Unlocking the Power of Equity-Based Incentive Compensation: Cash-Settled Equity Awards

This article is the sixth in our series on equity-based compensation intended to assist employers with answering a common question: What type of equity compensation award is best for our company and our employees? The first article is available here, the second article is available here, the third article is available here, the fourth article is available here, and the fifth article is available here.

This article will provide an overview of cash-settled equity awards. As an overview, this article will address only certain key aspects of cash-settled equity awards. It is not intended to provide comprehensive treatment of these awards. In addition, all discussion of taxes is limited to U.S. Federal income tax.

Description

What is a Cash-Settled Equity Award?

The term “cash-settled equity award” generally encompasses any compensatory award that is (1) valued on the basis of an underlying equity security, but (2) settled with a cash payment rather than the issuance of shares.

By way of example, a cash-settled stock appreciation right (SAR) is a cash-settled counterpart to a stock option, representing the right to receive, upon exercise, a cash payment equal to the excess of the value of the underlying share over the exercise price (sometimes referred to as the grant price or the strike price) rather than, in the case of a stock option, a right to acquire a share through payment of the exercise price. Another common example is a cash-settled restricted stock unit (RSU), which is a cash-settled counterpart to restricted stock, representing the right to receive, upon settlement after vesting, a cash payment equal to the value of the underlying share rather than, in the case of restricted stock, the right to retain, upon vesting, the shares issued at grant.

Cash-settled equity awards are often referred to as “phantom equity” or “phantom stock” because, although their value is based on the value of shares of stock or other equity interests, they do not represent the right to receive actual shares or other equity interests in an entity. This article will focus on cash-settled SARs and cash-settled RSUs, two of the most common types of cash-settled equity awards.

Why Grant Cash-Settled Equity Awards?

Cash-settled equity awards are often granted by employers to employees or other service providers (such as directors and consultants) because they help to align the service provider’s interests with those of the employer’s shareholders (see “Advantages” below), but do not result in dilution to shareholders because no actual shares are issued. For publicly-traded companies, cash-settled equity awards can be attractive because they are not subject to the stock exchange requirement that, in general, shareholders must approve equity compensation involving the issuance of actual shares.

What Are Some Typical Terms of Cash-Settled Equity Awards?

Cash-settled equity awards often have terms similar to their “real” equity counterparts. By way of example, cash-settled equity awards often have a vesting schedule during which the service provider must remain employed or in service for the cash-settled award to become exercisable, in the case of cash-settled SARs, or vested and settled in cash, in the case of cash-settled RSUs. Vesting schedules often range from three to five years in total, with some form of ratable vesting over the entire service period. The vesting schedule selected, like the vesting schedule for “real” equity, will typically reflect a balance between the employer’s desire to maintain a longer-term retention incentive and the need to ensure that the service provider perceives the vesting schedule as achievable. Performance goals may also be included as a condition of vesting or exercisability.

Tax Treatment

Cash-Settled SARs

Cash-settled SARs are treated similarly to nonqualified stock options for tax purposes. In general, cash-settled SARs do not have any immediate tax consequences for the employer or the service provider at grant or vesting. Instead, the tax recognition event occurs when the cash-settled SARs are exercised. At the time of exercise, the service provider typically recognizes ordinary income in the amount of the cash payment, which is generally equal to the amount by which the fair market value of the stock underlying the cash-settled SAR exceeds the exercise or grant price (the “spread”), and the employer will generally receive a corresponding tax deduction. For employee holders of cash-settled SARs, the spread is generally treated as supplemental wages for tax withholding purposes and is reportable as such on the employee’s Form W-2. For non-employee holders of cash-settled SARs, the spread is generally treated as compensation and reportable on the appropriate Form 1099.

To receive the tax treatment described above, however, cash-settled SARs must satisfy a few requirements, including the following:

• Compensation payable under the cash-settled SAR cannot be greater than the excess of the fair market value of the underlying stock on the date the SAR is exercised over the exercise or grant price of the SAR with respect to a number of shares fixed on or before the date of grant of the SAR.
• The exercise or grant price of the cash-settled SARs must be set no lower than the fair market value of the underlying stock at the time of the grant. (See “Disadvantages” below.)
• The cash-settled SARs must relate to the stock of the entity for which the service provider provides services or a parent of that entity. Cash-settled SARs cannot generally be granted in relation to the stock of a subsidiary of the entity for which the service provider provides services.
• The cash-settled SARs may not have any additional feature for the deferral of income beyond the date of exercise.

If a cash-settled SAR meets all of these requirements, it generally will be exempt from the tax rules on nonqualified deferred compensation known as Code Section 409A and therefore receive the tax treatment outlined above. If a cash-settled SAR does not meet all of these requirements, then it may be subject to Code Section 409A, which imposes strict requirements on the timing of deferred compensation and, if such requirements are not met, a 20% penalty tax and other adverse tax consequences. Because cash-settled SARs often do not satisfy the timing requirements of Code Section 409A, it is generally desirable that they satisfy the four requirements above to qualify as exempt from Code Section 409A. Alternatively, cash-settled SARs that do not satisfy all of the four requirements above may be structured as an arrangement that is subject to, and compliant with, Code Section 409A, but doing so typically involves the holder of the SAR giving up significant flexibility regarding their ability to choose when to exercise the SAR.

