Long-term incentive structures are a key tool used by companies to attract, retain, and motivate talented employees over the long term. These structures typically provide employees with some form of equity ownership or other financial incentive and are often structured to align employee and company interests over the long term. There are a variety of long-term incentive structures that companies can use, including vesting stock options, vesting shares, profits interests, phantom stock, ESOP plans, RSUs, performance shares, and SARs. Each of these structures has its own unique features and benefits, and the choice of structure will depend on the company’s specific needs and goals. In this guide, we will explore each of these long-term incentive structures in more detail, highlighting their pros and cons and providing guidance on how to choose the structure that is the best fit for your company.
Long-Term Incentive (Equity or Equity-esque) Incentive Structures Available and Most Aligned with MSP Founders’ Objectives
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Vesting stock options: A vesting stock option is a right to purchase company stock at a fixed price over a specified period of time. These options typically vest over a period of years, with a portion of the options becoming exercisable at predetermined dates. Once the options are exercised, the employee has the right to purchase the stock at the predetermined price, which is typically lower than the current market price. The primary advantage of stock options is that they provide employees with the potential for substantial gains if the company’s stock price increases.
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Vesting shares (vesting equity grants): Vesting shares are shares of stock that are awarded to employees as part of their compensation package, but which are subject to a vesting schedule. The shares typically vest over a period of years, with a portion of the shares becoming fully owned by the employee at predetermined dates. Once the shares are fully vested, the employee has the right to sell the shares or hold on to them. The primary advantage of vesting shares is that they provide employees with a direct ownership stake in the company.
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Profits interests: A profits interest is a form of equity compensation that entitles the holder to a percentage of the company’s future profits. The value of the profits interest is tied to the future growth and success of the company, so it provides a powerful incentive for employees to work towards the company’s long-term goals. Unlike stock options or vesting shares, profits interests do not have an exercise price or require the holder to purchase shares.
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Phantom stock: Phantom stock is a type of equity compensation that simulates the value of the actual stock without actually issuing any shares. The value of the phantom stock is tied to the value of the company’s actual stock, and employees receive a cash payout based on the increase in the value of the phantom stock. Like stock options, the phantom stock provides employees with the potential for substantial gains if the company’s stock price increases.
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Employee Stock Ownership Plans (ESOPs): An Employee Stock Ownership Plan (ESOP) is a type of employee benefit plan that provides employees with an ownership stake in the company. The company contributes shares of its own stock to the ESOP, and the shares are then allocated to individual employee accounts based on a predetermined formula. Employees typically become fully vested in the ESOP after a certain number of years of service. The primary advantage of an ESOP plan is that it provides employees with a direct ownership stake in the company and can help to align their interests with those of the company.
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Restricted Stock Units (RSUs): Restricted Stock Units (RSUs): Restricted Stock Units (RSUs) are a type of equity compensation that represents the right to receive a certain number of shares of the company’s stock in the future, once certain vesting conditions are met. RSUs are similar to vesting shares, but unlike traditional stock options, employees do not have to pay an exercise price to receive the shares. When the RSUs vest, the employee typically receives the shares or the cash equivalent of the shares. RSUs can be structured to vest based on time, performance, or a combination of the two.
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Performance Shares: Performance Shares are a type of equity compensation that is tied to the company’s performance against certain pre-determined metrics. Like RSUs, performance shares are typically subject to a vesting schedule, and the number of shares that vest depends on how well the company performs against the set metrics. The metrics may be related to financial performance, growth targets, or other key performance indicators. Performance shares are often used to incentivize executives and other key employees to focus on achieving specific performance goals.
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Stock Appreciation Rights (SARs): Stock Appreciation Rights (SARs) are a type of equity compensation that provides employees with the right to receive the appreciation in the company’s stock price over a certain period of time, without actually owning the underlying shares. SARs are similar to stock options, but unlike options, the employee does not have to pay an exercise price to receive the benefit. Instead, once the SARs vest, the employee receives the cash equivalent of the appreciation in the company’s stock price. SARs can be structured to vest based on time, performance, or a combination of the two.
In general, these long-term incentive structures all aim to provide employees with a financial stake in the success of the company over the long-term. However, each structure has its own unique features and advantages, and the choice of incentive structure will depend on the company’s specific goals and needs. Vesting stock options and vesting shares provide employees with a direct ownership stake in the company, while profits interests and phantom stock offer a more indirect form of equity compensation. ESOP plans provide employees with a significant ownership stake in the company, while other types of incentive structures may provide different benefits and incentives.
Overall, these long-term incentive structures are all designed to provide employees with a financial stake in the long-term success of the company. While they share some similarities, each structure has its own unique features and benefits, and the choice of structure will depend on the company’s specific needs and goals. RSUs and performance shares are typically used to incentivize executives and other key employees to focus on achieving specific performance goals, while SARs provide a more indirect form of equity compensation that is tied to the company’s stock price.
