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The Good, The Bad and The Ugly: Compensation Issues Faced by Government Contractors

Posted in Contracting Rules and Regulations
Part 3 of 3

This is the final installment of a three-part series on compensation methods used by government contractors.  The first two installments discussed the differences between equity and non-equity compensation, as well as the benefits and disadvantages of stock options and restricted stock grants.  This article will discuss the benefits and disadvantages of synthetic equity.

Synthetic equity can be generally described as a contractual right structured to simulate the economic benefits of equity ownership in a company.  Since the rights are based on a contractual arrangement, rather than on statutes, the potential forms and structures are nearly limitless.  The two most common forms are long term incentive compensation agreements and stock appreciation rights plans.  Both are primarily structured to provide compensation to recipients upon the occurrences of certain triggering events.  Note that the compensation can take the form of cash or equity.  However, we will focus on the non-equity compensation in this article, since equity compensation falls within the scope of previous articles.  The most common event triggering payment under most synthetic equity arrangements is the sale of the company.  However, several other triggering events can be used as well (e.g. death, disability, retirement, etc.), and these are beneficial for companies unlikely to be acquired in the near term. 

A long-term incentive agreement is an agreement entered into between the company and a single employee to incentivize the employee by providing a payment upon certain triggering events.  These types of agreements are beneficial, and often the best option, where the company needs to incentivize a small number of individuals. 

Good:

  • The employee has an incentive to grow the value of the business.
  • Can be used by companies not able to use equity compensation as a result of SBA restrictions on ownership.
  • Can be structured to terminate with employment, with no payment by the company, or to limit payment to certain termination events.
  • Recipients do not become equity owners and do not have any governance rights.
  • Can be structured to vest over time, or upon certain triggering events, like a stock option.
  • Payments are deductible to employer as compensation in the year the payment is made.

Bad:

  • Payments are typically taxed as ordinary income, with no capital gains benefits.
  • Payment commitments are treated as a liability on the company’s balance sheet.

Ugly:

  • If not structured properly, the compensation plan could be subject to stringent labor or tax regulations (e.g., Section 409A of the Internal Revenue Code or ERISA).

Stock appreciation rights (“SAR”) plans are structured to allocate a portion of the increases (and decreases) in the changes in a company’s value to the recipient.  If the company’s stock price increases, the recipient of stock appreciation rights will be entitled to a higher payment value upon a triggering event.  The benefits and disadvantages of these plans are similar to those listed above for long-term incentive compensation arrangements, but below are some additional considerations for SAR plans:

Good:

  • Can serve as a substitute for option plans if the company is unable to issue options due to ownership restrictions.
  • There is no limit on the number of rights that can be granted to employees.

Bad:

  • Can be difficult to explain to employees.
  • Grants must be limited to high-level employees.
  • Some structures require a periodic valuation of the company.

Ugly:

  • Unlike some option plans, most SAR structures provide no liquidity to employees prior to a triggering event.
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