How do you plan the best equity compensation plan to ensure a key executive stays with your company?
Or, if you aren't sure you can keep them around, how will you pivot for succession?
It’s a common scenario with a complex answer.
Recently, the CEO of a $20 million eCommerce company reached out to me. She wanted to know how to build the best equity plan for her COO, who was approaching the end of his first year with the company. The CEO wanted to retain him for the long haul — but didn’t know what kind of equity compensation plan could make that happen.
Throughout this article, you’ll hear more about this CEO, but the truth is that her reality is not your reality. Creating an equity compensation plan for key executives is a complex process with a lot of moving pieces and open-ended questions that — quite frankly — don’t come with easy answers.
We’ll explore those factors and what you need to consider to find the right equity compensation plans that align with your goals.
First, let’s look at why this process is so complex and challenging.
The process involves four different specialties and perspectives.
First, there’s the human resources perspective. From a people and talent perspective, what’re we trying to accomplish?
Second, there’s the legal perspective. How do we document the equity compensation plan? What are the legal mechanics of the process?
Third, there’s the financial aspect. What can we afford? How do we make this work within our budget? How can we balance budget considerations while also ensuring the amount is meaningful and appropriate? What is the right timing for the payments?
Last but not least, there’s the tax perspective. What’re the tax considerations and mechanisms at play across different equity plans?
It’s a lengthy list of questions to consider. The typical entrepreneur may know and understand one of these — but all four? It’s difficult for anyone to understand everything, and therefore why it’s hard to find one advisor with all the answers.
That’s where we can offer some insight.
Although creating equity compensation plans is a complex process, it’s still a process. No matter the size and specifics of the company, we have a battle-tested, five-step blueprint that helps companies find the right solution.
Within each of the following steps, you’ll see the considerations that go into putting a plan in place (and how it worked for the CEO I mentioned earlier).
Every plan starts with setting goals and expectations. Goal setting begins by asking yourself a simple question: What are you trying to accomplish with this equity incentive plan?
Typically, we get one, or a blend of, the following answers:
When we asked the eCommerce CEO’s about her goals and objectives, she said she wanted to create an owner mindset and a long-term incentive. She wanted a win-win scenario in which both the business and COO would benefit from financial success.
The mechanisms of an equity plan vary drastically depending on your business’s entity type.
For example, let’s assume you’re organized as an LLC and want to grant equity compensation to certain employees. Well, once an employee gains an equity interest in your LLC, they’re treated as a partner because, in the IRS’s eyes, an LLC member can’t also be an employee.
Now, this individual needs to be issued K-1s instead of W-2s.
Now, their salary should be treated as a guaranteed payout.
Now, they have to pay estimated taxes each quarter.
The ramifications go on.
That’s why the second step looks at your organizational structure to eliminate irrelevant and cumbersome solutions right off the bat.
The eCommerce company was an LLC, so we discussed the following four options:
Immediately, we were able to nix the equity buy-in option because it wasn’t the desired solution for either the business or the executive.
In the third step, we assess conceptual design by experimenting with different solutions and mechanisms. Also, we identify potential scenarios and walk through desired outcomes.
For instance, let’s assume you have an employee who you want to have an owner’s mindset. An example that most people are familiar with are law firm partners. It’s common for law firms to require partners to buy equity in the firm. Now, more and more businesses are structured in such a way that owners and founders are seeking to create this level of buy-in among their executive team.
This structure can have a profoundly positive impact on your organization but comes with considerations.
Well, what if the person to whom you’re giving equity options leaves in two years? What if they leave next month?
What’s the organizational impact? What do you want to happen?
From here, we can explore the outcomes of the various plan options. During this stage with the eCommerce company, we walked through the mechanics of the remaining three options.
The phantom equity plan would reward the COO upon an exit event, such as a company sale (e.g., if the company sold for $20 million, the plan documents that the executive would receive 2% of the sale price). But there were two problems: (1) there wasn’t much of a tax benefit, and (2) it may not create an owner mindset because it was phantom equity. So, we eliminated this option.
The profit interest units (PIUs) would make the COO a full-time member of the firm, allowing him to participate in all company profits (including distributions). Again, there were downsides. First, the distributions would create a lot of tax complications. Second, since the COO would be a firm member, he’d immediately gain access to equity earnings and insider information, which was more intimate of a partnership than the CEO desired. Third, this option created short-term and long-term incentives; the CEO didn’t want to encourage apathy by immediately providing equity interest.
Finally, we landed on PIUs with very specific conditions. In other words, the COO’s equity wouldn’t have value until a sale occurred, which created a long-term incentive. The CEO wanted an exit event and expected it was roughly five years away. And this equity compensation plan aligned with this goal — plus, it offered simpler tax mechanisms and a long-term tax benefit.
For the fourth step, we take a granular approach to ensure the plan executes its purpose: creating an incentive that makes sense from a financial standpoint and from the employee’s perspective. To do so, we build upon our conceptual designs by modeling revenue projections and dilution analysis.
Once we landed on PIUs that vested upon an exit event, we consulted tax experts and ran detailed models. At this point, we aimed to answer several questions, such as:
At this step, we prepare an outline that each key expert can review and opine on. For instance, we can involve legal counsel to ensure the plan’s mechanics can be legally documented — or accountants to mitigate potential tax issues.
Then we meet with all parties to answer questions, get feedback, and work through finer details.
And we had the same process for the eCommerce company. We shared their plan’s model and mechanics with their legal and tax professionals. We consulted with the company owner, answered questions, and then entered execution mode.
We’ve seen companies pour resources into devising elaborate equity plans — except they didn’t actually achieve the desired behavior of creating an incentive. We’ve also seen simple and straightforward solutions do precisely what the company intended.
Although the process requires analytics and modeling, creating the right equity compensation plan is an art.
And “right” doesn’t need to be expensive. The best plan should be a win-win for your organization and that key member of your team that you want to keep around.
As a full-stack CFO firm, AVL Growth Partners provides a complete breadth of skills and finance and operations expertise for rapidly growing small and medium enterprises. Visit our website to connect with us.