Privately-owned companies enjoy many advantages compared to their publicly-traded counterparts in the current economic and regulatory environment. Their detachment from the public markets allows them to operate under less scrutiny and governance bureaucracy. Yet, it also creates some practical barriers when considering incentive compensation alternatives.
The absence of a public market, and the easily- accessible company valuation it supplies, makes it difficult for privately-owned companies to structure, adjudicate and communicate equity compensation to participants. That said, as publicly-traded companies continue to deliver a large portion of total compensation in the form of long-term equity- based awards, some alignment in incentive design can provide private enterprises with a more competitive compensation offering, one that effectively meets the objectives outlined at right.
An ongoing campaign by influential shareholders and organizations to have boards and management refocus on longer-term decision-making is sparking conversations around how to apply this mantra to incentive design. As these companies consider moving towards longer-term full share instruments, private companies face similar decisions related to sufficient alignment and the practical application of non-traditional incentives instruments.
As outlined in this briefing, private companies have several options for long-term incentive plans (LTIPs) that can mimic stock compensation and allow participants to share in the longer-term growth in company value enjoyed by shareholders (in cases where real equity ownership is not desired). Selecting appropriate instrument(s) will require careful consideration of several factors not applicable to publicly-traded companies, including company valuation and liquidity.
LTIP Objectives
The overall objectives of an long-term incentive plan will influence which design is most appropriate. Common objectives include:
Attract Talent: to attract the right employees, a company will want to consider what is competitive in its industry — considering both publicly-traded and private incentive structure
Incent Performance: to strike a balance between measures of success for the company / shareholders and over what the employee has “line of sight” influence. For many organizations, equity compensation plans can effectively support the objective of coalescing the management team around a common goal and share in the company's long-term growth
Alignment with Shareholders: to ensure participants have sufficient “skin-in-the-game” and to reinforce a culture of ownership
Retention of Key Personnel: to ensure sufficient retention mechanisms are in place (e.g., through deferral of compensation and vesting / forfeiture conditions)
SPECTRUM OF LTIP VEHICLES
Long-Term Vesting
- Settlement of equity awards with treasury shares (as opposed to cash or market-purchase settlement) can allow for longer award terms (i.e., settlement beyond three years) and more flexibility on timing (i.e., fewer tax limitations)
- While vesting can still occur after or over three years, at which point the participant has earned the right to the full award, the settlement of the award can extend longer (e.g., seven years), thereby deferring the tax impact during that period
- This structure promotes longer-term alignment with shareholders, however, some complexities can arise when settlement is extended beyond three years
KEY CONSIDERATIONS FOR EQUITY AWARDS
Similar to publicly-traded companies, private enterprises will need to weigh the pros and cons of settling equity awards in either cash or treasury shares. One major factor is the favourable personal tax treatment for Canadian Controlled Private Companies (CCPCs), which offers added tax benefits when using real equity. In either case, companies will have to approach the issues of company valuation and share liquidity carefully.
Corporate Tax
Cash: deductible expense for the company
Real Equity: not deductible by the company
Personal Tax
Cash: taxed as regular income
Real Equity: if a CCPC, initial grant value is taxed at capital gains-like rate. Increase / decrease in value is eligible for capital gains / loss treatment. Also, individuals have a life-time capital gains exemption of $824,000
Accounting Treatment
Cash: liability accounting Real Equity: fixed accounting
Dilution
Cash: no shareholder dilution
Real Equity: shareholder dilution
Cash Outlay
Cash: cash outlay at time of settlement
Real Equity: no cash outlay
Company Valuation
Determining a share price to unitize value is often the most difficult aspect of developing a private company LTIP. The focus should be on developing an easily administered and consistent approach which accurately measures the change in the value of the business.
There are two primary valuation methodologies a company can use:
Fair Market Valuation: A third party valuation may provide the most accurate appraisal of the company, at the expense of line-of-sight to value divers and cost
Formulaic Valuation: A simple fixed financial metric multiple (e.g., EBITDA) offers clear line- of-sight to value drivers, however, may be difficult to apply over time
Share Liquidity
With no public marketplace to facilitate the purchase and sale of equity, the company is typically responsible for providing liquidity to the plan participants. The liquidity requirements can be managed through careful planning and budgeting, scenario-testing, and the implementation of certain “safeguards” (e.g., cap on trading to ensure fundability, prohibition of trading between employees, no commitment under extraordinary circumstances)
Other Considerations:
Tax implications of share buybacks – may require the creation of a trust so as not to trigger adverse tax consequences
Exit and change of control treatment – will not be under the same degree of shareholder scrutiny as in the public arena
CONCLUDING THOUGHTS
As evidenced by usage levels among publicly-traded companies, LTIPs are viewed as effective tools to incent executives to focus on goals that extend beyond the short-term and share in long-term growth in company value. Two final thoughts:
- When considering adopting an LTIP at a private company, it will be important to weigh the tax and alignment benefits against the practical complexities and risks of implementing such a framework
- There is significant flexibility afforded to private companies in designing an LTIP – gaining an understanding all of the options available, and their associated benefits, can be a worthwhile exercise