INTERIM LIQUIDITY OPTIONS
It is possible to include mechanisms in the legal documentation associated with long-term incentive structures that provide for interim liquidity events, even if there is no actual liquidity event or change of control.
For example, one mechanism that can be used is a “put option” or a “liquidity put” provision, which would give employees the right to sell their shares back to the company at a pre-determined price or formula, in the event of a specified trigger, such as a certain length of time passing or a certain level of company performance being achieved. This mechanism would allow employees to realize some liquidity without requiring a full liquidity event or change of control.
Another approach is to use a “secondary market” or “private auction” mechanism, which would allow employees to sell their shares to other investors or buyers in a private transaction, without requiring a full liquidity event or change of control. In this approach, the company would work with a broker or intermediary to create a private auction platform where employees could offer their shares for sale, and interested buyers could bid on the shares. The price for the shares would be determined by the market, and the company could set certain parameters and guidelines to ensure that the sale process is fair and transparent.
It’s important to note that including such mechanisms in the legal documentation associated with long-term incentive structures may require careful consideration of legal and regulatory requirements, as well as potential tax implications for both the company and the employees. Companies should work closely with legal and financial advisors to ensure that any such mechanisms are structured in a way that meets the needs of the company and the employees, while also complying with applicable laws and regulations.
PROS & CONS of Each Structure/Option
Vesting stock options:
PROS:
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Provide employees with the potential for substantial gains if the company’s stock price increases
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Offer flexibility in terms of timing and the exercise price
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Can be structured to align employee and company interests over the long-term
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May offer tax advantages to the company
CONS:
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Can be complex and difficult to understand for some employees
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May not provide as direct an ownership stake as other incentive structures
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This can lead to the dilution of existing shareholders if a large number of options are issued
VESTING SHARES
PROS:
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Provide employees with a direct ownership stake in the company
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Align employee and company interests over the long-term
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Can be structured to vest based on time or performance goals
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Can help to retain and motivate employees over the long-term
CONS:
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May not offer as much potential upside as stock options or profits interests
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Can be complex to administer and may require significant paperwork and recordkeeping
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This can lead to the dilution of existing shareholders if a large number of shares are issued
PROFITS INTERESTS
PROS:
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Provide employees with a direct financial stake in the long-term success of the company
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Can be structured to incentivize specific behaviors or outcomes
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Do not require the employee to purchase shares or pay an exercise price
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Can help to align employee and company interests over the long-term
CONS:
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Can be complex to structure and administer
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May not offer as much potential upside as other incentive structures
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May be subject to tax implications for both the company and the employee
Phantom stock:
PROS:
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Provide employees with the potential for substantial gains if the company’s stock price increases
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Do not require the employee to purchase shares or pay an exercise price
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Can be structured to align employee and company interests over the long-term
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May offer tax advantages to the company
CONS:
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Do not provide employees with a direct ownership stake in the company
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Can be complex to administer and may require significant paperwork and recordkeeping
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May be subject to tax implications for both the company and the employee. phantom stock plans typically do not provide the same tax benefits as capital gains. The tax treatment of phantom stock plans can vary depending on the specific details of the plan and the relevant tax laws in the applicable jurisdiction. In some cases, the income from phantom stock may be subject to ordinary income tax rates, rather than the lower capital gains tax rates
Regarding phantom stock plans, you are correct that they can be relatively straightforward from a legal and administrative standpoint, as they do not involve the actual issuance of shares. However, they may still require careful structuring and administration to ensure that they achieve their intended purpose and comply with applicable laws and regulations..
ESOP Plans:
PROS:
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Provide employees with a significant ownership stake in the company
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Can be structured to incentivize specific behaviors or outcomes
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Offer tax advantages to both the company and the employee
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Can help to align employee and company interests over the long-term
CONS:
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Can be complex to structure and administer
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May require significant resources to establish and maintain
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May be subject to regulatory and legal requirements
Restricted Stock Units (RSUs):
PROS:
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Provide employees with a direct ownership stake in the company
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Can be structured to vest based on time or performance goals
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Do not require the employee to purchase shares or pay an exercise price
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Can help to retain and motivate employees over the long-term
CONS:
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May not offer as much potential upside as stock options or profits interests
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Can be complex to administer and may require significant paperwork and recordkeeping
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Can lead to dilution of existing shareholders if a large number of RSUs are issued
PERFORMANCE SHARES
PROS:
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Provide employees with a direct financial stake in the long-term success of the company
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Can be structured to incentivize specific behaviors or outcomes
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Align employee and company interests over the long-term
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Can help to retain and motivate employees over the long-term
CONS:
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Can be complex to structure and administer
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May not offer as much potential upside as stock options or profits interests
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May be subject to tax implications for both the company and the employee
STOCK APPRECIATION RIGHTS (SARs)
PROS:
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Provide employees with the potential for substantial gains if the company’s stock price increases
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Do not require the employee to purchase shares or pay an exercise price
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Can be structured to align employee and company interests over the long-term
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May offer tax advantages to the company
CONS:
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Do not provide employees with a direct ownership stake in the company
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Can be complex to administer and may require significant paperwork and recordkeeping
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May be subject to tax implications for both the company and the employee
Stock Appreciation Rights (SARs) and phantom stock plans are both types of equity compensation that provide employees with the potential for gains based on the increase in the company’s stock price. However, the tax implications for the recipients of SARs and phantom stock may differ.
