Which Incentive Plan Is Right for Your Company?

A stock option plan is an arrangement that enables employees to purchase company stock in the future, but at today's price. For example, an employee might be given 100 options to purchase shares that are currently priced at $10. There might be a vesting period, so they will have to wait three years to exercise the right to purchase. At that time—or up to the expiration date, which is commonly 10 years—they can choose to purchase the shares. 

Suppose they wait until the shares are valued at $18. They would write a check to the company for $1,000 and instantly own shares worth $1,800. Depending on the nature of the shares, they may or may not be taxed on the $800 value. 

Should they hold the shares for at least another year before selling, then they should expect capital gain taxation on any growth beyond the $1,800 value. 

Stock option plans are most commonly found in public companies, or in private companies on an initial public offering (IPO) track. Private companies should consider the liquidity needs and dilution impact of a stock option plan before it is implemented.

A performance share plan allows employees to earn actual stock in their company. The company establishes specific financial objectives which, once achieved, will trigger the awarding of stock grants to employees. Financial targets might include such measures as earnings per share, or earnings before interest, taxes, depreciation, and amortization (EBITDA). Once issued, the shares may still remain subject to vesting schedules or other restrictions. The tax effect to employees is identical to that of restricted stock.

A restricted stock plan is a common way to share stock with employees in public companies. The shareholder-approved plan simply allows for the issuance of stock to selected employees. Unlike stock options, employees receive the full starting value of the shares. Customarily, restricted stock will carry a vesting schedule. Employees will forfeit some or all of the shares unless they remain with the company for a specified number of years (e.g., three or four). 

Employees must pay ordinary income taxes on the value of the shares. The tax is due no later than the time the shares vest. Employees may choose to be taxed as of the date of grant by filing a Section 83(b) election within 30 days of receiving the shares.

A full-value phantom stock plan is a deferred cash bonus program that creates a similar result as a restricted stock plan. The sponsoring company determines a phantom stock price through an internal or external valuation of the company. Employees are awarded some number of phantom shares that carry specific terms and conditions. 

At some point in time active employees will receive a cash payment equaling the value of the original shares plus the appreciation thereon. At a predetermined future date the company will calculate the value of the phantom stock price and pay the employee the full value. For example, assume an employee receives 100 phantom stock with a starting price of $10. Assume the share price grows to $18. The company will pay the employee $1,800. 

Phantom stock plans do not result in shareholder dilution because actual shares are not being transferred. Employees do not become owners. Instead, they are potential cash beneficiaries in the underlying company value. Phantom shares result in ordinary income taxation to the employees when they turn into an actual cash payment. More information on phantom stock can be found here.

A phantom stock option plan is a deferred cash bonus program that creates a result similar to a stock option plan. The sponsoring company determines a phantom stock price through an internal or external valuation of the company. Employees are awarded some number of phantom options that carry specific terms and conditions. 

Should the company phantom stock appreciate over time, employees will receive a cash payment equaling the difference between the original price and the appreciated price. At a predetermined future date the company will calculate the value of the phantom stock price and pay the employee any positive difference. For example, assume an employee receives 100 phantom stock options with a starting price of $10. Assume the share price grows to $18. The company will pay the employee $800. 

Phantom stock plans do not result in shareholder dilution because actual shares are not being transferred. Employees do not become owners. Instead, they are potential cash beneficiaries in the appreciation of the underlying company value. Phantom stock options result in ordinary income taxation to the employees when they turn into an actual cash payment. 

More information on phantom stock options can be found here.

A performance phantom share plan contains two distinct performance-based elements. First, employees must achieve certain predetermined performance targets. Should they do so they are awarded phantom shares. The number of shares may vary by employee and by the degree to which the targets were achieved. Financial targets might include such measures as Pre-tax Income or EBITDA. 

The second performance element relates to the potential improvement in value that may come through phantom stock value appreciation. Once awarded, the phantom shares may still remain subject to vesting schedules or other restrictions. The tax effect to employees is identical to that of phantom stock.

A strategic deferred compensation plan is a performance-based retirement program. Individual, non-qualified retirement accounts are created for the plan participants, typically executives and senior managers. The company annually establishes performance targets which, if achieved, will lead to contributions to the participants' accounts. Better results lead to higher contributions. 

Once the contribution has been made, the employees are given the ability to self-direct their account allocation among a variety of investment options. The investments are handled in the same way as a standard deferred compensation plan and are subject to the same limitations and risks. Plan accounts are also typically subject to vesting schedules.

A performance unit plan (PUP) allows the sponsoring company to select two or more financial metrics that are used to value units awarded to employees. The units will be converted to cash payments at a future time, commonly three or four years. 

For example, a company establishes a unit price of $100. (Note: the determination of the starting value is completely arbitrary.) Next, the company creates a table that illustrates targeted improvements in two important metrics, such as margin improvement and sales growth. The table shows the employees how much the value of the PUPs will grow assuming achievement of the specified metrics. The employees are rewarded for achieving the targets outlined. 

Commonly, the company will award new PUPs each year with either the same or different targets. Alternatively, new PUPs may be issued at the end of the first payment, beginning a new cycle.

A profit pool is the simplest of all the long-term incentive plans. The sponsoring company selects a percentage of annual profits to contribute to a pool for employees. The percentage may reflect an amount above a minimum profit threshold. The pool contribution is then allocated among the participating employees. The company may be discretionary when determining the allocation formula. 

This process continues annually for several years. Let's assume it's a three-year period. At the end of year three, the company would pay one-third of the accumulated value to each employee and carry the remaining two-thirds forward. The idea is that each employee's pool grows as profits increase. Likewise, after the third year, their annual payment would also increase. When employees leave the company, they would customarily forfeit any remaining amount. 

The pool may or may not be credited with interest.