Cash-Settled RSUs

There are generally no income tax consequences at the time a cash-settled RSU is granted; rather, the value of the RSU is taxed as ordinary income and subject to income tax withholding, if applicable, when the award is settled. A recipient may not make an 83(b) election related to an award of cash-settled RSUs. FICA will be due with respect to employee-held RSUs when the RSUs are not subject to a substantial risk of forfeiture (such as upon retirement eligibility), even if they are not settled until a later date.

The company will generally be eligible to take a deduction with respect to cash-settled RSUs when the recipient recognizes ordinary income.

Advantages

Cash-Settled SARs

Cash-settled SARs have several potential advantages as an incentive compensation vehicle:

• There is a possibility of large gains if the stock value increases significantly, which can be highly motivating to employees and other service providers and help to align their interests with shareholders.
• Cash-settled SARs are generally easy to understand, making it more likely that service providers will perceive them as valuable as long as the stock value is believed to be likely to increase.
• The employer generally receives a tax deduction corresponding to the compensation recognized by the holder of cash-settled SARs upon exercise.
• Cash-settled SARs (in contrast to incentive stock options) may be granted to non-employee service providers, such as consultants and directors.
• Cash-settled SARs, in contrast to stock options, do not require the holder to provide cash upon exercise to fund the exercise price and, in the case of nonqualified stock options, withholding taxes.

Cash-Settled RSUs

Cash-settled RSUs have potential advantages as an incentive compensation vehicle:

• Cash-settled RSUs generally require no personal investment from recipients.
• From the company’s perspective, granting a recipient a cash-settled RSU does not give the recipient any rights as a shareholder.
• Cash-settled RSUs provide similar economic incentives to holders as restricted stock or stock-settled RSUs, aligning their interests prior to settlement with those of shareholders, but, in contrast to restricted stock or stock-settled RSUs, they do not result in dilution to shareholders.

Disadvantages

Cash-Settled SARs

Some potential disadvantages to cash-settled SARs include the following:

• Because of the exercise or grant price, cash-settled SARs have no value to the holder unless the value of the underlying stock increases above the exercise or grant price. If the stock does not increase in value, or declines in value, cash-settled SARs can quickly lose their motivating power or even become demoralizing if the stock value remains below the exercise or grant price for an extended period.
• Upon exercise, the amount of cash received (the spread of the SARs) is taxed as ordinary income. There is no opportunity for capital gains treatment. If the holder of the cash-settled SAR is an employee, the income is also subject to tax withholding and employment taxes.
• Upon exercise, the company must pay cash equal to the spread and, in contrast to stock options, receives no cash from the holder through payment of the exercise price.
• To set the exercise or grant price, the employer generally must determine the fair market value of its stock at the time of grant within the framework of Code Section 409A, which can involve incurring additional costs if the company is not publicly traded and an independent third-party appraisal is used. A discussion of the Code Section 409A framework for valuing stock is available here.

Cash-Settled RSUs

Some potential disadvantages to cash-settled RSUs include the following:

• Cash-settled RSUs provide no opportunity for capital gains.
• Cash-settled RSUs may be subject to Code Section 409A, which limits the flexibility in design and can introduce significant complexity.
• Cash-settled RSUs can raise concerns under ERISA if the payout occurs only upon termination of employment or after more than 10 years.

Other Considerations

Accounting

Whether equity awards are settled in cash or shares is relevant to their accounting treatment. Although a full discussion of the accounting of cash-settled equity awards is beyond the scope of this article, in general, RSUs or SARs that can be settled only in shares receive “fixed” accounting treatment similar to their real equity counterparts. The fair value of the award, determined at the time of grant, is typically expensed over the service period. If awards must or may be settled in cash, on the other hand, then they may be subject to liability or variable accounting, requiring them to be marked to market periodically.

Documentation

Cash-settled equity awards, like their real equity counterparts, are normally documented using either (1) a plan containing the main terms and conditions applicable to the awards, with individual award agreements given to each recipient setting forth the particular terms and conditions of their awards, such as the number of shares subject to the award being granted, the exercise or grant price (if applicable), and the vesting period, or (2) a stand-alone award agreement including all of the material terms for the specific award. Whether the board of directors or management can approve cash-settled equity awards typically depends on the amount involved and the materiality of the amount to the organization.

As we noted at the beginning of this article, because the article is intended as an overview, it addresses only certain key aspects of cash-settled equity awards and does not provide a comprehensive discussion. If you have questions about the topics covered in this overview of cash-settled equity awards not addressed in this article, or if you would like to explore other equity compensation alternatives, please refer to the other articles in this series, or contact your Foley attorney for more information.