APRIL / MAY 2004
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Stock Options
Where Have You Gone?
by Michael G. Schwartz
Schwartz, Manes & Ruby
Before the dot.com bubble burst, many tech companies distributed stock options like candy. The idea was relatively simple. Granting stock options to valued employees cost the company nothing but provided a valuable incentive for employee performance. From the employees’ perspective, it was only a matter of time before the options were “worth millions.”
In some cases, this worked out as expected. You only need spend a few minutes watching “Lifestyles of the Rich and Famous” to see some of the young techies who made it. However, for many others (if not most others), stock options simply did not work out as anticipated.
The Problems With Options
Looking back with the benefit of hindsight, the shortcomings of stock options came from a variety of sources. First, some companies chose to use a special type of stock option called an “Incentive Stock Option” or “ISO.” These special ISOs have enormous income tax benefits from the perspective of both the employer and employee. However, ISOs have a fatal flaw which arises from a separate taxation system in the U.S. called the Alternative Minimum Tax. The Alternative Minimum Tax imposes a tax on the exercise of ISOs even though such exercise is exempt from ordinary income taxes. The result is a large Alternative Minimum Tax bill when the ISOs are exercised, even though there are no cash proceeds at such time to meet the tax bill.
Another problem arose when the tech company did not perform as well as anticipated. Suddenly, key employees who had been banking on stock options as a primary component of their compensation package discovered such options were worthless because of the company’s underperformance. As a result, many tech employers found an exodus of key employees at a time they could least afford it.
Additionally, for those companies which did perform, the employers were not always happy to find that share ownership meant a new set of owners with potentially differing views on how the company should be run. Even though minority owners do not have enough power to control a corporation, they also cannot simply be ignored. Shareholders have a variety of court-imposed rights by the very fact of their stock ownership.
Finally, recent changes in accounting standards regarding how stock options are reflected on a company’s financial statements have caused disfavor in the business community.
Stock Equivalent Plans
Many tech stock companies have turned to Stock Equivalent Plans which are sometimes referred to as phantom stock plans. Stock Equivalent Plans provide many of the same benefits as stock options in terms of attracting, retaining and rewarding key employees. To understand the benefits Stock Equivalent Plans provide, a basic understanding of stock rights is helpful.
Owning shares in a company provides three important rights to its owner. First, the shareholder gets to share in the economic success of the company. These economic benefits are realized through dividends, liquidation distributions or sale proceeds in the event the company is sold. Second, a shareholder gets a say in how the corporation is operated through voting rights attached to the shares. And finally, a shareholder has access to company information such as financial information, compensation levels and a variety of other information not generally available to the public.
The underlying presumption in Stock Equivalent Plans is that key employees are not overly concerned with voting rights or access to confidential company information. The primary motivation for share ownership has always been the potential economic rights associated with such share ownership.
This is where Stock Equivalent Plans shine. Because Stock Equivalent Plans are not real shares, they are only entitled to the specific rights bestowed on the owners of such shares by the plan document. Typically, such plans give the owner a right to share in any dividends, liquidating proceeds or sale proceeds along with real shareholders. However, such owners are not entitled to any voting or information access right.
The economic rights under a Stock Equivalent Plans are frequently structured as an employee performance incentive. Such economic rights may be tied to company profitability, target productivity levels, achieving specified objectives, or any number of items deemed worthy by management. Additionally, just like a stock option plan, the rights under a Stock Equivalent Plans can vest over a number of years to provide incentive for employees to stay with the company while protecting the company against short-term employees.
If this leaves the impression that Phantom Stock Plans are extremely flexible – they are. Phantom Stock Plans can be custom designed to meet a company’s specific needs. If your company wants to explore whether a Phantom Stock Plan is right for your company – just call us!
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