Attract, Retain, Reward: Stock Options Not Just for Big Companies
Stock options aren’t just for big multinationals. Stock options and other more advanced deferred compensation tools provide companies with many opportunities to attract, retain and reward key employees while providing many tax benefits.
With the current staffing shortages many companies are facing and many employers offering these tools, considering these strategies should be a top priority for employers and employees alike.
stock options are a mechanism by which a company grants an employee the option to purchase shares of the company, often at a future date and for a set price. An employee realizes the benefits of stock options when he exercises his option, buys the stock at the strike price, and then sells it back at a higher price (commonly referred to as monetization). Publicly traded companies most often use this tool because it allows the company to compensate employees with these stock options rather than cash.
Stock options are not restricted to publicly traded companies. A fast-growing company that is aiming for private equity or other means of additional downstream capital funding would be an ideal candidate to use stock options to attract highly skilled employees who are willing to see the long-term benefits. As with publicly traded companies, these fast-growing companies (and many of them here in Northern Michigan) have the future trigger events necessary for employees to monetize their options.
Often these fast-growing companies need to attract highly skilled employees, but are constrained by current cash flow constraints. The use of stock options provides the mechanism to fairly compensate current work with less money now while providing the longer-term upside potential that a mission-believing employee would be willing to benefit.
Restricted Stock Units are the outright ownership of shares, but come with stipulations about when they can be sold (called vesting). As with standard stock options, it is often assumed that RSUs are only available to publicly traded companies. However, when properly developed, RSUs can provide many of the positive benefits provided by stock options, but with fewer compliance requirements. Because an RSU is a direct award of actual shares (just restricted), it avoids the often prohibitive need to exercise an option to purchase the underlying stock.
This exercise often requires the holder to sell some of the shares to enable the transaction and can minimize the effects. Moreover, the sale of shares may not even be possible for a private company.
Since an RSU is a direct share award, the holder does not need outside money to acquire the share – they already own it. RSUs also mitigate a common disadvantage of stock options in that stock options only have value if the market value of the stock is greater than the grant price. Otherwise, the employee is paying more for the shares than he could, in theory, buy them on the open market.
A phantom stock scheme is a benefits plan where eligible employees (and their employers) can enjoy many stock ownership benefits without actually owning stock in the company. These plans are available with significantly lower compliance costs and do not require outside purchases like publicly traded stocks or cash injection events.
A phantom stock plan is essentially a long-term defined bonus plan with rewards tied to the overall value creation of the company, as if the employee were an owner. As with stock options and PSUs, the company and employees benefit from deferred income streams combined with long-term growth.
With a phantom stock plan, the employee benefits from the growth of the business (for which, in theory, they are directly responsible) while not being burdened with complicated flow-through earnings impacting their tax returns. often associated with private corporations, legal liabilities related to share ownership or ongoing compliance requirements. However, the offset for these benefits is less favorable tax treatment in the long run, which ultimately results in less overall wealth creation than alternative strategies.
It should come as no surprise that there are different circumstances in which each of these strategies makes more sense than the others. They should be considered the same as various tools in a toolbox, each with a different intended use. As the saying goes, “the greater the risk, the greater the reward”. Each of these tools offers advantages and disadvantages for both the employee and the employer that must be taken into account. All three have different tax and compliance complexities, different levels of commitment, and different long-term goals that need to be weighed against the circumstances of the business and the individual.
Say you’re an employee of a company offering stock options, restricted stock units, or phantom stock – congratulations on the diversification of your total compensation and the opportunities for wealth creation.
With this diversification and the increased potential benefits come some complexity and planning opportunities that need to be considered. If you are a business owner exploring creative ways to compensate current employees or attract new employees to your business, stock options, restricted stock units, or stock plans ghosts can be the tools you should consider to reward your employees and differentiate your business in the market effectively and efficiently.
Jon Sluis, CPA, is president of Intrust CPA in Traverse City. With a background in public accounting and private industry, he has over 20 years in the industry. Specific areas of expertise include federal tax law, tax credit financing, long-term strategic and financial planning, entity structuring, financial improvement measures and financial reporting. For more information, call (231) 935-1590 or visit www.intrustcpa.us.