granted on a one-unit-to-one-share basis. These are most used by public companies and is usually used in coordination with other types of equity awards. The second category of performance units is a company-defined denomination for each unit. One of these units may be worth several shares or may be based on a specific dollar amount that is then converted to shares in the event of earning, vesting, or payout. This type of unit is most often used in private companies or in companies that only peripherally link these awards to other equity plans. In both categories earning, vesting, or payout is determined by performance metrics and, in some cases, a period.