Benefits of Equity-Based Compensation

6 questions to ask when considering private equity for your business

Compensating key members of management with equity is a great strategy to attract and retain talent. But providing equity-based compensation such as synthetic equity or phantom stock is also a powerful tool that can benefit both the company and the employee, without having to distribute actual ownership.

Attracting talented new leadership into your organization often demands a higher price tag. A rich compensation package may be justifiable as long as the employee can contribute to the company’s growth. Equity-based compensation is an attractive way to incentivize these individuals to join the organization without having to commit to a defined compensation amount. Rather, the compensation package can be a mix of salary, performance-based bonuses, and a long-term equity-based incentive plan.

One of the main benefits of equity-based compensation is the ability to align key management’s goals and objectives with those of ownership’s. For many business owners, significant amount of their personal wealth is tied up in the value of their company. As a result, the owner does not truly reap the benefits of the company’s growth until there is a liquidity event, such as a sale. Equity-based compensation can supply the recipient with that same type of arrangement, depending on how the plan is  structured. You can provide a payout upon the recipient’s retirement or departure from the company that is based on the value of the business at that time, rewarding the employee for their contribution to the company’s growth throughout their tenure.

Another important – and often underestimated – benefit of phantom equity plans is the fact that the owner does not have to worry about the legal issues associated with real equity. Giving out real equity means that you have another shareholder. Even if they are a minority shareholder, you still need to be accountable and fair to them in order to avoid a potential minority shareholder abuse claim.

These arrangements often do not involve a cash outlay by the recipient. Actual equity awards (e.g., stock options) typically require the recipient to invest their own personal assets in order to obtain their equity. This is necessary so the recipient only benefits from the future growth of the company. Since equity-based compensation
plans can be more flexible, each recipient’s arrangement can be customized to only provide a benefit based on the future growth in the company’s value from the date of the award.

In addition, equity-based compensation plans have longer vesting provisions, which makes them an effective method to retain key players for the long-term. A plan can
be crafted to provide a vesting schedule for as long as desired, but keep in mind that if it is unreasonable (e.g., 20 years), it may ultimately be discouraging for the recipient.

Issuing actual equity can result in a current tax obligation to the recipient and lead to a higher tax bill. Whereas, phantom equity is essentially deferred compensation and
is generally not taxable to the employee until it is constructively received. If the recipient is not receiving their equity-based compensation until after they retire, they very well could be in a lower tax bracket and ultimately pay less tax on their benefit.

Equity-based compensation plans represent a great option to incentivize your key management team to stay and participate in the overall growth of the company.  However, setting up such plans requires careful consideration of the tax and financial implications to the company, the employee, and the business owner, which may
be complex. The plans themselves are not one-size-fits-all, and should be customized to each party’s long term goals and objectives. An advisor who has experience with such plans can help you navigate the process and assist in their structure and setup.

Brian J. Sharkey can be reached at Email or 215.441.4600.

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