How do you compensate key executives?

Using the 'carrot' approach

Since both startups and buyouts depend in large part on extraordinary performance by managers, one principal aim of the planners of new ventures is to put stock or stock equivalents in the hands of senior managers without occasioning tax liability. Indeed, managers may be required to accept stock instead of cash compensation in order to preserve cash flow for the benefit of the lenders. The trick is to use stock as currency without occasioning immediate tax, not a simple exercise since, in the final analysis, stock is being awarded for past or future services, a taxable event in classic terms.

Second, the [index]equity[/index] should be allocated, if possible, in a way that has minimal effect on reported earnings. In this connection, tax practitioners write a majority of the commentaries on this issue; when a compensation scheme enables the company to take a tax deduction, they view that as an unalloyed "plus."

All other things being equal, of course, tax deductions are favorable. But if the cost of casting a system in a given way is a "hit" to earnings as reported to shareholders, then it is time to revisit the question. Thus, an option should not be weighted exclusively by the after-tax effect on the recipient, the grantee.

The fact is that the chief value of a stock option under today's rules may be the option's effect, or better, its lack of effect, on the grantor. Until the Financial Accounting Standards Board (FASB) changes its rules, the grant of stock options as a form of employee compensation impacts the income statement as of the date of the grant, which is to say not at all, since the value of the option itself as of that date is indeterminate if the grantee's exercise price is equal to "fair value." As the option grows in value, culminating on the day it is exercised, the grantor's earnings are unscathed (FASB lost the battle to charge compensation expense earnings as options increase in value; the compromise relegates disclosure to the financial statement footnotes). By way of contrast, a phantom stock plan, which periodically awards to employees "units" ultimately redeemable in cash (the value of the units being tied to stock performance), can have an enormous negative impact on earnings. (To be sure, any issuance of rights to purchase shares has a potential effect on the all-important earnings-per-share number.)

The issue on this head can be of startling importance. Upon an exit event, meaning a sale of Newco or a Newco IPO, the price paid is usually calculated as a function of current and historic earnings. For every dollar in GAAP earnings lost, the exiting shareholders, including the employees concerned, may well sacrifice large upside dollars in accordance with the price/earnings ratio then applicable—$10, for example, if the P/E ratio is 10 to 1. Indeed, recent calculations show that the costs to some public companies, where executive options are repurchased (i.e., replaced) with cash, are in the billions of dollars.

A central planning imperative is to tie equity to the performance of the employee. Thus, if shares (or options or stock equivalents) are awarded, it is important that employee "fat cats" are not thereby created, employees who can relax from and after the date of the award and watch their colleagues make them rich. Accordingly, awards, once made, usually "vest" over time, meaning that the price is fixed as of the date of the grant, but the options or stock can be recaptured for nominal consideration if the employee elects to quit prematurely.

Regardless of how sophisticated the stock or stock option plan may be, it is likely that the employee will have to pay tax at some time on the value he has received. The trick is to match the employee's obligation to pay tax with his receipt of income with which to pay the tax.

This article has been reprinted from www.vcexperts.com Book O of the Encyclopedia of Private Equity & Venture Capital.

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