Replacing Pay with Equity to Preserve Cash in a COVID Economy
As pandemic effects linger, companies intent on avoiding layoffs are looking at compensating workers with equity in lieu of cash as part of their pay.
10 min read
In August 2020, the United Kingdom began winding down its Coronavirus Job Retention Scheme, which provides direct support to UK companies to keep furloughed workers on the job. On October 31, that program ends. In March 2020, the United States Congress enacted the Coronavirus Aid, Relief, and Economic Security Act, which delivers financial support to companies and individuals, portions of which continue to remain in effect. But with a divided Congress, the United States has been unable to enact a second coronavirus stimulus package.
As companies look for ways to survive until the economy recovers, they are coping with dwindling government support, stagnant revenues and the inevitable pressure to slash payroll.
Having long since exploited redundancies and cut staff as deeply as they could, some employers are turning to a creative strategy for preserving cash while maintaining a productive, motivated workforce at the same time: replacing a portion of workers' pay with equity compensation, such as restricted shares in the company, stock options or restricted stock units (RSUs).
Equity compensation can help companies save cash and keep up staffing levels while filling the gap created by salary reductions, unpaid furloughs or decreased benefits. For companies that are experiencing dips in their share price but expect growth to return in the future, offering equity awards can be an efficient and cost-effective way of delivering a meaningful share in this growth to their employees in the long term.
While the strategy can be—and has been—deployed effectively, replacing pay with equity presents a legal, financial and reputational minefield. The potential costs and penalties for implementing such a strategy—even in the short term—without thorough consideration of the regulatory, tax, human resources and even employee culture and morale dimensions of the scheme can easily outweigh any potential benefits.
Consent is key
As with any employment arrangement, the designated procedure for modifying compensation varies by jurisdiction. In most cases, companies seeking to replace pay with equity will need to obtain the consent of employees, and/or the employees' union, works council or other representative body, to a compensation agreement modification.
Achieving consent should not be difficult where employees appreciate that the modification is a last-ditch alternative to layoffs or furloughs. Where employees are confident that the company's value is temporarily depressed and likely to rise, they may offer their consent with little reservation, so long as the agreement also leaves employees with sufficient cash pay to meet their personal financial obligations. Mixing cash and equity compensation in this way is a longtime practice in tech startups, where new joiners come on board wagering that the company's valuation will rise.
In many companies, especially in Europe, modifying compensation demands negotiating with one or more employee representative bodies such as unions or works councils to amend a collective agreement.
In France for example, as in many European Union member countries, unions are reflexively hostile to benefits reductions, and pay modifications require negotiating with a resistant union to amend a collective agreement on compensation or benefits. The same is true wherever France's Collective Performance Agreement (CPA), created by the Macron administration in 2017, is in force. But with a CPA, if the union agrees to the modification, any employee who then refuses the modification can be terminated with cause. In practice, the CPA empowers the company to impose a reduction of remuneration or working hours to all employees without requiring their individual consent, subject to achieving a successful negotiation with the union representatives.
Consent is less of an issue in the United States, where most workers are employed at-will and there is no employment agreement in place; such employees' compensation often can be modified at the employers' discretion, and the only remedy for the non-consenting employee is to resign.
Where a contract or other explicit employment agreement in the United States is in force that details compensation, pay modifications demand not only negotiation with the affected employee, but also careful review of the existing agreement. For example, an existing agreement might entitle workers to resign and claim severance in response to an unwanted pay modification.
Companies will also want to review applicable state law to ensure compliance with salary reduction notice requirements, if any. For example, under New York law, employers are required to provide written notice of any reduction in salary at least seven days prior to any such reduction. Other states, such as Colorado, do not require notice prior to a reduction in salary. In the event that a company fails to comply with the applicable notice requirements, most states impose a fine, typically a predetermined amount per day, per employee.
Risks abound
Even where consent is an easy get, there are many ways a plan to replace pay with equity can run afoul of unintended consequences.
In the United States for example, reducing base pay, even if that amount is effectively replaced with equity compensation, can drop an employee's pay below the minimum salary threshold for exempt status (US$35,568 annually) under the Fair Labor Standards Act. In such cases, unless another exemption is available, newly non-exempt employees would be entitled to overtime pay for work beyond 40 hours a week, among other changes.
Should the pay modification result in an employee being misclassified as exempt or non-exempt, the company can face stiff penalties for the error. Before swapping equity for salary, companies should carefully review the applicable reductions in salary to ensure that state and federal minimum wage and overtime requirements (for non-exempt employees) continue to be met even after the pay reduction.
