In the ever-evolving landscape of modern business, companies face a critical choice when it comes to rewarding and motivating their key talent. The debate between adopting traditional token distribution models and embracing Synthetic Equity with deferred cash payments based on performance has continued to shape the compensation strategies of organizations worldwide. This article explores synthetic equity and its appropriateness for specific capital and tax structures. By illustrating its flexibility and benefits in owner succession, it showcases its potential through a compelling case study and offers insights into the advantages and pitfalls of each approach. Comparing Synthetic Equity And Traditional Token Synthetic equity, unlike traditional equity plans, is a compensation approach that grants executives and contract-based employees the right to a defined portion of enterprise value without requiring them to invest their own capital. It offers exceptional versatility and can be tailored to meet specific criteria related to who receives what, when, and under what conditions in terms of value sharing. It offers an alternative to the traditional token issuance model, integrating performance management seamlessly. It aligns stakeholder and shareholder interests, encourages innovation, and rewards high performance. Furthermore, it addresses a common challenge faced by startups—creating and measuring key performance indicators (KPIs). Synthetic equity is ideal for companies committed to thriving and nurturing top talent. Individuals who meet their KPIs are rewarded, while those failing to contribute positively to the business unit's performance forfeit part of their compensation. Token Distribution: Pros: Immediate Ownership: Token distribution provides immediate ownership, aligning team members with the project's success from the outset. Strong Incentive: Tokens are potent incentives, as their value can soar if the project prospers. Transparency: Blockchain-based tokens often offer transparency and traceability in ownership and transactions. Avoiding Ownership Dilution: Tokens allow companies to avoid diluting their cap tables. Payment Efficiency: Salaries and performance-based bonuses in token form can conserve cash reserves, with employees seeking liquidity in the market. Cons: Market Volatility: Token values can be highly volatile, creating uncertainty for team members. Limited Liquidity: Token liquidity constraints make converting tokens into cash challenging. Tax Implications: Transferring token value can trigger income tax obligations. Legal and Regulatory Compliance: Issuing tokens, especially in countries like the US, often involves legal, financial, and administrative hurdles. Access to Top Talent: High-caliber talent may be hesitant to accept tokens due to market volatility. Synthetic Equity: Pros: Performance-Driven: Synthetic Equity and deferred cash payments link rewards directly to individual or team performance, fostering a strong work ethic. Predictable Rewards: Cash payments offer stability and predictability compared to volatile tokens. Flexibility: Synthetic Equity and cash incentives can be customized to align with specific performance metrics and goals. Avoiding Ownership Dilution: Tokens allow companies to avoid diluting their cap tables. Value for Investors: High-performing organizations often deliver greater value to shareholders. Cons: Performance management system set up: Synthetic Equity requires strong expertise in establishing performance management and incentive structures. Delayed Ownership: Synthetic Equity lacks the immediate ownership associated with tokens. Administrative Complexity: Implementing and managing a comprehensive incentives program can be administratively intricate. How Companies Make Decisions The decision between token distribution and Synthetic Equity hinges on an organization's objectives, risk tolerance, and the preferences of founders and team members. Some organizations may choose a combination of both to balance immediate ownership and performance-based incentives. Legal, regulatory, and tax considerations, as well as project dynamics, must be carefully weighed. Consulting with legal and financial experts can prove invaluable in crafting an effective and compliant compensation strategy. Synthetic equity is a powerful tool for attracting, retaining, and rewarding top talent, especially in owner succession planning. However, many business owners and advisors possess only a rudimentary understanding of synthetic equity and its design. Six Fundamental Examples Of Synthetic Equity Programs: Phantom Stock: An executive is entitled to a percentage share of the company's value. For example, Joe holds 5% of the company's value expressed as phantom stock. Phantom Stock Over An Owner's Threshold: An executive has the right to a percentage share of the company's value beyond an initial fixed threshold value or formula. For instance, Joe has 5% of the company's value above $10 million. Stock Appreciation Rights (SARs): Executives are granted the right to share in a set percentage of the company's value exceeding its value at the time of the grant—similar to employee stock options. For instance, Joe has 5% of the company's value above the current valuation of $20 million. Value Band Plans: Executives are entitled to a graduated percentage share of the company's value based on predetermined thresholds. For example, Joe has a baseline right to 3% of the company's value and can earn an additional 1% for every $10 million in growth, with a maximum share of 7%. Sales Bonus In the Event of Change of Control: Executives are entitled to a percentage share of the company's value payable exclusively in the event of a change of control. For example, Joe has 5% of the company's value expressed as phantom stock, payable only if a change of control occurs. Simulated Equity Plan: Executives are entitled to a percentage share of the value of a specific division or segment of the company, determined by a predefined formulaic breakup value of the company. For instance, Joe holds 5% of the European division's value based on a preset formulaic breakup value of the company. Benefits Of Synthetic Equity Programs Flexibility These diverse synthetic equity programs offer flexibility and the ability to tailor incentive structures to meet specific business objectives and circumstances. The possibilities are virtually endless. Synthetic equity is akin to a sculptor's clay for incentive structures—it can be molded into a wide array of forms to suit a business owner's preferences. It can transform from a tracking stock to a pure performance-based incentive. Independence Synthetic equity operates independently of the company's shareholders' agreement and related buy-sell terms. This independence grants a high degree of flexibility, particularly concerning payout. Synthetic equity agreements must adhere to IRS code section 409A, which outlines rules governing plan payouts. According to 409A, synthetic equity plans can be triggered by six permissible events or plan termination. Control Three events that cannot be predicted are death, disability, and unforeseeable emergencies, while the three strategic triggers are change of control, time certain, and separation of service. Consequently, business owners have the authority to determine when executives can realize the value of the plan. This contrasts with a typical employee stock option plan, where executives decide when to "exercise" their stock options independently. In summary, synthetic equity plans provide business owners with enhanced control and flexibility in terms of plan design and payout. Combining Synthetic Equity And Traditional Token: A Blockchain Approach However, Synthetic Equity alone is just a piece of the puzzle, to fully unlock the potential of token economies and performance management, there should be a collaboration between the Synthetic Equity model and the normal token distribution model. In this combined system, the blockchain is the railroad, Synthetic Equity acts as the conductor, and the token is the cargo. In this hybrid model, all of the individual benefits can be realized and taken advantage of with more dynamic offerings. While token distribution still goes from the company (Point A) to the employee ( Point B), Synthetic Equity governs the amount of that token (cargo) that will be delivered and at what time. In this framework, there is still the ability to distribute tokens in a streamlined manner irrespective of KPIs, allowing normal salaries or preexisting agreements to remain constant. However, as the business grows, companies would be able to implement more intricate performance management systems without further complicating the current distribution model. Synthetic Equity should be seen as a vessel to carry out the most effective compensation models in dynamic organizations. Conclusion Synthetic equity stands as a compelling option for organizations seeking to optimize cash resources, empower succession, and reward high performance. Unlike the traditional token distribution model, it offers a robust and flexible framework, ensuring that top talent remains motivated and aligned with organizational goals. Embracing Synthetic Equity can truly set a company on the path to sustained high performance and success. This article(Unlocking Performance And Rewards: Synthetic Equity v Token)was co-authored by Ema Vukovic(Principal at Agile Dynamics), Hunter Riedel (Principal at Agile Dynamics) and Paul Lalovich (Partner at Agile Dynamics). I hereby disclose that I was duly granted the permission to edit and publish it on HackerNoon as an addition to the body of work on Tokenomics.
