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Long Term Synthetic Equity Incentive Plans in Compensation
In today’s dynamic and competitive business landscape, companies seek innovative ways to motivate and retain top talent, especially key executives and high-potential employees. While traditional equity plans such as stock options and restricted stock units have long been a staple, many organizations are increasingly turning to Long Term Synthetic Equity Incentive Plans (LTEIPs). These plans offer many of the motivational and alignment benefits of actual equity ownership, but without granting real stock or diluting ownership.
This article explains what Long Term Synthetic Equity Incentive Plans are, how they work, their benefits, challenges, and best practices for implementation.
What Are Long Term Synthetic Equity Incentive Plans?
Long Term Synthetic Equity Incentive Plans are compensation arrangements that mimic the economic benefits and incentives of actual stock ownership, but without employees receiving real company shares. Instead, employees receive rights or units whose value is tied to the company’s stock price or other performance metrics.
Because synthetic equity does not involve issuing actual stock, it avoids shareholder dilution and some of the regulatory and accounting complexities that accompany real equity awards. Typically, synthetic equity awards vest over several years and are paid out in cash or stock equivalents based on the company’s performance.
How Do Synthetic Equity Plans Work?
Synthetic equity plans generally come in a few common forms:
- Phantom Stock
Phantom stock grants employees a contractual right to receive a cash payment or stock equivalent equal to the value of a certain number of company shares at a future date. Phantom stock typically vests over a multi-year period, and the payout reflects the appreciation of the company’s stock price, including dividends in some cases.
- Stock Appreciation Rights (SARs)
SARs give employees the right to receive a cash or stock bonus equal to the increase in the company’s stock price over a set period. Unlike phantom stock, SARs typically do not include the base value of the shares—only the appreciation is rewarded.
- Performance Units
Performance units are synthetic equity tied to the achievement of specific performance goals. When the performance period ends, the units convert into cash or shares based on how well the company met the targets.
Why Companies Use Long Term Synthetic Equity Incentive Plans
- Avoiding Shareholder Dilution
Because no actual shares are issued, synthetic equity awards do not dilute existing shareholders’ ownership stakes, making them attractive to privately held companies and startups concerned about equity distribution.
- Simplified Administration
Synthetic plans often avoid the complexity of stock issuance, transfer restrictions, and securities regulations, simplifying administration and reducing legal costs.
- Alignment with Company Performance
Like real equity, synthetic equity aligns employee rewards with company performance by basing payouts on stock price appreciation or other business metrics.
- Retention Through Vesting
Synthetic equity awards typically vest over several years, encouraging employees to stay with the company long term.
- Flexibility in Payout
Since payouts are often made in cash, companies can structure the timing and amount of payments to balance cash flow with employee incentives.
Benefits of Long-Term Synthetic Equity Incentive Plans
- Motivation and Engagement
Synthetic equity offers employees the chance to share in the company’s success, boosting motivation and engagement without the complexities of real ownership.
- Retaining Key Talent
The vesting schedules inherent in synthetic plans help retain valuable employees by incentivizing them to stay for the long haul.
- No Equity Ownership Transfer
Since no actual stock is transferred, companies retain full ownership control, which is especially important for family businesses or closely held firms.
- Customizable Performance Metrics
Companies can tie synthetic equity payouts to a wide range of metrics beyond stock price, such as revenue growth, EBITDA, or other operational goals.
- Easier Tax Treatment
While still taxable, synthetic equity often has simpler tax implications than actual stock awards, though specifics depend on jurisdiction.
Challenges and Considerations
- Cash Flow Impact
Because synthetic equity is usually paid out in cash, companies must plan for potential significant cash obligations at payout times.
- Employee Perception
Some employees may perceive synthetic equity as less valuable or less prestigious than real stock ownership, which could impact motivation.
- Plan Design Complexity
While simpler than real equity plans, synthetic equity plans still require careful design to align incentives and comply with tax and legal requirements.
- Accounting Requirements
Companies must properly account for synthetic equity liabilities on their financial statements, which can affect reported earnings.
Best Practices for Implementing Synthetic Equity Plans
- Clear Communication
Ensure employees fully understand how synthetic equity works, its value proposition, and payout mechanics to maximize engagement.
- Align with Business Goals
Design plan performance metrics and vesting schedules to support the company’s strategic objectives and financial capabilities.
- Plan for Cash Flow
Anticipate and budget for cash payouts, especially during periods when multiple awards vest simultaneously.
- Consult Legal and Tax Experts
Work closely with legal and tax professionals to design compliant plans that optimize tax treatment for both company and employees.
- Regular Review and Adjustment
Review plan effectiveness regularly and make adjustments to maintain alignment with business needs and market practices.
Conclusion
Long Term Synthetic Equity Incentive Plans offer companies a powerful way to motivate and retain key talent while avoiding some of the complexities and downsides of traditional equity compensation. By providing employees with rewards tied to company performance without diluting ownership, synthetic equity strikes a balance between incentive and control.
When thoughtfully designed and communicated, these plans foster a strong sense of ownership and long-term commitment, driving sustained business success. Companies considering equity incentives but hesitant to issue actual shares should explore synthetic equity as a flexible, effective alternative.
