Philip Palaveev
Philip Palaveev
THE BIG PICTURE shares in a parent company or a pool of equity created by acquisitions . These are not synthetic instruments , per se . They just function differently , since they are connected to the performance of many firms rather than one .
Does It Work ?
To evaluate how well synthetic equity works or doesn ’ t work , we would need to look at what real equity does , and therefore what effect we ’ re trying to simulate . In my experience , businesses use equity compensation ( or the right to purchase equity ) to do a few things :
• Create a better alignment of interests between the firm and its key people ;
• Recruit more effort from people eager to contribute to something they control and derive the fruits of ;
• Protect the business by discouraging the departure of key people , doing so with both rewards and restrictions ; and
• Promote a long-term focus in decision-making and discourage short-term profiteering or the taking of risks that might harm a firm ’ s reputation .
If we evaluate synthetic equity options we will find that they mostly achieve the alignment of interest very well , especially if the right instrument is used for the right situation ( for example , phantom shares are best only when they ’ re used in a company that ’ s likely going to sell ).
The one challenge for synthetic equity is that it does not seem to always generate the same kind of effort as the real thing .
Another advantage of real equity , of course , is that it ’ s subject to capital gains tax rates , something that makes it more attractive than cash compensation . This is important to note , since the tax treatment of some synthetic alternatives is different from that of real equity . For example , if I have 5 % of the shares of a firm sold for $ 10 million , I will likely pay capital gains taxes of 20 % ( assuming I am in the highest tax bracket for that tax ) on $ 500,000 or $ 100,000 . On the other hand , if I had 5 % phantom shares , I still get my share equal to $ 500,000 but now I will likely pay ordinary income taxes of 37 % ( assuming again I ’ m in the highest tax bracket ) or
$ 184,000 . This tax “ inefficiency ” will be a drawback to phantom stock , stock appreciation rights and “ income partnerships .”
In other words , synthetic equity works well but , just like saccharine , it is not a perfect substitute .
The Real Thing ?
In my experience , employees who receive synthetic equity are much more likely to ask questions such as these :
• I was offered a higher compensation package at another firm by a recruiter . Why should I stay ?
• I understand other advisors at my level get at least 30 % of the revenue they manage . How come my salary is such and such ?
• I account for 20 % of the new clients in the firm but I am only a 5 % owner . Is that fair ?
Somehow , with synthetic equity there is always a strong sense that it is not the real thing , which means it will be subject to haggling . There is something about it that seems to say , “ It ’ s a contract , it ’ s not love ,” and thus it ’ s more subject to negotiation . After all , if you are selling an employee non-voting shares , they will remember that you don ’ t want them talking when decisions are made . When you give them phantom shares , they will remember that these shares are somewhat imaginary when they are making their personal career decisions . The only drawback of synthetic equity is that it is not the real thing .
That said , if it were me , I would rather have synthetic equity than no equity at all . The traditional path of working in a company and earning the right to buy some percentage of the shares may be near extinction . That said , if I am building something , I want to own at least a percent of it , and there are many ways to participate in the building of a business . It may be time to embrace synthetic equity . After all , we may not have a lot of the real thing left .
PHILIP PALAVEEV is the CEO of The Ensemble Practice , the leading business consultants to the financial advisory industry , and founder of the G2 Leadership Institute , a leadership program that trains the next generation of leaders .
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OCTOBER 2024 | FINANCIAL ADVISOR MAGAZINE | 17