Kathy ZehrLWBJ Capital Advisors

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Types of Incentive Programs◦ Short-term◦ Mid-term◦ Long-term

Goals of Each ProgramParticipants in Program

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Start-up companies often use stock as incentives since cash is sometimes tight and borrowing from banks somewhat costly and difficult to obtain.

More established companies will likely build more cash compensation in their overall mix.

Incentive programs very common and make your company competitive with larger employers vying with you for talent.

Plans also aid in employee retention. Need to be mindful of overall compensation

program strategy.

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Short-term (1 year)

Mid-term (3 years)

Long-term (>5 years)

Focus of measure

Operating performance

Longer-term performance

Shareholder/ owner value

Typical measurements

RevenuesOperating profitEBITDA

ROEROI

TSRShare price

Typical award base

Cash Cash or shares Options, SARs, shares

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What measures are used by similar companies in my industry?

What are opinions of my accountant, investors and key managers?

Do I use the same or different measures for different groups of participants?

Do I reward group, individual or both types of performance?

What is the length of earn-out for the plan?

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Virtually all plans are performance-based and should not become entitlements.

Bonus plans should be written documents shared with all participants.

Objectives:◦ Tied to realistic, quantifiable and achievable goals◦ Simple to understand◦ Easy to measure

Employer deducts these payments as business expenses.

Employee pays income tax when paid the bonus.

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Important to define metrics and how they will be computed to ensure consistency.

Good to build in higher rewards for exceptional performances.

Clearly define employment conditions and how changes in status affect bonus.

Provide quarterly updates to keep participants focused on goals.

Annual review to insure plan remains relevant to current company initiatives.

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Target bonus 30% salary of $50,000

Target/Budget ActualWeight 90% 100% 120% Results Payout

Revenues 450,000 500,000 600,000 550,000 1

40%

3,000

6,000

9,000 7,500 Operating Profit 45,000 50,000 60,000 48,000 2

30%

2,250

4,500

6,750 3,600 Cash Flow 63,000 70,000 84,000 60,000 3

30%

2,250

4,500

6,750 -

Total

7,500

15,000

22,500 11,100

Payouts of target bonus 50% 100% 150%

1 - exceeds target 2 - below target3 - below minimum acceptable

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Generally less common than short-term or long-term plans.

Same type of general rules as short-term plans◦ Bonus plans should be written documents shared with all

participants◦ Objectives:

Tied to realistic, quantifiable and achievable goals Simple to understand Easy to measure

Virtually all MT plans are performance-based emphasizing teamwork (company) performance.

Can be set up as a cumulative measure (each year adds or subtracts towards three-year goal) or attainment of a goal at end of year three.

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Important to define metrics and how they will be computed to ensure consistency.

Good to build in higher rewards for exceptional performances.

Clearly define employment conditions and how changes in status affect bonus.

Provide at least annual updates to keep participants focused on the goals.

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Incentive plan to earn shares based on dollar value if company reaches targeted ROE (return on equity) of 15% at the end of a three-year period.

ROE is computed as year three after-tax earnings divided by total equity as determined by the annual audit.

Target value of shares is $40,000 over three year period for employee whose base is $60,000; or 22% of base pay over three years.

Eligible to all managers and above. Employee must be employed by company on the

date of the payout announcement – which must be within 75 days after the end of the third fiscal year.

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Participants’ rights to receive payment of shares under an award shall be determined based on the following schedule:

Actual performance over the period as a percentage

of target

Target Value of payment as

a percentage

of the target

incentive

Payouts

<85% 0%

85% 12.75% 50% $20,000

100% 15% 100% $40,000

115% or > 17.25% 150% $60,00012

Almost always equity-type awards. Most common are

◦ Stock options◦ Restricted stock◦ Phantom stock◦ Stock appreciation rights◦ Employee stock purchase plans

Accounting issues can be somewhat complex for certain equity awards.

Taxability issues vary greatly depending on type and terms of awards for both awardees and employer.

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Right to buy a number of shares at a price fixed at the grant date at some date in the future.

Stock options can:◦ Vest based on a service period - over time or cliff vest ◦ Vest based on performance - achieve a level of revenues

Once vested, options can be exercised at the grant price at any time up to the expiration date of the option.

Two kinds of stock options:◦ Incentive (ISO)

Tax advantages to defer taxation from the date of exercise until the date of sale and qualify for capital gains rate

Several conditions (including 10 year life, limited number available each year, and minimum holding period)

◦ Non-qualified (NSO) Taxed at ordinary income rates at exercise date

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Two primary ways to exercise stock options:◦ Use cash to purchase the shares.

