Synthetic Equity: Non-stock Compensation Alternatives

Although restricted stock and stock options are by far the most common tools to provide team members with the opportunity to participate in the upside of a startup, at times it may make sense to use “synthetic equity” - a category of compensation that in many ways looks and feels like “true equity” but does not have all of the same rules and requirements. 

Synthetic equity is a strategic tool used by early-stage startup companies to compensate employees and other service providers, especially in scenarios where traditional stock options or restricted stock might not be the best fit. A few scenarios where synthetic equity may be a fit include the following:

• If a company's fair market value (FMV) has significantly increased, making it challenging to issue equity to employees at a lower, more accessible value, synthetic equity can be used such that employees do not have to pay the current FMV. 
• If the company failed to issue equity to employees earlier when the FMV was lower, synthetic equity can be a way to "true up" these employees, providing them with the benefits they missed out on without having to dilute the cap table further.
• If the company has a desire to maintain a very clean cap table and limit the number of shareholders.
• Another scenario where synthetic equity comes into play is when a company is not structured as a C-Corp. While most startups seeking venture capital should ideally be set up as C-Corps, those that are not—such as consulting firms or other types of businesses—may find synthetic equity a better fit than traditional stock. 

Although synthetic equity is less common than restricted stock or options, it serves a crucial role in specific contexts where these alternatives fall short.

Synthetic Equity Structure 

While there are many different ways to structure synthetic equity, we will focus on three primary structures: phantom stock, creative bonuses, and stock appreciation rights.

Phantom Stock

Phantom stock is a contractual arrangement which entitles the recipient to a payment equivalent to what they would have received if they had held actual shares. This payment is treated as ordinary income, meaning it doesn't benefit from capital gains treatment or qualify for the Qualified Small Business Stock (QSBS) exclusion. Payments are typically triggered by events such as a Change in Control (CIC), issuance of dividends to stockholders, or an Initial Public Offering (IPO). Phantom stock can either have no base price, meaning the full value of a share is paid, or a base price set at the FMV at the time of the grant, where only the increase in value above the base price is paid. The latter approach is more common. Phantom stock grants are often subject to vesting, ensuring that employees earn their rights to the payment over time.

Stock Appreciation Rights (SARs)

Stock appreciation rights (SARs) offer recipients the right to receive a payment, either in shares or cash, representing the increase in value above a base price (set at the FMV at the time of the grant). The triggers for when the payment pursuant to a SAR occurs can vary, but may include a set period of time or specific events such as a CIC. If the SARs are structured such that payment is in cash, this is virtually the same set up as phantom stock with a base price. The spread on the value of the shares—between the base price at the time of the grant and the value when the payment is made—is treated as ordinary income (and this is the case whether the payment is in cash or stock). SARs can also be subject to vesting, and like other forms of synthetic equity, they provide a way for employees to share in the company’s success without the out-of-pocket costs associated with purchasing stock.

Creative Bonuses

In addition to the above approaches which closely mirror the rights of true stock grants or stock option grants, companies can get creative with how they structure bonuses. Bonuses provide a flexible structure that can be tailored to fit the company’s needs. These bonuses can generally be based on any formula the company devises or set at a specific value. Like phantom stock and SARs, bonuses are treated as ordinary income and can be triggered by various events, such as CIC, dividends, retention targets, company or individual KPIs, or others. These bonuses can also be subject to vesting, aligning employee incentives with company performance over time.

Rules

When offering synthetic equity (and many other forms of compensation), companies must navigate the complex rules governing deferred compensation under Internal Revenue Code (IRC) §409A. Generally, compensation paid in future years for services performed in prior years is considered deferred compensation, subject to specific tax rules. And if the rules are not followed, then significant excise taxes apply. However, some types of equity and synthetic equity, such as certain stock options and certain SARs issued at FMV, are exempt if they meet specific conditions. As a general rule, in order for any compensation arrangement to be free from the harsh excise taxes under IRC §409A, the arrangement must either be exempt from 409A or compliant with 409A.

The most common exception to IRC §409A used by startups is the “short-term deferral exception”. Under this exception, compensation is not considered deferred if payment is made within 2.5 months of the end of the year in which the compensation is earned (or in fancy tax lingo, when the compensation is no longer subject to a substantial risk of forfeiture). This exception is often used in synthetic equity (and other compensation) arrangements. Agreements governing such arrangements often say that all payments must be made by March 15 of the following year after certain events occur such that the compensation is deemed earned (not subject to a substantial risk of forfeiture). 

Another common approach which is often used in synthetic equity (and other compensation) arrangements is to require that the employee remain an employee when the payment is actually made. Under this approach, technically the compensation is not considered earned (i.e. it remains subject to a substantial risk of forfeiture) until it is actually paid. By using this approach, there really is no deferred compensation because the compensation is not earned until it is paid. 

However, if the goal is to mimic actual stock arrangements as closely as possible, a different tool may be needed. In the case of a true stock grant, an employee would typically earn stock and then they get to keep the stock after they leave the company and still get to participate in the upside of the company if it is ever acquired or IPOs. And if the approach described above (requiring continuous service until the payment is made) is used, a former employee would net get to participate in such upside. To meet this goal, startups can structure a synthetic equity arrangement such that the individual does get to retain the right to participate in a CIC even if they leave the company. This is because a CIC is one type of event that is specifically listed in IRC §409A as being a permissible payment event even though it is deferred. However, it is worth noting that an IPO is not such an event, and neither is the right to payments in the event of dividends. 

To tie all of this together, a startup desiring to issue synthetic equity may, for example, put together agreements which allow for employees to have the right to a payment in the event of a dividend or an IPO (but both tied to remaining an employee when such event occurs and when a payment from such event occurs), and also the right to a payment in the event of a CIC (and this right can survive even if the employee is no longer working with the company when the CIC occurs). As noted above, the employee would not need to pay out of pocket for these rights (unlike true stock arrangements), but also would be taxed based on ordinary income rates.

While synthetic equity arrangements are not as common as traditional restricted stock or options, they provide an alternative which may make sense in specific situations. It allows startups to compensate key employees without diluting ownership, offers a way to reward employees in a high FMV environment, and can be a flexible tool for non-C-Corp companies or those seeking to avoid adding more stockholders to the cap table. 

However, navigating the legal and tax implications of equity compensation requires careful planning and expert guidance to ensure compliance with complex rules and to avoid legal issues. If your team needs help developing equity (or other) compensation structures for your startup, reach out to us.