Equity-based compensation provides an excellent solution for practice owners who need a reward system that goes beyond the traditional salary/bonus structure and shares the economic value of equity, but not equity itself.
A critical element in the success of any small business is its ability to recruit, reward, and retain talented advisors and support staff. To this end, equity compensation is often used to achieve these goals. Synthetic equity is a tool set that can provide ownership-level benefits without buying or selling actual stock in an advisory business.
To be clear, the process of transforming a single-owner practice into a sustainable business generally relies on equity. Equity, or stock, is what next-generation advisors invest in, and over time and with hard work benefit from, above and beyond what compensation alone can provide. Equity is the shareholder value created in a business managed from a bottom-line up perspective with a focus on earnings or profits as the ultimate financial goal. Equity is a powerful building and motivational tool, but with the opportunities come obligations. Because of these obligations, buying or selling equity isn’t the only way to offer key employees ownership-like benefits, nor is it always the best option.
Synthetic equity plans, sometimes referred to as equity alternatives, generally provide the economic characteristics of equity without the associated legal and tax issues or debt-load of buying stock from the founding owner. In most cases, synthetic equity plans mature into cash compensation to the employee with an offsetting deduction for the employer. Because synthetic equity is a form of compensation, it can be readily sculpted in a variety of ways to address virtually any situation.
Synthetic equity solutions make sense for advisors who face these common situations:
A current owner who wants to share the economic value of equity, but not equity itself;
A key employee who wants to receive ownership-like benefits, but is unable or unwilling to take on the financial risk of actually buying and paying for equity in the business;
An owner who wants to retire and sell his or her practice in five years or less and wants to reward one or more key employees at the time of the sale without having to actually sell equity beforehand;
An owner who wants to not only provide a key employee with incentives for growing the business but also needs to create strong disincentives against the employee leaving and competing with the business, soliciting clients, or acting in a manner detrimental to the business;
A key employee who is interested in equity but is fearful of signing personal guarantees or taking responsibility for issues such as an office lease, a line of credit, payroll costs, or the obligations inherent in a buy-sell or a continuity agreement;
A key employee who desires to be an owner but who does not have the necessary licenses or qualifications to be a full equity partner.
How Does Synthetic Equity Work?
Synthetic equity works best in a business model that utilizes either a corporation or a limited liability company (LLC) entity structure. An LLC taxed as a partnership provides the greatest level of fluidity and flexibility in the synthetic equity models, while Subchapter S-corporation taxation is more intuitive and is often less complex.
The best way to understand the concept of synthetic equity is to consider how actual equity works and to borrow the needed tools from that toolbox. To that end, owning equity in an independent financial advisory business typically provides benefits that include:
- Voting rights
- Limited liability
- A proportional share of the profits
- An opportunity for capital appreciation
- Long-term capital gains tax rates on sale
- Access to financial records pertaining to the business
- A voice in the business’s governance structure
These are substantial benefits that apply to all of the equity partners—both with majority and minority interest. This “bundle of rights” has measurable value which is why there is a cost when buying equity and a tax implication when granting it. What isn’t commonly understood is that the rights in this bundle are separable—an existing owner doesn’t have to sell or grant the entire bundle of rights. A key employee might be granted, for example, just one or two rights from the full bundle such as the ability to share in the appreciation of the business’s value, or a profits interest, or both. Synthetic equity is a benefit that stems from owning less than all of the rights in the bundle, but something of significant value.
Synthetic equity, just like actual equity, can be used to reward and retain the necessary key employees to grow a strong and valuable practice. As with full equity, synthetic equity can re-center the focus of a key employee, advisor, or producer, and encourage them to contribute—at every level—to a growing and sustainable business.
Download our newest white paper, "Synthetic Equity: An Innovative Approach to Compensation," to learn more about this powerful tool set.