1,000 options granted at $10, pay $10,000 for shares now worth $20 or $20,000

◦ Use a cashless transaction requiring you to exercise enough options to cover the exercise price. 1,000 options granted at $10, stock price now $20,

exercise the 1,000 options and sell 500 at the current stock price to get the $10,000 needed to exercise the options

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Private companies do not have as much flexibility as publicly-traded firms. ◦ They are the market for any stock option

exercises.◦ Business valuations are required at the grant date

and any exercise date and can be expensive.◦ Often times companies restrict the exercise or

sale of the shares acquired through exercise until the company is sold or goes public.

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1,000 NSOs awarded to each management team member at $10 per share.

Options cliff vest after three years and have a term of ten years.

Stock price at the end of three years is $8.50 - Employee would hold, since the option is “under water.”

Stock price at the end of four years is $12 – Employee could exercise since “spread is now $2 – Employee is taxed on $2,000 at ordinary income rates.

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Shares given to employees with specified restrictions as to ownership that lapse usually with passage of time.

Most common time periods are three to five years either ratably or cliff vesting.

Restrictions can also be tied to certain performance goals of the company.

May or may not receive dividends, right to vote or other shareholder benefits during the restriction period.

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Section 83(b) election allows taxability at ordinary income tax rates at the award date with any future appreciation receiving capital gains treatment.

Otherwise, employee must pay ordinary tax rates on the value of the total award at the vesting date when the stock may have risen in value.

Some risks with 83(b) election – if pay tax and restrictions do not lapse, no tax refund or stock. Also if stock price significantly declines, tax liability would be less at vesting.

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1,000 shares of restricted stock awarded to each management team member when price is $10 per share.

Section 83(b) election made, pay tax on $10,000.

Each team member receives dividends and voting rights during the vesting period.

Shares cliff vest after three years when price is $12.

Avoid tax on extra $2,000 of award due to 83(b) election.

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Plans that grant the right to receive an award based on the value of the stock.

Provides cash or stock bonuses based on the value of a set number of shares to be paid out at the end of a specific time.

May provide dividend equivalents. May be tied to service or performance. When paid, the value is taxed as ordinary

income. If widespread issuance and designed to pay

out at termination, may be subject to ERISA.

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1,000 phantom stock units awarded to each team member when price is $10 per share.

Each team member receives payments that approximate dividends during the vesting period.

Phantom units cliff vest after three years when price is $12.

Each team member receives 1,000 shares of stock at the end of year three.

Taxes at ordinary rates due upon receipt of shares.

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Similar to Phantom Stock but key differences include:◦ SARs typically provide the employee with a cash

or stock payment based on the increase in the value of a stated number of shares over a period of time.

◦ No dividend equivalent payments.◦ SARs may not have a specific settlement date and

employees may have flexibility regarding exercise date.

◦ Accounting treatment varies depending on whether SARs are settled in cash or stock.

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Plans to allow employees to set aside after-tax payroll $ over an offering period to purchase stock.

Qualified 423 Plans – allow employees to take capital gains treatment on any gains with rules similar to ISOs. Rules include that most FT employees with >2 years service must be included in the offering.

If not qualified, becomes non-qualified with no tax advantages.

Stock purchases normally made at a discount of up to 15%. (A portion of this may be treated as compensation.)

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Common to have a look-back feature in which the purchase price is based on the lower of the price at the beginning or end of the offering period.

Most offering periods are either six months or some multiple of six. If more than six months, common to have interim purchase periods.

Employees taxed when stock is sold. If hold the stock long enough, may get capital gains treatment, but discount always taxed at ordinary income rates.

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Start of offering period, stock price is $30. One-year offering period, buy at 15% discount

with look-back provision. At end of one year, stock price is $40. Employee A sets aside $2,550 after-tax dollars

during the one-year period. She is eligible to buy 100 shares at $25.50 ($30 @ 85%), 25 more shares than if had to use the $40 price.

Employee holds stock for two years, sells at $45. Capital gain on $15/share, ordinary income on $4.50/share.

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Cash bonus programs are generally offered to larger employee groups rather than equity programs.

Any program that is offered to a broad base of employees and is tied to retirement may be subject to ERISA. Most onerous ERISA requirement is that some funding of the liability associated with the program is mandatory.

Be sure and check with legal counsel when designing an incentive program to ensure proper documents are in place.

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Thanks for your time and interest

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