Genetic Engineering News , April 1, 1999, pages 6 and 41
By Robert A. Adelson, J.D., LL.M.
In the volatile biotechnology, medical device and pharmaceutical industries, executive and technical talent is critical to success and ever harder to maintain. Are you doing all you can to attract and retain talent for your company?
A prized hire says “show me the money” and you don’t have it. If you had the recruit, you could grow and make the money. Is there a way out of the box?
Key executives or technical people leave when you can’t keep pace with industry pay levels. How do you keep the team in place and motivated? Can you cut pay-driven turn-over?
This article offers techniques for incentives and pay raises to beat the competition, build your company, not break the bank and even save money. These techniques deliver (1) big-time dollar value to the employee, (2) lower tax cost than normal bonus pay, (3) greater perceived value to employee, (4) no net cash cost to company and (5) actual cash savings.
Use a Signing Bonus
Technical and executive hires often resist switching jobs because of vesting benefits, expected bonuses, and other “Golden Handcuffs.” A signing bonus can be your “Golden Key” to unlock the door to hiring.
In 1996, Alex Mandl left his job as chief operating officer of AT&T to become CEO of early stage telecommunications carrier Teligent with a $25 million signing bonus to compensate Mandl for what he lost leaving AT&T.
When cash like that is out of the question, your golden key can be fashioned in creative use of company equity to serve the same purpose. An Equity-based signing bonus can equally cement the bond with your company and compensate new hires for risks taken in leaving a job.
What you pay up front can vary, depending on your need and the immediate value the person brings, as well as what the person gives up to join you. An equity based bonus can take many forms – qualified or non-qualified stock options, restricted stock, or phantom stock.
Meaningful Equity Benefits Employee and Company
The offer of meaningful equity – stock, options or phantom stock in your firm – can set your company apart in the battle to build your team.
To enhance and “sell” your equity, the company can offer a package of rights to deliver a real equity stake to key employees. This can include anti-dilution protection of the value of employee’s equity against future corporate changes and future issues of stock to others. Cash-out protections can allow the employee an “exit strategy” to realize cash value on shares where there is no prospect of an IPO or sale of the company. Alternatively, change of control protections accelerate vesting of shares when the company is sold and employee’s position may be at risk. Post-termination protections allow stock concessions to lesson fear of termination when most employment is at will.
Employee equity also benefits the company. Equity for pay preserves cash. It can also make money from tax deductions as explained below. Equity helps in other ways – it rewards employees for their loyalty, their individual project achievements and the firm’s success and to bring employees an entrepreneurial mindset. It can also backstop or serve as consideration for non-compete and confidentiality agreements which are often signed at the time equity is offered..
Use Tax-favored Equity Boosts Pay
To leverage the firms future payout to employees, you should structure equity so it’s taxed as low as possible. This structuring will boost the technical and executive take-home pay.
Because pay increases are taxed at the person’s highest marginal rate, the ability to cut that tax bite and increase the take home pay is a powerful tool to show the equity based signing bonus or pay raise is more valuable to the employee. Here, the rule of thumb is stock options are better for high-value equity and restricted stock is better for low-value equity.
Founders Shares Attract Key People
For senior recruits, technical or executive, you want to offer more to beat the competition. Fro key people, non-qualified options or restricted stock can be offered in lieu of cash – to deliver immediate value with a strike price much less than current fair market value.
By offering stock or options at a nominal price, the recruit has a built-in value on day one. Yet by using its stock the company has avoided cash cost. The company will only have to pay out if a future stock buy-back is offered. Yet, by that date (several year later) the company may be out of the box – in a cash position to pay.
Stock offers key advantages that make equity more valuable to employees than cash:
- Pre-IPO stock is valued at discount, and all stock is awarded without brokerage charge;
- Stock offers the potential for considerable appreciation that cash lacks;
- Appreciation is taxable at lower capital gains rates of 20%, with no withholding;
- Stock offers the potential for future roll-over so that tax may be deferred indefinitely.
The tax-free roll-over is new from the 1997 Tax Law – to potentially allow employees who receive stock from C corporation software companies the right to sell these shares and roll-over profits into new ventures, with tax deferred until the final sale of shares.
Shares and Tax Gross-Up Save Money
In addition, because the issue of founders shares is deductible, the company can save money that would have gone to taxes by using stock for pay. The tax windfall can also be used creatively to enhance efforts to recruit or retain key people. This is done by sharing the company’s tax windfall with employees.
This sharing in the form of stock appreciation rights or tax gross-up can have the effect of reducing effective tax restricted stock from the 39.6% ordinary income rate to 20% capital gains rate or even lower. This is also useful in family businesses or professional corporation which cannot offer stock or options but must use phantom stock instead.
Employee-Company Win-Win: Example
Problem: BioCo. (BC) has 100m to spend. Smith seeks 150m pay.
Solution: BC gives Smith 100m cash, 50m stock, 34% gross-up.
Effects: For Smith: He has 170m perceived gross value – he’s happy.
For BC: It spent 94k cash after-tax, got Smith & saved $$.
Analysis: 50m Stock deductible to BC, @34%, it saves $16m.
16m gross up cuts Smith’s taxes @39.6% on stock to 10m.
Stock after-tax value 40m. Normally takes 70m to net 40m.
Both stock & tax gross-up deducted by BC, net savings 6m.
The table above shows an example of a biotechnology company, BioCo, that uses equity and the resulting tax deduction to save itself money but still offer what appears to be a large premium to land Mr. Smith, the technical or executive hire it was recruiting. In this example, the company can only offer $100,000 but employee Smith wants $150,000. By creative use of founders stock and tax gross-up, the company can offer a premium package worth $170,000 but at a cash cost to the company of only $94,000.
However, tax advice needs to ensure the right mix of equity, including restricted stock, ISOs, non-qualified options, Stock Appreciation Rights, or Phantom Stock. In each case, plans must be carefully structured to avoid ruinous “tax surprises”. Accounting advice is also important to balance the benefits of wealth transfer in below market stock and options, SARs and tax gross-up with potential hit to earnings on financial statements. Clearly, these techniques are not for everyone. Where a company is in play and its PE ratio critical, accounting concerns will govern. However, if growth is the priority, cash savings important, and building the team critical, these merit close consideration.
Robert A. Adelson, J.D., LL.M. is a Boston corporate and tax attorney. He represents companies and individuals in the bioltechnology and medical device fields across the U.S. on employment, stock, options, relocation, severance, executive, employee compensation issues and in consulting, sponsored research and alliance contracting, and on mergers and acquisitions.
Since 2004, Robert Adelson has been a partner at Engel & Schultz LLP. He can be reached at 617-951-9980 or firstname.lastname@example.org
Copyright © 1999 Robert A. Adelson.