Attention CEPI students: Since 2020, the CEPI curriculum has been all-digital, and the CEPI provides you digital access to the books, including this, as part of the exam fee. You still can buy the printed books from us as a supplement to the free digital access you receive from the CEPI. See our CEPI information page.
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 19th edition, which went to press in early 2022, chapters 3 and 6 were revised and updated, and minor changes were made to chapter 8.
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"
In closely held companies, owners may have plans or obligations to provide family members, partners, or investors with a specific percentage of the company, either for control or economic reasons. Or, in many cases, they may have a conviction that they cannot share more than a certain percentage of total ownership rights. In some closely held companies, there are venture capital investors who may place strict limits on how much equity value can be shared, in whatever form. They may also have minimum guidelines from these investors for how much ownership they want key employees, or even all employees, to have, either by corporate contribution or by employee purchase. Companies with significant debt may also want to check whether there are any loan covenants that would make it difficult or impossible to pay out employees for their equity awards during the term of the loan.
The most common approach to this problem is to set a fixed ceiling on how much ownership or equity value can be shared, such as 10% of the shares at any time or 5% of the equity value of the company (earned in shares or in cash) in any two-year period. Deciding in advance on a fixed percentage, however, is probably the least rational way to make a decision on this issue. First, companies that are growing often make the error of setting aside a certain percentage of stock ownership or equity value for employees and giving out most or even all of these shares to whoever is there early on. As the company grows, it then has only a small and shrinking pool of stock ownership or equity value to make available to new employees. The result is that a two-class system emerges of owners and those owning little or nothing, even among people doing the same jobs.
Another problem with the fixed percentage approach is that even if employment remains fairly stable, the job market can change. While departing employees may surrender their shares to the company to give out to new employees, the new employees may now expect more stock ownership or equity value than the company can make available. Similarly, company philosophy can change, calling for a greater emphasis on equity awards.
Finally, 10%, or any percentage, of one company is not the same as 10% of some other company. Giving employees 10% of a startup without a product or profits is a very different matter than 10% of an established, profitable corporation. Very few employees actually care what percentage of a company they own, individually or (even less) collectively. They care about what it is worth. Deciding on how much to share should be a function of what is needed to attract, retain, and motivate people over time, including the possibility of growth, while at the same time not scaring off investors or existing shareholders.
From Chapter 2, "Phantom Stock and Stock Appreciation Rights"
SAR grants and phantom stock awards are generally made to encourage employee retention, provide an incentive to grow shareholder value, or a combination of both.
If the employer’s principal objective is to motivate the participants in the program to grow the value of the business, a SAR grant is typically more appropriate. The holder of a SAR award receives no benefit unless the underlying stock value appreciates. As a result, the holder has an incentive to improve financial performance with the expectation of growing the stock value. SAR grants are frequently made subject to a vesting schedule to encourage retention, as well as to provide an incentive to grow value. However, the vesting element of a SAR grant is successful as a retention tool only to the extent that the value of the underlying stock continues to appreciate. If the underlying stock declines in value from the date of grant so that the SARs have no value, the employee might be more willing to entertain an offer to go elsewhere because he or she forfeits no value upon departure. For example, assume an employer makes annual SAR grants with a graded five-year vesting schedule for each grant. Assume further that the underlying stock value appreciates each year during the first four years from $10 to $15, $20, $25, and then $30. If, at the end of five years, the underlying stock is valued at $40 per share, the employee would have a significant unvested build-up of the early awards. In this case, the annual SAR grants, with their five-year graded vesting schedules, become a valuable retention device. If, however, the underlying stock is more volatile and the value at the end of five years, based on the prior example, drops to $20, the retention value is more limited.
