What are the arguments for establishing long term incentive plan metrics that are different than those tied to the annual incentive plan?

Question:

What are the arguments for establishing long term incentive plan metrics that are different than those tied to the annual incentive plan?

Answer (by Dan Walter)

Great question!

There are several arguments for clear differentiation between the metrics used for annual incentive plans and LTI plans.

1)   The first concern is that overlapping metrics can create too much leverage for a specific objective, or tie too much risk to a potential goal.   Ex. When your short term goals are revenue and profit margin and your long term metric is EBITDA you are essentially incenting the same thing twice.  This may result in people no longer focusing on other critical factors.  And if there is a big swing up or down it may blow up your compensation strategy and budget.

2)   Another concern is that certain metrics are more valid and less volatile over several years. The wide swings in some metrics from year to year may be good when getting people to focus on the immediate horizon, but they may not align with a compensation philosophy that is intended to align employee or executives with shareholders.

3)   Some metrics are the result of a longer term cycle of Decision, Action, Behavior, Result. Focusing people on the entire cycle, rather rewarding each component individually may get them to see the big picture in a new way. Example: Company realizes its internal software for supporting the business is out of date and needs to be replaced.  The process requires finding the right replacement, getting it built or set up, rolling it out, then managing the tool and users to ensure they get the most out of it. Without a long-term program for the whole process you may get a series of results that take down a hole of failure.  Imagine: Decision to get new software is delayed because there is not short-term metric for it this year. The next year the decision to get new software controlled by a short-term budget goal that must be met, even though the software will be a long term investment.  The cheaper software requires far more work in year 2 or 3 to get installed correctly and it conflicts with the annual incentive plan in that year, so corners are cut to get a ”simpler” version put in place. The simpler version turns out to be less effective that the old software (which you are still using). A partial roll out occurs and is immediately followed by outcries that the new software is terrible. The team meets and decides to start all over again.  In the means time 4 or 5 years of annual incentive payments were made because each small piece seemed to be achieved, but no concept of the successful long-term deliverable was included in the pay program.

4)   Certain types of LTI programs (example:  equity plans) have a far different impact than short-term plans. These plans also rely on metrics like stock price that are built into the plan but not directly controllable by the individuals. Metrics for these programs need to account for the different “nature” of the plan and compensation instrument itself.

How do you sell Facebook stocks (RSUs) that you have?

Question: (org. on Quora)

How do you sell Facebook stocks (RSUs) that you have?

Answer (by Dan Walter)

This answer will be generally accurate for any RSUs that can be settled in company stock. Your company may have additional rules or restrictions.

1. The RSUs must vest. When they vest they essentially turn into stock.

2. Pay the taxes due at the time of vest. For most companies this is done automatically using some of the shares that trail from vesting.
Withhold to Cover, or Net Settlement is a process where the company simply holds back vested units with a value roughly equivalent to the taxes owed. (This was the historical process used by Facebook)
Sell to cover is a process where the company will take some of the vested RSUs that have turned into stock and have a designated broker immediately sell those shares on the open market. (This is the current process used by Facebook for most RSUs)
In both cases the remaining shares are then delivered to you. Typically they are sent directly to a designated brokerage account.

A small percentage of companies also allow you to write a check for the taxes. They then deliver all of the vested shares. This process is a pain and often ends up in the individual failing to make a timely payment so it’s pretty uncommon.

3. The shares that are delivered to you can then be sold by you. A) but you can’t be in a trading blackout period     B) you can’t have any inside information that would otherwise prohibit you from trading in the companies stock.   C) all other securities laws etc will apply to you.

Lastly, if you RSUs have not vested, or will never vest (as in the case where you no longer work for the company), then you are out of luck.

What happens with AMT if you exercise stock options in a private company and sell in the same year, but the sales price is less than the 409 value of the company?

Question: (org. on Quora)

What happens with AMT if you exercise stock options in a private company and sell in the same year, but the sales price is less than the 409 value of the company?

So let’s say your ISO option strike price is $10 and the latest 409 valuation puts the stock at $40 a share, but you sell for $20 a share in the same year you exercised. Do you have to pay AMT on the difference between $10 and $40 or is it just considered a normal stock sale that you paid $10 and sold for $20 and AMT is irrelevant? Will there be any issues with the IRS since the price paid for the shares is less than the recent 409 value?

