The Use of Synthetic Equity for Start Up Businesses

John E. Rich, Jr.
Director & Chair, Tax Department
Published: New Hampshire Bar News
December 16, 2015

Increasingly, New Hampshire business owners are using non-qualified deferred compensation arrangements to provide targeted economic benefits to key employees.

Synthetic equity plans are particularly useful for small and startup employers, because they provide flexibility to the employer while helping to retain and incentivize select employees during a company’s growth phase, without giving up equity.

All non-current employee compensation can be divided into two broad categories: qualified and IRA plans, and non-qualified deferred compensation plans. Qualified plans, such as 401(k) plans, and IRA plans allow employees to save money for retirement.

These are important employee benefits, but are generally not considered to be employee retention tools. Qualified and IRA plans have annual benefit limits, limited vesting schedules, discrimination and other rules that significantly limit an employer’s flexibility to use the plan to reward select key performers.

A non-qualified deferred compensation plan is any plan that results in benefits earned in one year being paid in a future year. The universe of non-qualified deferred compensation plans is further divided into plans whose benefits are based on the value of the business’ stock (or unit value in the case of LLCs), equity-based plans and those plans whose benefits are based on some other metric, such as supplemental executive retirement plans (SERPs), which provide retirement income.

Flexibility with Synthetic Equity

For startup and smaller employers, equity-based programs provide considerably more flexibility than qualified and IRA plans and are a better fit than other deferred compensation, because the benefits to employees are based solely on the value and growth of the business.

Employers can selectively reward top performers who help grow the business without fear of discrimination rules. If the business does not grow, the business owner will incur little or no payment obligation.

A key decision is whether the plan will result in employees owning equity or the potential to own equity, as with restricted stock and option plans. Although employees will normally save taxes on the future sale of equity interests, business owners often do not want to give up equity, because equity ownership gives employees statutory rights of access to corporate books and records, and the right participate in annual meetings.

In these situations, so-called synthetic equity programs, such as phantom unit and unit appreciation rights plans, are the best fit, because they do not confer to the holder any of the other benefits, rights and privileges of being an actual unit or stockholder.

Phantom Unit Rights & Appreciation Units

Phantom unit rights (or phantom stock in a corporation) are used to provide employees of LLCs a cash payment based on the value of a unit (or stock for a corporation) at the time of a liquidity event, times the number of phantom unit rights awarded.

Phantom units are usually granted over a period of years, and the grant is usually conditioned on service and some performance criteria, either of the employee or of the company as whole. There must be a method to value and communicate the unit value on an annual basis.

For startup businesses with units or stock not subject to marketplace valuation, the value can be determined under the terms of a formula based on book value, or a reasonable multiple of earnings, or some combination of the two. Regardless of the formula, it is critical that the employees understand how the unit or stock is valued and believe the valuation method is fair.

Because phantom unit rights confer both past and future value, a vesting period will normally be used whereby employees will vest in the units over a period of years. Normally, the employee will forfeit the phantom unit if he or she terminates employment before the liquidity event, which is normally the sale of the business. These forfeiture provisions (or sometimes the plan itself) are referred to as “golden handcuffs,” as they bind employees to the employer. Depending on the situation, the payment terms can be fairly complex to account for different types of sale transactions and the possibility of consideration other than cash being received. These plans also have the flexibility to provide for payments prior to the sale of the business, if desired to reward employees who have added value to the business for periods prior to a sale.

For businesses that have achieved a measure of success, phantom appreciation units can be designed that only entitle the holder to a cash payment equal to the increase in value of the business from date of the award to the date of the liquidity event. Often these appreciation rights plans will give employees the right to exercise and receive payment prior to the sale of the business. However, the exercise right is normally conditioned on meeting vesting requirements or performance goals, whether for the individual or the business as a whole.

As with any type of synthetic equity, there is complete flexibility to design the plan for the particular needs of the business. Regardless of the type of synthetic equity used, because payment is not made until a future liquidity event or date, employees are not taxed, and the employer does not receive the corresponding tax deduction, until payment is made.

Regulatory Issues to Consider

Although a discussion of all regulatory issues is beyond the scope of this article, advisors designing synthetic equity plans should be mindful of compliance with Tax Code Section 409A, which requires very specific design requirements. Similarly, to avoid violating the Employee Retirement Income Security Act of 1974, as amended (ERISA), participation in the phantom plan must be limited to a select group of management or highly compensated employees.

In summary, synthetic equity plans can provide small business owners with the flexibility to structure compensation packages that provide incentives to employees who assist in growing the businesses.