Nearshore Americas

Legal Insider: Incentive Compensation for U.S. Employees of Foreign Service Providers

By William B. Bierce

Recruitment and incentive compensation of local onshore residents require careful structuring and execution. Since experienced business developers are difficult to attract and retain, offshore service providers need to develop effective strategies and tools for incentive compensation.

American employment law offers a large choice of tax, corporate, employment, incentive compensation and retirement planning opportunities to align the interests of the U.S. executive team with those of the company. Offshore service providers can choose a variety of possible incentive compensation tools, beyond the typical compensation plan of a base salary plus a simple commission structure plus an expense account. The challenge is to identify the most effective tools, mitigate risks of potential abuses, and succeed in rapid and solid growth of brand value, cash flow and market share for foreign BPO companies entering the U.S. market.

Designing Effective Executive Compensation Programs

Sophisticated emerging growth companies usually seek to align short-term performance and long-term goals.  A well-aligned executive compensation structure for sales talent may include a combination of base salary, annual incentive compensation (with defined sales performance targets), long-term incentives for consistent multi-year achievement of targets, the grant of stock options (or an equivalent reward reflecting an increase in company value), pension (retirement) plans, medical insurance plans and potential special compensation based on specific goals or needs.

“Performance-Based” Compensation: In the world of multi-million dollar deals, exceptional business developers can generate huge compensation. Tax law prevents employers from deducting compensation in excess of $1.0 million unless the portion over $1.0 million is “performance-based.” Aside from a $1.0 million maximum for such compensation, the applicable conditions should be defined.

Defining the Performance Criteria: A broad range of discretionary performance-based compensation plans are available. Essential elements include a neutral description of the “performance goal” (such as increased sales, revenues, net profits) for a “performance period” (typically, a calendar or “contract” year).  For example, in a commission-based structure, performance goals could provide one percentage commissions for initial sales and different percentages for higher tranches of sales.

Preventing Abuses: Forfeiture and Clawback.

 Employers don’t want to pay large value for unprofitable deals.  In traditional commission models, commissions are payable immediately after closing of the sale.  To avoid potential abuses, business developers should be paid only for deals that conform to well-defined company policies on pricing, price structure, risk management (e.g., for foreign exchange, labor costs, and other benchmarks), relationship management or long-term profitability.  This raises the question whether the business developer should be at risk of losing commissions if the deal is terminated early or otherwise fails to meet the company’s “client relationship quality” viability standards.

U.S. tax regulations encourage employers to mitigate such risks.  In one scenario, performance-based compensation might be forfeited under specific events (such as termination for cause, such as willful misconduct, breach of covenant against unfair competition).  In another scenario, the employer might be entitled to recover previously paid performance-based compensation (under a “clawback” clause) within a specified period after the “forfeiture” event.

Long-Term Incentives: To ensure that business developers pursue long-term viability goals, long-term incentives are designed based on longer-term measures of value. They can be structured as “stock appreciation rights,” “phantom stock” or stock grants.

Vesting: The key to long-term alignment is to put the employee at risk of losing the incentive compensation if he or she ceases employment before a “vesting” date. “Vesting” refers to the satisfaction of all requirements for acquiring a right, such as the right to purchase stock at an agreed price upon continued employment after an agreed term. Typically, vesting of stock options occurs in equal proportions over a period of three or four years.  Sometimes vesting is “accelerated” upon a “change in control” of the company.

Section 83(b) Election: An individual (whether employee or independent contractor) can convert stock (or other property) received under a deferred option program from “ordinary income” to a capital asset by making an election within 30 days after the grant of the option.  Upon sale of the stock, the individual pays capital gains on the appreciation between the value on receipt of the stock (or the stock option). If the stock is held for a year or more, the tax rate is reduced to long-term capital gains rate (scheduled to be 20% in 2013, absent a change in law).  This approach only works well for startups with no substantial company value, since the individual could risk forfeiting the stock by not meeting the vesting requirements yet still pay tax on the value of the property received in return for services.

Qualified Stock Option Plans:  Under a qualifying stock option plan (“QISO”), an employee avoids ordinary income tax altogether, but the plan must meet certain conditions.  The employee can delay payment of U.S. income tax until eventual sale of the stock received upon vesting.  This QISO structure is available for option plans in a foreign company’s shares, but only if it is a parent, subsidiary or sister-company of the U.S. employer. As a result, some foreign companies establish QISO’s for the U.S. employees of their U.S. subsidiaries, thereby making the U.S. operation into its own profit center for which the Americans can try to maximize revenue.

Founder’s Stock: For smaller foreign providers, establishment of a U.S. sales subsidiary might be too risky without local “partners.”  To get both talent and some funding for a U.S. market entry, innovative foreign providers might be willing to co-invest (or invest 100%) for an initial year’s budget and allow a team of senior U.S. sales and marketing executives to become founding shareholders in the U.S. subsidiary.  The onshore talent would purchase “founder’s stock” for a modest price.  Employment agreements and a shareholders agreement would define incentive compensation, governance and shareholder relations.  To avoid abuse, the subsidiary could buy back the shares at a low price later if performance targets were not achieved, or it could buy back the shares at a fair market price upon termination without cause.

Other Incentives: Other elements of incentive compensation include medical insurance and pension (retirement) plans.  Under 2010 Patient Protection and Affordable Care Act (“ObamaCare”), the legal regime for medical insurance will be much more complex as of January 1, 2014, and pension plans are equally complex.

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Documentation: An effective incentive compensation program will incorporate multiple elements, not just the terms of employment or sales commission agency agreement.  Non-competition covenants and assignments of intellectual property rights are customary, but beware of problems with California sales personnel due to local law.

Disputes: Under American law generally, employers are allowed to make decisions about employee performance that could abuse the business developer’s expectations for significant incentive compensation.  American courts support employers who terminate employment shortly before achievement of a performance milestone that involves payment of commissions or vesting of stock options.  While such terminations can be legal, they can also destroy the employer’s goodwill in the market for onshore talent and thus become self-defeating.  Managers therefore consider both short-term and long-term impacts of deciding to terminate employment or otherwise exercising lawful discretion that deprives onshore talent of a commission or other incentive.

Foreign service providers can achieve significant competitive advantage in developing and managing incentive compensation plans under the U.S. law. The flexibility of such law offers substantial benefits to both employer and business developer.

William B. Bierce is an award-winning lawyer in international business and technology with the law firm of Bierce & Kenerson, P.C. in New York City.  He services businesses across the full lifecycle, technology providers and users, investors and governments.  He is fluent in French and reads technical Spanish.

Narayan Ammachchi

News Editor for Nearshore Americas, Narayan Ammachchi is a career journalist with a decade of experience in politics and international business. He works out of his base in the Indian Silicon City of Bangalore.

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