Answer (by Dan Walter)

This is a great question and an important fact for Incentive Stock Option (ISO) holders to be aware of.

When you exercise an ISO the spread is an Alternative Minimum Tax Income preference item. If you simply exercise and hold you will be required to perform an AMT tax calculation (there are lot’s of posts and discussions about tis, so I won’t go into the details.

If you sell, gift or “otherwise hypothecate” your exercised ISOs within 2 years of the grant date and 1 year of the exercise date you have disqualified them from preferential tax treatment (a “disqualifying disposition”).

A disqualifying disposition that occurs in THE SAME CALENDAR YEAR as the exercise that caused the AMTI preference items, negates the AMTI preference item and no AMT calculation is required when preparing your taxes in the following calendar year.  BUT, if you forget and hold the shares until even January 1 of the calendar year following the exercise, you will be forced to do the calculation and, perhaps, pay the associated taxes.

The trick is this.
IF you exercise and ISO and choose to hold any or all of the resulting shares in order to potential receive the tax benefit of avoiding ordinary income taxes in favor of capital gain taxes…
THEN you should have a tax professional or a qualified investment advisor of some sort help you evaluate the resulting shares in early December of the same year as the exercise.
IF the AMT risk seems high, it may make sense to get rid of the shares, take the ordinary income hit and pay the associated taxes.
If the AMT risk seems low, it probably makes sense to hold the shares and take advantage of the great saving that capital gains rates offer you.

NOTE: I am not a qualified tax advisor or attorney or financial advisor. While I do have extensive knowledge of these issues nothing here should be considered advice or guidance.  You must speak to your own advisors about your specific facts and circumstances to get advice about this issue.

 

 

I’m leaving a startup. How much co-founder equity should I get?

Question: (org. on Quora)

As a grad student, I worked 5M part-time (25% of total time) with a co-founder, who came up with, funded and executed the idea. We were supposed to split 50/50 if I become full-time. However, we missed a  milestone & I’m leaving to look for a full-time job. We never had a formal discussion with a contract, details on vesting schedule, etc.
I want to be compensated in equity for the work I put in. How much equity should I ask? What % equity is fair?

Answer (by Dan Walter)

culture. Learn more at www.performensation.com. My expertise includes equity compensation programs.

Can contractors be paid in RSUs or only employees?

Question: (org. on Quora)

What are the tax implications vs getting paid in cash? (I understand how RSUs work for employees [viewed as income], but I don’t know if it is viewed as income if the person is a contractor)

For example, if a person is a board member of a company and not an employee, can they offer to receive payment in RSUs vs cash?
 
Answer (by Dan Walter)
RSUs are allowed, by law, to be granted to employees and non-employees alike. This means they can be used for contractors and outside directors.
From an individual income and tax perspective they are also similar to RSUs given to employees.  The income generated at the time of vest is Ordinary Income and is subject to associated taxation.  Unlike RSUs given to employees, the company is not required to (and in fact should not) withhold taxes.
This means the reporting of income and payment of taxes is the responsibility of the individual.  At the end of he year the company will provide an 1099-misc, but your tax burden may need to be satisfied prior to that.
From a company perspective the accounting consequences are quite different when granting to non-employees.  RSUs, when give to employee and settled in stock, are generally accounted for as equity and have a fixed compensation expense that is amortized relative to the vesting schedule. For non-employees this expense must be accounted for using FIN 28 (even though this doesn’t technically exist anymore) methodology.  This means that each reporting period (assume quarterly) you will need to adjust the expense associated with the RSUs.  If the stock price at the company grows this can result in the company take a far greater expense for a non-employee RSU that was granted at the same time as an employee RSU.
All of that being said…Plan documents can be written to expressly forbid granting any type of of equity to non-employees. If the plan doesn’t allow it, then it doesn’t matter if the law does.

For $0 CEOs, how is their initial equity-compensation determined?

Orig. Question on Quora.

Answer by Dan Walter:

Very few $0 CEOs start at $0 Salary.  Most start with a reasonable salary-bonus-equity combination.  As the company grows to be more successful and the equity they own (or have future rights to via vesting) becomes more valuable they reach a point where more salary basically pointless (since salary above $1,000,000 is not tax deductible to a profitable company it ios also pointless to the company).  In many cases any amount of salary at all is pointless due to the wealth of the individual.

