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A key issue faced by many government contractors is how to compensate their employees in ways that will ensure that they can attract a talented workforce. Many executives and employees expect compensation mechanisms based on increases in the value of their employer, in addition to their regular salary compensation. However, many government contractors are subject to restrictions on certain types of compensation due to regulatory restrictions. This entry is part of a three-part series on compensation issues faced by government contractors that will explain the benefits and disadvantages of various types of compensation structures used by government contractors. This first entry will briefly explain the positive and negative points of both equity compensation and non-equity deferred compensation.

Under equity-based compensation structures, the executive obtains a direct ownership interest in the business entity itself, through direct grants or options. This ownership gives the employee a direct financial interest in the business’ long-term success.

Good:

• The employee has an incentive to grow the value of the business.
• Equity is easily explained and understood.
• Cash is retained by the company, which would otherwise be used to pay salaries or bonuses, and the value of the compensation is shown as equity on the company’s balance sheet, rather than a liability.
• Equity can be structured to vest over time or upon the occurrence of certain events.

Bad:

• Many employees do not understand the impact on their personal taxes or the lack of ability to liquidate their equity.
• Grantees obtain state law rights as equity-holders.
• Administrative costs to the company can be high if equity is offered to large numbers of employees.

Ugly:

• Some contractors cannot use equity compensation, due to SBA restrictions.
• Can have immediate negative tax consequences for the employee if not structured properly, or if offered by certain types of entities.

Non-equity based deferred compensation provides the employee with financial incentives based on the occurrence of certain events (e.g., the increase in the value of the company over a period of time, the achievement of revenue metrics, or the sale of the company). If needed, deferred compensation can be structured to simulate equity-based compensation.

Good:

• The employee has an incentive to grow the value of the business.
• Some structures can be used by companies not able to use equity compensation as a result of SBA restrictions on ownership.
• Can be structured to terminate with employment, with no payment by the company.
• Grantees do not become equity owners.

Bad:

• Some structures can be difficult to explain to employees.
• Payments are taxed as ordinary income, with no capital gains benefits.
• Payment commitments are treated as a liability on the company’s balance sheet.

Ugly:

• If not structured properly, the compensation plan could be subject to stringent labor or tax regulations (e.g., Section 409A of the Internal Revenue Code).