There have not been any meaningful new developments in executive compensation since the 1970s, and current plans only attribute to minor single-digit improvements for both the business and the executive. Compensating management with equity is to align executives' interests with shareholders. Yet, stock-based compensation has several drawbacks such as taxation, market risk, dilution effects on earnings per share, and future employee recruiting. This article will cover the benefits and drawbacks of stock-based compensation along with an attractive alternative that can move executive compensation from a liability to an asset on the balance sheet.
There are five main types of stock-based compensation
Shares
Restricted Share Units (RSUs)
Stock Options
Phantom Shares
Employee Stock Ownership Plan (ESOP)
Based on the financial model used, stock-based compensation could be classified as equity or liability.
Stock-based compensation incentivizes employees to stay with the company (they must wait for shares to vest). It helps to align the interests of employees and shareholders – both want to see the company prosper and the share price rise.
Doesn’t require cash upfront, and shares can be awarded at a later date if performance targets are met.
Shares can be awarded over time so that employees receive them when they are ready.
The company does not have to pay tax upfront on any stock-based compensation granted (which is what happens if it pays out cash bonuses) but can defer that tax payment until a later date (when the shares are issued).
This means that companies do not lose as much money as they might have if they had paid out their entire bonus in cash upfront.
While equity-based compensation has many advantages, it also comes with some disadvantages.
Challenges and issues with equity remuneration include:
Dilutes the ownership of existing shareholders (by increasing the number of shares outstanding).
It may not be helpful for recruiting or retaining employees if the share price is decreasing. It may also affect employee morale if they see their own shares decrease in value due to a company's poor performance or market conditions.
It's essential that companies have clear policies regarding vesting schedules (when an employee becomes eligible to receive an equity award), vesting terms (how long an employee must stay at a company before becoming eligible for all or part of an award), and clawback provisions (what happens if there are layoffs).
The real risk lies with the employees. Not only are you receiving income from the employer, but you are also taking additional risks with such a highly concentrated position.
It can be challenging for employees to know whether they've received enough stock options or restricted stock units to meet their financial goals until after they've left their jobs. At this point, it's too late to do anything about it, highlighting the real risk of stock-based compensation.
Earlier this year, Bolt, a payments processing startup, provided personal loans to employees to purchase their stock. The chief executive at the time, Ryan Breslow, called it "the most employee-friendly stock option program possible.” Months later, Bolt eliminated about 1/3 of its workforce.
Click here for the full article.
The purpose of an evergreen option provision is to provide for an automatic allotment of equity compensation every year. Rather than go through the process of approving allotments every year, a company can adopt what is known as an evergreen option provision, which provides for an automatic allotment of equity compensation every year.
The most common type of evergreen option provision is one that automatically grants a certain number of options to each employee in the company on January 1st. These provisions can be based on salary levels or other criteria, such as years of service or annual performance ratings.
From the investor's perspective, an evergreen provision has both positive and negative aspects. On the positive side, this provision ensures that your company will continue to issue equity compensation to key personnel and hopefully keep their efforts focused on maximizing the value of your shares.
While it may seem like a good idea to have a company issue more and more shares over time, it's important to realize that these new shares don't come with any new value added by the company. In fact, they dilute the existing shareholders' stake in the business by decreasing their ownership percentage. This is especially true if a startup issues additional shares at lower prices than what they were valued at when they first issued them.
In addition, institutional fund managers are now paying close attention to companies utilizing Evergreen provisions.
While traditional stock-based compensation is the most common form of equity compensation, it may not be the best fit for your company or team. You need to consider several factors before deciding on a form of equity compensation and whether or not it's right for your business.
Consider utilizing leveraged life insurance as an option. Utilizing life insurance for income is nothing new, and combining it with bank financing isn't new either. We take a conservative asset and use specific loans to maximize the benefits. What is new is the financial requirement required to participate. This structure required an individual net worth of at least ten million in the past. Today, you can qualify based on a $100,000 annual household income.
Leveraged life insurance is a strategy that benefits the employee and employer in one of the most tax advantages available today. It helps fund the difference between what we need to do and can do.
The strategy combines the financial protection of life insurance that provides death and living benefits with a 3-to-1 leverage component; most of the contributions are funded by the lender, providing more benefits at a lower cost. The cash value may be protected from bankruptcy while employee benefits are portable.
Growth without downside risk
60% to 100% more income compared to traditional options
Tax-free income
No personal guarantees, credit checks, collateral, or loan documents
Death benefit protection with living benefits
Only five contributions by the employer
The life insurance contract is the sole collateral for the loan
Executive benefits and compensation move from liabilities to an asset on the balance sheet
Costs companies less than stock options with improved employee outcomes.
Simple administration
Recruit and retain more effectively
New contract negotiations
Organizational consolidation - integrate with your existing plans, especially if plans are underfunded.
Cost reduction with improvement in benefits (and cash flow)
If you are interested in learning more, click here to schedule a time to review your options.
While executive benefits haven’t changed since the 1970s, it’s also important to understand this isn’t a new strategy either. Premium financed life insurance has been around since the 1950s. What is new about the strategy is the fact that you don’t have to sign for or qualify for the financing. Also, it doesn’t require a 10mm+ networth to participate, just a $100,000 household income.
By utilizing premium financed life insurance, both the business and executive receive more benefits. Companies can save money, and employees can have a better and more predictable retirement income.
This solution represents a step-change improvement to executive remuneration in terms of both cost and risk, especially when compared to traditional stock-based compensation. This is why we believe it is time for companies to consider premium financed policies as a better form of compensation for their highly compensated employees.
Schedule a call to learn more.
No worries. Feel free to subscribe to our blog so we can stay in touch.