Phantom stock awards are more valuable if the objective is to promote employee retention. Phantom stock awards are typically subject to a vesting schedule for several reasons, not the least of which is to encourage retention. The vesting schedule may be designed with specific objectives in mind. If the employer’s sole objective is retention, the forfeiture provisions may be based solely on the passage of time (e.g., a five-year cliff vesting schedule, meaning the award does not vest at all until the end of the fifth year, at which time it becomes 100% vested). In this case, for example, if 500 units of phantom stock are granted when the underlying stock is worth $100 per share, the initial value of the award is $50,000. Even if the value of the stock drops in half to $50 per share, the employee would forfeit significant value if he or she left the company during the five-year period before the units become fully vested. Forfeiture provisions may also be designed to assure that the employee remains in the service of the company during a critical period. For example, the vesting provisions may be tied to the repayment of the company’s outstanding senior loan or until the completion of a merger or acquisition. In addition, if the objective is a combination of retention and performance, the size of the award or vesting provisions could be tied to the achievement of certain financial targets (e.g., EBITDA targets). For example, some plans use relatively long vesting schedules (e.g., six to seven years) for grants, but provide accelerated vesting if certain performance measures are satisfied. Alternatively, it would be possible to achieve combined goals of retention and performance incentives by (1) granting a target number of phantom shares and then (2) adjusting the number of shares upon which payment will be made based on the company’s performance over a specified performance period.
Although it is a broad generalization, it would be more common to see top-level executives receiving SARs (because the executives would be perceived as making policy-type decisions more likely to affect the stock price), next-tier executives receiving a combination of SARs and phantom stock, and still lower-level recipients receiving all phantom stock (to encourage retention).
From Chapter 3, "Restricted Stock Awards, Units, and Purchases"
Share withholding offers considerable advantages to both the company and employees: it relieves the employee of the sometimes considerable burden associated with making a cash payment, and it does not require coordination with outside vendors (such as a brokerage firm).
Example 9: An employee is granted a restricted stock award for 1,000 shares. When the award vests, the shares have a fair market value of $16 per share. The employee recognizes $16,000 of compensation income on the vest date ($1,000 shares multiplied by $16 per share). This income is subject to federal tax withholding as follows:* $3,520 of federal income tax, $992 of Social Security, and $232 of Medicare. The aggregate tax withholding for the transaction is $4,744. The company withholds 297 shares to cover the taxes ($4,744 divided by the $16 per share fair market value, rounded up to the nearest whole share). The withheld shares have a total value of $4,752, which is slightly higher than the tax withholding obligation; the company can refund the excess $8 in value to the employee or can aggregate it with the employee’s tax payment and deposit it with the IRS on the employee’s behalf. The employee receives 703 shares (1,000 shares released less the 297 shares withheld to cover the taxes).
* Based on 2021 withholding rates, including a flat rate for federal income tax purposes of 22%, a Social Security tax rate of 6.2%, and a Medicare tax rate of 1.45%. Assumes the employee has not yet reached the wage cap for Social Security tax purposes (and, likewise, the threshold at which the additional Medicare tax applies). State taxes may also be applicable.
Under some plans, the withheld shares are returned to the plan reserve and can be regranted to other participants, referred to as “share recycling.” Under the ISS Equity Plan Scorecard, where a plan provides for share recycling, points are deducted from the plan’s score (ISS considers this to be a “liberal share counting policy”). Some plans may earn enough points elsewhere in the scorecard that the loss of points for this provision is not important; other companies may be forced to choose between retaining the share recycling provision and reducing their share request. Other proxy advisory firms and institutional investors likewise may not view share recycling favorably.
From Chapter 4, "Performance Award Plans"
Successful implementation and rollout of a performance equity plan may require new internal communication and data integration techniques; the communication regarding the entire life of each award must be seamless. Unlike time-based awards that require little in the way of regular management, unless there is a major corporate or individual event, performance equity requires integration at the time of the award, at regular intervals (at least quarterly) during the measurement period, at the time of final measurement, and at the time of vesting and payout. Building these processes at the outset will afford focus on the effectiveness of the plan, rather than the process.
Awards with market conditions require complex valuation upon grant. While the financial reporting after the award date is fixed, the progress toward the goal is not. Implementation should include a method and frequency for determining proximity to the goal. Communication of this proximity must also be defined to ensure that the award is fulfilling its intended objectives.
Awards with performance conditions can be valued in a manner similar to time-based equity. The expense for these awards must be evaluated every quarter, based on the probability of attaining the goal(s) associated with the award. A company must always amortize expense based on no less than the number of shares that are probable to vest. Depending on the nature of the goal, this may be a simple formula or it may require interaction between multiple departments and data sets. The values used in the probability to vest may not always coincide with the proximity details being communicated to the staff.