Equity-Based Incentive Plans

What Are Equity-Based Incentive Plans?

Equity-based incentive compensation plans are an increasingly popular component of overall compensation packages. At its core, an equity-based incentive plan is used to attract, retain, and incentivize employees.  Companies often reward employees, partners, directors, contractors, or others by granting them shares or units (these terms are used interchangeably herein) in an equity plan.  Providing equity awards more closely aligns the recipients’ interests with the interests of the subject company and its ownership.

Historically, equity plans were limited to the enterprise market and specifically the professional management of major corporations.  Equity plans originally focused mainly on the issuance of options.  However, a number of regulatory, market-driven and societal factors have substantially expanded the breadth of equity compensation plans.  Today, equity plans have not only expanded into nearly all sectors, including the middle market and privately-owned companies but also encompass a broad variety of incentive awards.  Options are no longer the dominant form of award, and a significant portion of awards are performance-based.

There are many different types of equity awards utilized in practice.  One commonality among most plans is that the value of the award is dependent on the value of the underlying equity in the subject company.  For private companies, this results in valuation needs generally at the time of plan implementation, as well as on an ongoing basis for the purpose of administering the plan.

Types of equity-based incentive plans which MPI has seen utilized by its clients include the following:

• Direct interest in private company stock
• Employee stock options
• Stock appreciation rights
• Restricted stock units
• Profits interests

In addition to values being necessary for the purpose of generally administering an equity plan, there may be both tax and financial reporting implications.  Under tax rules for compensation, an employee is almost always taxed on the value of shares on the date such shares transfer to the employee.

The IRS has general guidance on how to determine the fair market value which the courts have consistently relied upon for decades.  Revenue Ruling 59-60, Section 1, states “the purpose of this Revenue Ruling is to outline and review in general the approach, methods, and factors to be considered in valuing the shares of the capital stock of closely held corporations…”.  The Revenue Ruling goes on to provide additional guidance and factors to consider in determining fair market values.  The IRS has issued more specific guidance that discusses how and when equity compensation is included in an employee’s income.

Turning to financial reporting, the FASB’s Accounting Standards Codification 718 – Compensation-Stock Compensation (formerly SFAS 123R) (“ASC 718”) provides guidance for the accounting treatment of equity-based compensation.  The objective of ASC 718 is to recognize the fair value of employee services received in exchange for equity awards issues, or liabilities incurred, as the employee provides the related service to the subject entity.  Important considerations are whether the equity award should be classified as a liability or in equity, as well as the measurement date and period which would generally be the requisite service period.

Beyond the high-level tax and financial reporting implications noted above, if the entity issuing equity awards is an early-stage company there may be additional complications.  Early-stage companies often grant equity awards to employees and others in exchange for goods and services.  Estimating fair market value (or fair value) for early-stage companies can be difficult as such companies often lack revenue or earnings, have complicated capital structures, and incur significant change in very short periods of time, among other factors.  The AICPA has issued guidance on valuing the equity of early-stage companies in its guide Valuation of Privately Held Company Equity Securities Issued as Compensation. 

As may be inferred above, the valuation of equity awards can be complex and often requires considerations and procedures that must address the expectations of more than one audience.  As a leading, independent corporate valuation firm, MPI assists clients by providing detailed, transparent, and credible valuations.  Please contact us if we may be of assistance.