In a previous article we discussed Partner Progression Models and how they can assist in transitioning to your internal next gen. That article mentioned that most employees within a firm will not become equity owners and that it’s inappropriate to reward those individuals with actual equity. Instead, we recommend that firms use synthetic programs for key employees (note: a discretionary bonus may be the best program for non-key employees).
For employees who will not be owners of a company, a synthetic equity program gives the employee something that looks and feels like a share but is not. Instead, the employee is awarded “Synthetic Shares,” which have many of the attractive features of ownership without some of the drawbacks. Many business owners prefer synthetic plans because they allow employees to participate in the financial rewards of ownership without having a direct ownership interest and without the complications associated with having additional Shareholders involved in the company.
In addition, from the business owner's perspective, synthetic plans are often preferred over traditional equity plans because they can be subject to vesting requirements, they can be forfeited upon an employee's termination or departure, and they can be repurchased using payment schedules. Unlike traditional equity that need to be repurchased under the terms of a buy/sell agreement when an employee departs or is terminated, synthetic shares can disappear based on certain triggering events.
Synthetic shares can also be valued using any formula that an owner deems appropriate. For example, the synthetic shares may be valued based on the value of the firm over and above the value of the business when the synthetic equity program was started. That way, the employees only participate in the additional value that they help to deliver and do not participate in the value that already existed.
Synthetic equity programs also have several significant tax advantages that are attractive to both business owners and the key employees. First, when a key employee receives shares under the firm’s synthetic equity program, the IRS does not recognize that receipt as taxable income to the employee until he or she actually receives the money. This usually occurs when the firm is sold or when the employee retires and is cashed out (assuming the employee's synthetic shares are vested). This is very attractive considering that regular shares are taxed as ordinary income and the employee basically has to pay the associated tax even though he or she didn't receive any cash.
When the synthetic shares are redeemed, the key employee would receive ordinary income (rather than capital gains) tax treatment on any amounts received for his or her synthetic shares. However, keep in mind that the employee was not taxed while employed by the firm, meaning that employee can effectively defer payment of taxes on this benefit until a liquidity event occurs. The time value of deferring these taxes can be significant.
Second, when the firm pays a key employee to redeem synthetic shares, the company can treat it as an expense rather than a repurchase of shares and the company receives a tax deduction. If the company were redeeming traditional shares, the event would have no tax benefits to the firm.
Example: Say your firm is valued at $5,000,000 and you reward two key executives with synthetic shares each yielding 5% of the growth going forward. If the firm’s value rises to $6,000,000 next year, each is entitled to $50,000 (5% of the $1,000,000) appreciation in firm value. This is just an example – amounts and percentages are based upon the objectives and comfort level of the owner.
We suggest that ownership portions or options should be components of the Operating Agreement. How and when ownership portions are distributed to employees should be spelled out in exacting terms in the Plan Document and Operating Agreement. Also, be specific about how and when ownership portions are deemed and how and when options may be executed. Spell out the implications of poor employee performance, termination with cause, termination without cause, and divorce in the Operating Agreement and Employee Agreements. Then have a separate employment agreement that spells out how many ownership portions or options, with specific statements about how and when ownership portions are transferred to the employee. Rather than stating a percentage of the firm, we would suggest that you be specific in the number of ownership portions (shares) issued or optioned to the employee since there is ample ambiguity regarding what constitutes a percentage of the company.
When used correctly, synthetic equity programs can be a vital program to retain, motivate, and incentivize your key employees.