In general, the tax treatment of SARs and phantom stock will depend on several factors, including the specific terms of the plan, the applicable tax laws and regulations, and the individual circumstances of the recipient. However, there are some general differences between the tax treatment of SARs and phantom stock that may be relevant for companies considering these types of equity compensation.
Phantom stock plans typically provide employees with a cash bonus that is based on the increase in the company’s stock price, rather than actual ownership of the underlying shares. The income from the phantom stock bonus is typically subject to ordinary income tax rates, and may also be subject to Social Security and Medicare taxes.
In contrast, the tax treatment of SARs can vary depending on the specific details of the plan and the applicable tax laws. In some cases, the income from SARs may also be subject to ordinary income tax rates, similar to phantom stock. However, in other cases, the income from SARs may be subject to capital gains tax rates, which are typically lower than ordinary income tax rates. To qualify for capital gains treatment, the SARs must meet certain requirements, such as being held for a minimum period of time before being sold.
It’s important to note that the tax implications of SARs and phantom stock can be complex and may vary depending on the specific circumstances. Companies should work closely with legal and financial advisors to ensure that any equity compensation plan is structured in a way that achieves the desired goals while complying with applicable tax laws and regulations.
MOST FREQUENT LONG-TERM INCENTIVE STRUCTURES/PLANS FOR MANAGED SERVICE PROVIDERS
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Vesting Shares: As the company’s co-founders currently own 100% of the company, vesting shares may be a good option to provide equity ownership to key employees. Vesting shares would give employees a direct ownership stake in the company, aligning their interests with those of the co-founders and incentivizing them to work towards the company’s long-term goals. Vesting shares can be structured to vest based on time or performance, depending on the company’s needs and goals.
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RSUs: Restricted Stock Units (RSUs) may also be a good option for the EdTech company, as they can provide employees with a direct ownership stake in the company without requiring an up-front investment. RSUs can be structured to vest based on time or performance, giving employees a tangible incentive to work toward the company’s long-term success. RSUs may also be easier to administer than some other incentive structures, which could be beneficial for a smaller company with limited resources.
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ESOP Plans: While an Employee Stock Ownership Plan (ESOP) can be more complex to establish and administer, it can provide significant benefits to the company and its employees. ESOPs can help to incentivize employees to work towards the company’s long-term success, while also providing tax benefits to both the company and the employees. If the co-founders are willing to consider diluting their ownership stake in the company, an ESOP could be a powerful tool to help retain and motivate employees over the long term.
Ultimately, the choice of long-term incentive structure will depend on the specific needs and goals of the EdTech company, as well as the preferences and needs of the employees who will participate in the program. It is almost always advisable that the primary decision maker (e.g., one or more original MSP founders) work with legal and financial advisors to assess the company’s options and select the structure that is the best fit for its unique circumstances.
CONCLUSION REMARKS
In general, each long-term incentive structure has its own unique set of advantages and disadvantages, and the choice of structure will depend on the company’s specific goals and needs. Some of the key factors to consider when selecting a long-term incentive structure include the size and maturity of the company, the level of risk associated with the company’s operations, the goals of the incentive program, and the preferences and needs of the employees who will participate in the program. Companies should work closely with legal and financial advisors to ensure that the chosen incentive structure is structured in a way that meets the needs of the company and the employees, while also complying with applicable laws and regulations.
Long-term incentive structures are a key tool used by companies to attract, retain, and motivate talented employees over the long term. These structures typically provide employees with some form of equity ownership or another financial incentive and are often structured to align employee and company interests over the long term. There are a variety of long-term incentive structures that companies can use, including vesting stock options, vesting shares, profits interests, phantom stock, ESOP plans, RSUs, performance shares, and SARs. Each of these structures has its own unique features and benefits, and the choice of structure will depend on the company’s specific needs and goals. In this guide, we will explore each of these long-term incentive structures in more detail, highlighting their pros and cons and providing guidance on how to choose the structure that is the best fit for your company.