A Guide to Employee Incentive Plans

A Guide to Employee Incentive Plans
Business Attorney Houston

Drew Erickson


An employer’s motivation for implementing employee incentive plans typically revolves around the term “incentive” – employers want to retain key employees and incentivize them to continue working for them. The result of the incentive plan is that it gives the employee a stake in the business, and the employer and employee can be aligned in the same goal that when the business does better, they both do better.

There are many ways to reward key employees with a stake in the business, but the issue to consider is whether such a reward would have the effect of employers losing (or limiting) control of their business. Typically, owners of a business get “a seat at the table”, meaning owners have a right to vote on certain matters, have access to the confidential information of the business, and have a say in the future direction of the business. If an employer were to reward an employee with equity in the business, that employee now has a seat at the table. But there are ways employers can both incentivize employees with a stake in the business while retaining control. Here are are a few options to consider.

At the outset, note that this Article discusses employee incentive plans that do not involve granting equity ownership of an entity, but there are plans to reward employees with equity ownership in an entity while retaining control of the entity, primarily though the award or purchase of non-voting equity.

Net Profits Bonus Plan

One plan to consider is a Net Profits Bonus Plan. These plans are simple – the employer grants an employee a certain percentage of the business’ profits, payable at certain designated times, typically in the form of an annual bonus. The reasoning for implementing this type of plan is simple– by giving an employee a percentage of profits, it incentivizes the employee to work hard to make the business as profitable as possible. Note though that these types of plans do not pay a distribution or dividend to the employee; those types of payments are reserved for the business owners. Under a Net Profits Bonus Plan, the employee is getting a contractual right to a bonus payment, with it being agreed that the bonus payment is based on the profits of the business.

The attribute that makes this type of plan appealing is its flexibility. The employer can grant any percentage of profits it wants, can define “profits” however it likes, can specify different tranches or levels of participation, qualifying events, performance standards, and timeframes for calculating and paying the profits bonus, and payment can be tied to employment, so any right to payment would terminate when an employee’s employment terminates. This flexibility comes from the fact that this plan is a contractual bonus arrangement, so the terms can be whatever the employer wants (and whatever the employee will agree to).

This type of plan should be implemented if the employer believes it should make at least annual payments to the employee, which differentiates this plan from the two other plans detailed below which may result in no payments being made to an employee for an extended period of time.

Phantom Stock Plan

Another plan to consider is a Phantom Stock Plan. These types of plans grant the right for certain employees to participate in the proceeds from the ultimate sale of the business. This is referred to as “phantom” stock because the employees do not hold any legal title or rights of ownership in the business, but if the business sells substantially all its assets, or the owners of the business sell a majority of their equity (for example), then the employees will be entitled to receive a portion of the proceeds from the sale as if they were owners of the business.

What constitutes a “sale”, how “proceeds” are defined, and which employees are eligible to participate in the plan are all terms that can, and should, be specified in the plan. Like the Net Profits Bonus Plan, the employer has a lot of flexibility in drafting the terms of the plan. For example, the plan can restrict the transfer of such rights to participate as a phantom stock holder, define situations when such rights are forfeited (e.g., should the employee terminate his or her employment), and even include a vesting schedule where the phantom stock holder gets a specified percentage of phantom stock each year of employment.

Unlike a Net Profits Bonus Plan, phantom stock holders do not receive any share of the profits and do not receive any annual bonus payments. And, unlike business owners, phantom stock holders are not allocated any share of the annual profits for tax purposes. A phantom stock holder simply has a right to receive certain “proceeds” from a “sales event”, whenever such an event occurs.

An employer should consider this plan if the goal is to grow the business and ultimately sell the business in the near future (because if a business owner never plans to sell the business, then this type of plan will not be a good fit). The business owner should also understand what will incentivize the employees, knowing that this type of plan will not have any payments made to the employee until a sales event occurs. If that is something that resonates with the employees, then this is a great option for a business owner since it does not require any payments to the employees until an ultimate sale of the business.

Stock Appreciation Plan

The last plan to consider is a Stock Appreciation Plan. Similar to the Phantom Stock Plan, this is a plan that gives an employee a contractual right to certain pre-determined payments and the employee is not an equity owner of the business (meaning the employee has no right to vote at owner meetings, no right to manage the business, no right to access confidential information, etc.).  Under this type of plan the employee only benefits in the appreciation of the value of the business from the date of grant. If the employee helps contribute to the growth of the business, the employee will participate in that growth with a bonus payment based on a percentage of that growth achieved.

To illustrate how this plan operates, the employee participates in the right to receive a portion of the increase in value of the ownership interest in the business from the date the employee enters the plan until the end of the predetermined time. For example, a business owner could grant an employee 10,000 stock appreciation “shares” of the business (which are not actual ownership interests in the business) with an agreed value of $10 per stock appreciation share today with a measurement period of two years, with a portion of the difference in value (for example, 25%) being paid to the employee in cash at the end of the two-year period. Upon the two-year anniversary, the value of the business will be determined in the same way as originally valued, the difference will be determined, and then a percentage of that difference will be paid to the employee as a bonus payment. With the example above, if the valuation calculation determined the value of the the business in two years from now to be $20 per share, then the employee would receive a stock appreciation bonus payment of 25% multiplied by $100,000 (10,000 x $10 difference in value) or $25,000.

A Stock Appreciation Plan is somewhat in the middle of the other two plans described above – it usually does not pay out each year like a Net Profits Bonus Plan, but it pays out more frequently and sooner than a Phantom Stock Plan. Like the other two plans, it is a contractual arrangement between the employer and employee, and as such there is plenty of flexibility in drafting the terms of this plan (e.g., transfer restrictions, forfeiture scenarios, vesting schedules, how to calculate the value of the business, etc.).

While these plans do not need to be complicated, there are a lot of options and flexibility with each of the plans. It is important to understand the pros and cons of each plan, how each plan can incentivize employees differently, and other alternatives to the above before implementing an incentive plan to ensure that the business owner is getting a plan that works for them and that the business is protected. Each of these plans may also have tax implications for the employer and the employee so consulting a tax advisor is wise.    In addition in choosing and developing a particular plan, it is important to work with a knowledgeable attorney on how to define the plan in a way that meets the employer’s goals and plans.

About the Author: Drew Erickson is an Associate in the Transactional Law Group at Rapp & Krock, PC advising employers and working with tax advisors to establish various employee incentive plans as well as other business-related transactions.

ABOUT THE AUTHOR: Drew Erickson is an Associate at Rapp & Krock, PC in the Business Transactions group advising clients on corporate governance matters as well as mergers and acquisitions and other business transactions.


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