This document discusses compensation strategies for small businesses. It presents options like cash incentives with short and long-term goals, and equity awards like stock options and restricted stock. However, small businesses face challenges in offering equity compensation due to lack of liquidity and the owner's reluctance to share equity. The document proposes using "derivative securities" like stock appreciation rights (SARs) which allow employees to benefit from stock growth without the business sharing actual equity. SARs and profits interests in LLCs are presented as alternatives that can help small businesses recruit and retain top talent.

1. Presents
Compensation Strategies
for Small Businesses
Women’s Business Council-SW
April 11, 2011
Linda A. Wilkins
lwilkins@wifilawgroup.com

2. Your business/ your goals
Are you organized as a C corporation, an
S corporation, or a limited liability
company (LLC)?
Do you compete for talent with public
companies and large employers that
offer an array of employee benefits and
opportunities for stock ownership?
Do you see a compelling need to offer
comparable benefits to recruit and retain
your key employees?
Compensation Strategies for Small Businesses
Slide No. 2

3. Advantages of Long-term Incentives
Long-term incentives create a “golden
handcuff” for your key employees.
Vesting schedules can be tied to the
company’s objectives, such as a
projected 5-year plan.
Equity- “flavored” awards give the
employees “skin in the game” and a
sense of ownership leading to better
performance.
Compensation Strategies for Small Businesses
Slide No. 3

4. A Menu of Current Comp Strategies
Cash incentives
Short-term – cash bonuses,
performance metrics on an individual
and entity level
Long-term – 3- 5 year goals,
achievement at or above target results
in vesting of equity awards
Equity awards
Stock options, restricted stock
Compensation Strategies for Small Businesses
Slide No. 4

5. Compensation Hurdles
Public companies have inherent
advantages in designing their
compensation plans.
• Employees receive stock that results in
immediate liquidity. The company does
not pay cash “out of pocket” to
compensate its employees.
• The fair market value of the company’s
stock can be tracked daily.
Compensation Strategies for Small Businesses
Slide No. 5

6. Challenges for the Small Business
Liquidity – is cash available for short-term
and long-term incentives?
Timing of when the incentive is paid – it
may be desirable to defer until a
liquidity/exit event.
Sharing equity with key employees may
not be desirable to the business owner.
It also may not provide any tangible
benefits to the employees.
Compensation Strategies for Small Businesses
Slide No. 6

7. Using “Derivative Securities”
What is a derivative security?
It is a compensation element that is
“valued” based on tracking the value of
equity in the business.
For example, a stock option is a
derivative security - its value is
determined by the future appreciation in
value of the stock.
Compensation is typically paid in cash in a
privately-held company, not in equity.
Compensation Strategies for Small Businesses
Slide No. 7

8. Stock Appreciation Rights (SARs)
What are they?
Rights to future payments (in stock or
cash) equal to the future appreciation
in a fixed number of shares. An
award of 1,000 SARs would represent
the right to receive stock or cash
equal to the difference between the
FMV of those shares at the time of
exercise and their FMV at the time of
grant.
Compensation Strategies for Small Businesses
Slide No. 8

9. SAR Terminology
Grant date: the date of the award
Base price: the fair market value at
the grant date
Exercise date: when the SAR is paid in
cash
Spread: difference between the
base price and the FMV at
the exercise date.
Compensation Strategies for Small Businesses
Slide No. 9

10. How SARs Work
• The payout of the SAR = the
appreciation in the value of the
Company’s shares since the date of
grant, measured on the exercise date.
• SARs can be paid in stock or in cash.
• The Company’s FMV should be
determined at the date of grant by an
appraisal. In future years, the FMV can
be determined using a stated formula
(based on earnings).
Compensation Strategies for Small Businesses
Slide No. 10

11. Why SARs as a long-term incentive?
SARs reward key employees for the performance
of the company, measured by the increase in
the value of company stock during their
employment.
If SARs are paid in stock, why use SARs instead of
stock options?
Simplicity. There is no “exercise price” to pay
compared to stock options.
Why pay cash instead of stock?
You may not want to offer equity ownership to
your employees.
Compensation Strategies for Small Businesses
Slide No. 11

12. Design of an SAR Award
• SARs are usually subject to a vesting
schedule to create a “golden handcuff.
• For example, SARs could vest over a
period of 4 years’ employment.
• Typically, SARs will become 100%
vested upon a sale of the company.
Compensation Strategies for Small Businesses
Slide No. 12

13. How are SARs taxed?
There is no income tax owed when an
SAR is granted.
When an SAR is exercised, the holder
must recognize ordinary income equal to
the cash received or the FMV of the
shares received in payment.
The company is required to withhold
income taxes at that time at a rate of
25%.
Compensation Strategies for Small Businesses
Slide No. 13

14. Awarding Equity in the Business
If the business is an LLC, there are tax
advantages in awarding “profits
interests” in the LLC to key employees.
The employee does not receive any
ownership in the current capital in the
business, but shares in future
appreciation.
Owners of profits interests in LLCs can
share in distributions.
The terms for profits interests can vary..
Compensation Strategies for Small Businesses
Slide No. 14

15. Create a shareholders’ agreement
If employees are to receive equity – in a
corporation or in an LLC - they should
be required to sign a Shareholders’ or
LLC Membership Agreement. This
Agreement should prohibit transfers of
the equity without prior company
approval.
The Agreement should provide for a
holder’s equity to be purchased upon
termination of employment.
Compensation Strategies for Small Businesses
Slide No. 15