Some of these CEOs at $0 salary have stock worth more than a Billion dollars.  $1M in salary equals one-thousandth of their company provide wealth.  Moving their salary to $0 is just a way to make that corporate thorn go away. Equity compensation keeps them aligned with shareholders and allows them to continue being rewarded for grwoth and success.

I should point out that some of the CEOs who do this make the effort for far more altruistic reasons, but most of the CEOs at a $0 salary have already crossed the salary-requirement threshold.

So, equity compensation for these CEOs is based on a combination of market data, internal worth and shareholder acceptability.

Geo differentials don’t align to market data – Why Not?

Question: (original question from WorldatWork)

I have found that the geo-differential from Seattle might suggest that jobs, as a whole, in Seattle pay 10%-15% above the national market. However, when I ran a comparison of multiple surveys to identify the differential between the Seattle cuts and the National cuts, I found that the median differential, is much lower than the suggested geographic differential, overall.

  • Radford suggested that the Seattle cut vs the National cut had a median differential of only 1%
  • Culpepper suggested the Seattle cut vs the National cut had a median differential of about 7%

Is anybody able to provide some insight as to why these numbers are significantly less than what I have seen in terms of what the geographic differentials suggest?

Answer by Sam Reeve:

There are many factors that could lead to different geographic pay differential results between surveys.

Such as:

  • Different Data Sample.  Just about every survey out there will have a different group of companies that provide compensation data.  They may be from different industries, company sizes and some jobs may be more dominant than others.
  • Different Data Collection Methods.  Every survey has their own survey job descriptions and therefore companies will need to make a judgement call on how to match their roles to the survey.  In addition, not all companies provide quality information and it is difficult for survey companies to determine the good information from the bad.
  • Different Survey Methodology.  In school we learn the right way to use statistics and then some survey companies come up with their own creative spin on the science.  (I am not pointing any fingers here.)  Whether a company uses sound statistics or not, different survey methodologies with yield different results.
  • May have Different Definitions for Pay Elements.  Some survey companies may also define pay elements differently such as base pay versus fixed pay although, to my knowledge, this should not be an issue between Culpepper and Radford.  This is typically a concern with international surveys.

This doesn’t mean that surveys are all bad, it is just a fact that they are not a perfect representation of reality.  The bottom line is that the geographic differential process is inherently flawed.  It is not meant to be perfect.  It is meant to be a cheaper and less administratively burdensome than direct market mapping. (meaning, purchasing local surveys and mapping local jobs)  The key is to find the best source that works for your company and keep consistent with your methodology.  Understand that it is not perfect and check your employee attraction and turnover data to identify problems and adjust as needed.

The Best Ways to Retrieve and Organize Job Descriptions?

Question (orig. at WorldatWork)

Looking to understand what compensation professionals use to be more efficient  (or process) in retrieving, filtering and housing existing job descriptions as well as creating new job descriptions.  Would appreciate to hear the perspective from non-vendors.

Answer by Sam Reeve

There are a variety of document tracking systems that you could use to manage, check-out and update files.  I think these are great for large companies, but if your company has less than 400 unique positions you can manage these effectively using traditional files and folders. In most cases it is easy enough just to manage job descriptions like any other ongoing annual project.

I would suggest that you keep your documents in a shared folder and have published job descriptions in a pdf (or similar protected format) with version dates.  Unprotected working files are kept in folders shared by administrators of the project.

The shared published folder would contain your current PDF job descriptions organized by your job structure.

The administrative folder would include:

  1. the project plan,
  2. your job description template,
  3. job structure, and
  4. editable copies of all active and unpublished descriptions.

It is a great communication strategy to publish the job structure on the internal intranet with hyperlinks to the most current descriptions.  The job structure organizes your roles into business functions, which are subdivided into job families.  An example of this would be the job family of “Compensation” that includes roles sorted by level, like “Compensation Analyst”, “Senior Compensation Analyst”, “Compensation Manager”, etc.  This would all be included under the business function of “Human Resources”.

