At Prairie Capital Advisors, Inc. we know that owners of privately held businesses need to attract and retain quality managers in order to solidify and grow their businesses. Competition is keen to attract good people and many times the promises of competitive compensation and retirement plans are just not enough. Some highly qualified managers seek some form of equity ownership, which can take the form of either real or phantom equity. The direction taken is based on current ownership desire, the determination of future ownership mix and the tax consequences of the vehicle adopted.

Real equity incentives could include:

• Stock purchase plans – The company’s shares are sold to the manager at market value. Some business owners appreciate this form because of the requirement for managers to make an investment of their own money to purchase shares. On the other hand, the manager might not want to pay for the shares from his or her salary or bonuses, and as a result, might find the plan unattractive.
• Stock option plans – A stock option is a right given by the corporation to one or more individuals to buy a fixed number of shares at a fixed price. Stock options usually involve common stock and can typically be exercised over a certain time frame, such as five to ten years. It is not unusual for companies to grant these options to individuals based on some type of performance and/or length of service criteria. This “vesting” of equity ownership allows both parties to enjoy a period of time to be positive of their mutual commitment to one another.
• Stock bonus plans – - Involves the outright grant of stock to the manager. The grant is usually given to the manager based on position and performance. Further, the plan will contain forfeiture provisions based on vesting and transferability provisions that never lapse. Vesting is made contingent upon specific performance objectives such as stock price, net income or other measurable profitability goals. Since there is a substantial risk of forfeiture, taxable income is not recognized until stock is earned, and at that time, taxes are due at ordinary income tax rates. The manager needs to have the cash available to pay those taxes and, if not, a cash bonus plan may be integrated into the stock bonus program to provide this cash.

Phantom equity plans are cash-based “equity-like” plans that offer alternatives for the real equity plans discussed above. These phantom plans reflect the financial rewards of equity ownership without the burdens that accompany equity transfers. The most common phantom plans are:

• Stock appreciation rights (SARs) – A contractual obligation between the company and the manager that provides cash or stock compensation based on the increase in value of the company’s stock at certain points in time or upon certain performance objectives. This value-based incentive is taxable as ordinary income when paid, which could be structured periodically or upon the occurrence of certain events including business sale, initial public offering or successful achievement of some performance objective.
• Phantom stock – Phantom stock plans derive their name from the fact that the manager is given the economic elements of “stock” of the company without actually being granted equity in the company from a legal point of view. The rationale for granting phantom stock to key managers is not unlike that of the aforementioned SARs, except the entire value of the grant is usually conveyed rather than based on value appreciation. Some performance objective is quantified and later converted to either cash or stock and taxed at ordinary income rates. The company utilizes this measuring criteria and vesting schedules to retain valued managers and align their interests with those of the company.
• Performance units – A performance unit plan uses a more specific measurement such as the individual manager’s performance in achieving such criteria as earnings, sales growth, production, return on equity, return on investment, profit margin or other measurements that he/she can directly affect. This plan almost always pays cash to the manager and is taxed at ordinary income rates.

Understanding the means available to attract and retain good managers is critical to any successful business. Prairie Capital Advisors can help you create an equity incentive plan that will help retain key executives while balancing the company’s short and long-term goals.