What is an Employee Incentive Plan? Basically, an employee incentive plan is a tool by which a company and its owners provide “equity-sharing incentives” to employees. This allows employees to share in the company’s financial success. Broadly speaking, there are two kinds of equity-sharing plans: true equity sharing and equity-linked sharing. True equity sharing incentive plans, such as stock option plans and restricted stock plans, provide a path to actual ownership. Equity-linked sharing plans, however, such as phantom stock and stock appreciation rights plans, do not provide a path to actual ownership.

     What purpose does an employee incentive plan serve? The purpose of an employee incentive plan, regardless of its form, is to more closely align key employees’ financial interests with the company’s.

     Are employee incentive plans only effective for certain types of companies? No, definitely not. An employee incentive plan can be a powerful and effective tool for any company, regardless of the stage of the business life cycle in which a company is operating.

     Should an employee incentive plan favor the employer or employee? The employer holds all the cards and can therefore dictate the terms of any employee incentive plan. However, the company should want to maximize the likelihood that the plan will be effective. An effective plan is one with which employees will connect and find value, and, as participants, will be inspired to drive more value in the company. Company owners should challenge themselves to strike the right balance between allowing key employees to share in the company’s upside success--the “carrots” provisions--while also protecting against the company’s downside risk in the event that key employees fail to deliver the anticipated value on which the equity sharing is based. These are the “sticks” provisions.

     What is the starting point for considering an employee incentive plan? To select the right employee incentive plan, the company’s owners must determine what goals and objectives are to be achieved. There are fundamental questions that should be considered and answered. These include:
1) Does the company want to share real equity or equity-linked value with its employees?
2) How much of the company’s equity or equity-linked value is to be shared with employees?
3) Which employees will be eligible to participate (executives and senior management vs. rank-and-file employees)?
4) Is the primary focus to retain, recruit or motivate key employees? Stock options, restricted stock and phantom stock are more retention-oriented, and stock appreciation rights are more oriented to recruiting and motivating.
5) On what liquidity events will employees be paid out? Just the sale of the company or other events, such as an employee’s death or disability?
6) What restrictions or conditions are to be imposed on the equity or equity-linked value? This could be vesting, which could be time-based and/or performance-based, and forfeiture, which is the ability to recover the equity or equity-linked value if key employees depart the company prematurely or engage in “bad acts.”

      The answers tie back to the carrots and sticks provisions referenced above.

     Selecting the right employee incentive plan can be tricky, so choose wisely: The following hypothetical scenario illustrates how selecting the right plan can be a tricky process for a company.

      Three individuals (owners) joined together and formed a company, structured as an “S corporation” for tax purposes, to perform government contracting work. The owners have grown the company into a multi-million dollar annual revenue company. However, they believe the company has reached a plateau at level “x,” and in order to take the company to the level “y,” they will need to attract new talent with some form of equity-sharing incentives. Certain job candidates also have signaled they would need “a piece of the pie” to join the company.

      Based on those goals, would a restricted stock plan work out well? Perhaps not, and let’s see why.

      A restricted stock plan would likely lead to some potentially thorny and unintended consequences for the company. First, if awarded restricted stock, the key employees would, at the time of a sale of the company event, share in the full value of the company (and not just the part tied to their efforts to take the company from level x to level y).

      Second, for certain tax reasons (which go beyond the scope of this article), the owners likely would want to allow the key employees to accelerate the recognition of any ordinary income tax relating to the receipt of the restricted stock. But, this would require the company and owners, for tax purposes, to treat the key employees as true owners regardless of their not yet being vested to or truly owning the restricted stock. Moreover, due to the company’s “S corp” status and being limited to one class of stock, the company would have to treat the owners and the key employees as if having the same financial/economic rights. Any time the company would make pro rata tax or other distributions to the owners, the company would have to make matching pro rata distributions to the key employees.

      It is likely that some form of equity-linked plan such as a stock appreciation rights plan would be a better match for the owners’ goals and objectives. In such a plan, the employees’ pay-out would be limited to participation in the level “y” success, and the owners would avoid having to deal with any of the ownership issues described above.

      As you can see, choosing the right employee incentive plan can be a tricky process. So, choose wisely.

Dean S. Nordlinger is a partner of PilieroMazza PLLC in Washington, DC and heads the firm’s Business & Corporate Law Group. For over 25 years, PilieroMazza has helped small and mid-sized businesses to successfully navigate a diverse array of legal matters, with a primary focus on government contracting and the SBA’s procurement programs. Visit www.pilieromazza.com.