The same principles apply in France: A salary reduction must be capped to the minimum monthly wages, known as Salaire Minimum de Croissance (SMIC), or when more favorable, to the minimum wages scale negotiated with the national unions according to business sector.
In Germany, the existing equal treatment principles can complicate pay modifications. In principle, the company must treat all employees equally, unless the company is able to demonstrate that there is a justified reason that the modification treats some employees different than others. For example, if the company's equity-for-pay plan will work best if employees with fixed-term contracts are excluded, the company must devise an argument proving that the exclusion is not tantamount to unjustified, unequal treatment.
Tax traps are common
Savings on income tax, social security tax and other taxes may accrue to the company and employees from a well-designed program. In the United Kingdom, companies often may use the Share Incentive Plan, under which shares up to a value of £3,600 each year per employee may be paid out on a tax-free basis. Also available in the UK is the Company Share Option Plan (CSOP), under which market value share options can be granted to employees, with any gains being subject to capital gains tax. Approached with caution, use of this type of plan can deliver long-term value to employees along with reduced taxes, while also delivering significant savings in employer social security.
Despite these advantages, replacing pay with equity is rife with tax traps.
In the United States, pay modifications can trip up on Internal Revenue Code Section 409A, which deals with federal tax consequences of deferred compensation arrangements.
Any equity-for-pay scheme needs to have some sort of end date, a point at which the normal pay scheme will resume and outstanding debts between employer and employee, if any, will be settled. While a reduction in salary alone should not trigger 409A concerns, employers should be aware that any commitment to repay the amount of reduced compensation at a later date, in the form of delayed salary payments or salary payments replaced with other consideration such as equity awards, may be a deferred compensation arrangement under Section 409A.
Under 409A, deferred compensation arrangements must comply with specific timing and other rules governing when and how deferral elections can be made. Failure to comply with the Section 409A deferred compensation requirements could exact harsh penalties on affected employees, including accelerated income taxation and a 20 percent penalty tax.
Strategies for avoiding 409A penalties include paying the deferred amount no later than the end of the short-term deferral period (for calendar year 2020 compensation, by March 15, 2021), or structuring the program without an explicit commitment to repay lost wages. In this instance, the employer could unilaterally choose to repay the forgone salary amounts at any time, even beyond March 15.
The latter strategy is risky, requiring great care in both the structure of the program and all related communications with employees. These should be crafted to avoid statements that could create an expectation of deferred payment that might rise to the level of a "reliance" claim resulting in a "legal obligation" of payment which would implicate the deferred compensation rules of Section 409A.
Employers should also consider the effect that reducing compensation could have on potential excess parachute payments paid in connection with a change in control under Section 280G of the IRS Code.
Companies whose market value is temporarily depressed by the pandemic economy present ripe targets for mergers and acquisition. Reducing compensation ahead of a transaction can lower a disqualified individual's five-year average base compensation, which is used to calculate an individual's "base amount." Replacement equity grants could be viewed as a parachute payment if vesting will become accelerated as part of the transaction. In the United States, compensatory payments to certain individuals payable in connection with the merger will be subject to a 20 percent excise tax, and the company would lose a deduction for such payments, if the payments equal or exceed three times the disqualified individual's base amount.
Keys to success, safety
While any plan to replace pay with equity demands far more due diligence than outlined here, adhering to a few guiding principles can start a company on the right foot:
- Carefully consider company culture and workforce morale ahead of the plan. If workers are demoralized, can they be made receptive to such a change, or is it likely to backfire?
- Transparency is key. A strong, open dialog must evolve among management, workers and unions. Communications must clearly explain to whom the plan applies, how long it will last, why any alternative approaches were rejected, what the benefits are to employees, and most importantly why management believes the plan is essential to the company's success and the workers' continued employment.
- Line workers may be more receptive if assured that management will participate in the program on the same terms as workers.
- Communicate how the plan affects other employee programs (if at all), such as 401(k) plans, pensions, healthcare benefits and so on. Engage human resources at every stage of the plan to evaluate the HR effects of the plan and to help with communications.
- In both the plan's design and its implementation, be watchful for any events that could be construed as acts of discrimination, especially in cases where not all employees will participate in the plan equally.
- Be mindful of time limits. In many jurisdictions, there are specific regulations related to how quickly a pay modification can begin after its announcement.
- Model various scenarios for the fraction of base pay to replace with equity. In some jurisdictions the fraction may be limited by law. In general, avoid replacing more than 30 percent of base pay.
Finally, note that there are related alternatives to replacing pay with equity that can deliver many of the benefits of such plans but may be less risky. For example, some companies use equity awards not to replace pay, but to make up for benefits reductions. And some companies are using equity grants to replace back pay already lost during furloughs.
This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
© 2020 White & Case LLP