The project plan document includes all the jobs in your job structure with the version number and the date it was last reviewed.  In most cases we recommend that our clients review their job descriptions every 2 years, but this will vary depending on how fast the roles in your organization change over time.  Each year you will list the business functions that need to be reviewed and approved – for instance, you may focus on HR and Finance this year, then is Marketing, Sales and Legal next year, and so forth.

Hope this helps…

Sam

 

Profit Sharing Incentive Plan

Question (orig. at WorldatWork): 

Do you have a profit sharing incentive plan?  If so, what % of eligible wages does an award equate to?  What % of your company’s profit does the pool represent?

Any info would be appreciated.  Thanks.

Answer by Dan Walter

“Profit Sharing” is a term that is often misunderstood.

On one hand you may mean a formal, tax qualified, profit-sharing program that is subject to ERISA requirements etc.

On the other hand you may mean an STI or LTI plan that use profit amount, profit growth, profit margin or a similar metric, or combination of metrics to deliver cash or equity compensation.

The first type of profit-sharing is subject to some very well-defined rules, mainly via the IRS.  These rules tend to drive some similarity in the plans across companies.  But, these rules often are viewed as too difficult to deal with and this results in less companies using these plans than you might expect.

The second type of plan does not provide the tax advantage, but it is far more flexible in design, features and eligibility.  These plans are fairly common and there is not a lot of commonality between companies (nor should there be).

I am happy to chat with you about either type of plan or, if you provide a bit more detail here, I may be able to expound on this answer.

Would you or would you not exercise your stock options in this scenario?

Question details (original on Quora)

  • My strike price is $650, and the current fair market value is $1250
  • I must exercise my stock within 3 months from when I leave the company next week
  • The company won’t tell me how many shares are outstanding
  • The company is likely to go public (let’s say 70% probability) in the next 1-2 years at ~$10B IPO. I’d say the likelihood of an acquisition is pretty low.
  • Exercising all of my stock options would be a significant investment compared to my current savings, but if I were convinced this is a smart risk to take, I’d go all in
  • My stock does not meet the minimum requirements on secondary markets like Sharespost, so I’d only get a return at IPO or acquisition

Basically my question is: how do I calculate the expected return of my stock?

Answer, by Dan Walter

This is a more nuanced question than many people may imagine. There are certain things that truly are important to know before you make this decision.

1. Shares outstanding. While others have said this is not important, it is actually critical. Currently companies in strong IPO tend to have an IPO price of between $15 and $18 per share. Given your strike price the company likely has far fewer outstanding shares than it will have at the time of IPO.  This is probably a good thing. You will likely end up with far more shares after the split (lower price = more shares since total value won’t really change).  To get to a price of $17 given todays price of $1250 you would have to multiply the outstanding shares by about 73.5 times.  Since we have no idea how “accurate” the current value is, it would be hard to provide great advice on this point.

2. Rules regarding your grant.  Can the company buy back your VESTED and EXERCISED shares?  If so, at what price?  While this is not common, it has happened at some high profile companies over the past decade.  You may find yourself spending your money, then simply getting back in a couple of years.  You may have to write off losses and deal with the lost time-value of your money.  Without fully understanding your plan details, it is hard to know how this will work.

3. You haven’t mentioned whether you have ISO or NQSO stock options.  If you have ISOs then you won’t be paying taxes at the time of exercise, but there may be an issue with AMT if something great happens with the company before the end of the year.  With NQSOs the spread (right now $600 per share) will be taxed as ordinary income.  This will be paid at the time of exercise, and likely via withholding by the company.  They may allow you to have some of your vested shares withhold to cover the taxes, but more likely they will require you to add around 40% to the total exercise cost.

4. An IPO two years out is unlikely to be a 70% probability.  There are, of course, exceptions to this rule of thumb, but if the IPO is planned and being worked on for execution within the next 12 months, I would lower your expectations.  A lot can happen in 2 years…

And with all of that being said… You have options that are already almost 50% in the money.  It sounds like you have enough of them to make the exercise a burden, but perhaps not a life changing risk. If you had 500 stock options exercisable you would be looking at an exercise cost of $325,000, plus taxes due (assuming an NQSO) of around $120,000, having a value of $625,000.  So a net value at the time of exercise of $205,000.  Of course we have no real idea of the potential future vaue since we have no idea of the current company value. A $10B value in two years won’t mean much if today’s value is $7.5B.

I hope this gives you some good information to ask the company some specific questions.