Rewarding employees with blockchain-based synthetic equity

15 February 2023 Consultancy-me.com 8 min. read

The entrance of assets on the blockchain technology has unlocked an entire new playbook for professionals in the world of compensation & benefits. Paul Lalovich, partner at Agile Dynamics, outlines how the concept of tokenized synthetic equity can pose an attractive alternative to traditional rewards – in particular for top performers.

Synthetic equity refers to a collection of strategies and instruments frequently used to provide employees with financial advantages of share ownership without actual shares changing hands. It is a potent instrument that organizations may utilize to attract, retain, and reward competent employees.

The favorable economic qualities of equity are embedded into synthetic equity plans, also known as equity alternatives, without the financial obligations coming from purchasing shares from the initial owner. Instead, synthetic equity programs often develop into cash payments to the employee and a corresponding deduction for the employer.

Rewarding employees with blockchain-based synthetic equity

Since synthetic equity represents compensation, the concept can easily be adjusted to handle almost any scenario. The following scenarios exemplify the situations in which synthetic equity is an optimal solution:

  • An employee desires ownership-like benefits but is unable or unwilling to assume the financial risk of purchasing and paying for company equity.
  • An employee aspires to ownership but lacks the credentials or licenses required for a role of a full equity partner in the company.
  • Employees feel uncomfortable providing personal guarantees or accepting responsibility for credit lines, office leases, payroll-related expenditures, or the commitments made under buy-sell or continuity agreements.
  • A company owner wants to share the economic worth of equity rather than the actual equity. This includes owners not interested in supporting this transaction with seller financing.
  • A company owner wishes to motivate an employee to work on increasing the company’s value but also wants to discourage them from leaving and creating competition for the business, engaging in client solicitation, or performing other actions that might harm the company.
  • An owner planning to leave the company in the following 5-year period wishes to reward one or more critical workers at the time of the sale without requiring them to purchase and pay for equity.

Tokenization of business and individual performance

The above method has been known for decades. The critical challenge in the modern business world is ensuring that innovation and productivity are rewarded equitably across an organization. At the same time, executives must be compensated for creating these conditions.

However, rewarding innovation and equitably delivering executive-level incentives and rewards across the organization from the top to the shop floor is the alternative made possible only by deploying smart contracts and blockchain technology — tokenizing business and individual performance.

The tokenization of business elements such as performance and innovation is one of the newest ways to drive planned outcomes. The process is about moving your business to blockchain. Although it may seem complicated and challenging to implement, almost any entrepreneur can tokenize the building blocks of their business. Tokenization is simply transforming a company’s value into a digitized resource in the form of tokens.

Tokens represent a value within the organization in a transparent and auditable way. They can be cashed in upon completion of the vesting period if both company and individual targets have been met. What makes Synthetic Equity on the chain unique is its transparency, auditability of incentives, and most notably, equitable distribution of tokens corresponding to each employee’s job size.

The mechanism behind synthetic equity

For synthetic equity to produce favorable results, a profitable, successful firm with a proper entity structure is necessary. Corporations and LLCs can use the tools relating to synthetic equity. In some situations, they may also be used by sole proprietorships, albeit in a slightly different form.

To fully grasp the idea of synthetic equity, it might be helpful to understand the mechanism behind equity in general. Understanding how equity functions allows those interested in synthetic equity to utilize some of the tools used in working with actual equity.

For example, investing in an independent advisory company generally offers the following considerable advantages:

  • The right to vote
  • Participation in the corporate governance system
  • Access to the company’s financial documents
  • Limited liability
  • A proportionate cut of the revenue
  • Sale-related long-term capital gains tax rates
  • Capital growth potential

These advantages have a monetary value. Therefore, purchasing equity carries a price, and awarding employee equity has tax repercussions. A tiny ownership share in a fee-based firm might cost several hundred thousand dollars. In these types of businesses, the stock is often acquired and paid for after tax, and the equity partner or shareholder usually expects to obtain the entire set of rights in return for taking on the investment risk.

The rights can be unbundled, meaning that the current owner does not have to sell or provide the full bundle of rights to an employee or investment advisor. To fulfill specific goals, each of the rights mentioned above can also be further divided or redefined in as much detail as necessary. For example, one or two rights from the total package might be provided, such as the opportunity to grow the company’s worth or a percentage of the profits.

By allowing someone to own a portion of the rights in the bundle rather than all of them, synthetic equity generates an advantage. These unique rights or benefits are often described in a plan document and frequently provided via individual award agreements between the employer and employee. A wide range of flexible options for creating a solid and profitable company are produced when equity-like benefits and a long-term remuneration strategy are combined.

Synthetic equity plans often come in one of the following three forms:

  • Full-value plans can result in a substantially big payment to an employee since they pay both the value of the underlying stock and any appreciation that is gained over a certain period.
  • Performance unit plans swap out equity as the value metric for another metric like sales growth or profitability.
  • The value of any growth in the underlying stock value over a specific period following the date of the award is typically paid out under appreciation-only plans.

These kinds of plans are like conventional non-qualified plans insofar as they offer a possibility of discrimination and a significant risk of forfeiture that often lasts until shortly before the benefit is awarded to the employee.

Essentially, synthetic equity is a type of delayed compensation that links a worker’s financial incentive to the company’s performance. By striking the correct balance between the danger of losing a valuable employee and the potential future cost to the employer, each plan is specifically created to meet the advisor’s needs.

The plans are intended to reward employees for contributing to the company’s success, but they also ensure that no payment is due if either the company doesn’t develop as expected or the employee doesn’t uphold their end of the deal by quitting their job to work for a rival company or starting their own.

The benefits of synthetic equity

Synthetic equity is meant to be an equity-related instrument that helps a company find, reward, and keep hold of valuable people. Benefits include:

  • Synthetic equity inspires employees to adopt an owner’s perspective and put development and shareholder value first.
  • There is no debt since important participants do not buy phantom shares like full equity stockholders do.
  • If a participant’s job terminates before the designated vesting date, they typically forfeit any benefits under the plan.
  • Participants normally do not have voting rights or a vote in corporate governance and may or may not be entitled to collect profits from the company.
  • Synthetic equity programs provide flexible vesting timelines; vesting can take place over time, depending on the accomplishment of certain quantifiable company or individual goals.
  • If the company’s growth is slower than expected and the stock price does not rise, nothing is exchanged.
  • When a synthetic equity grant is issued, owners of genuine equity are not adversely affected by a dilution of their ownership percentages.
  • Compared to S-Corporations, which are often more restricted, more freedom is provided in terms of stock class and shareholder count.
  • The advising business’s shareholders’ or members’ agreement and associated buy-sell provisions do not immediately apply to synthetic equity.

Synthetic equity options’ versatility comes with many benefits but may also have many drawbacks. The companies need to make decisions regarding what valuation technique will be utilized, what vesting rules will be implemented, how liquidity problems will be addressed, what eligibility conditions will be imposed, and what rights to participate in corporate governance will be granted due to the wide range of possible directions for designing synthetic equity plans.

Conclusion

In the hands of a forward-thinking business leader, synthetic equity is a potent instrument. It may be utilized to solve the difficulty of attracting, rewarding, and maintaining top talent to create a great practice or viable business without the challenges of selling and paying for an actual ownership stake.

Like full stock, synthetic equity may refocus the employee’s attention and motivate them to contribute to a flourishing and profitable company.