Is there life after junior stock? Now that accountants have dampened the appeal of this second-tier stock plan by ruling that companies must count the stock issue as a full-value expense, small businesses are left scrambling for new ways to reward key employees. Enter the latest wrinkle in compensation schemes -- convertible subordinated debentures.
Last year, Massachusetts Computer Corp. (Masscomp), in Westford, Mass., included a $1.35-million debenture in the pay package of its new chief executive officer, August Klein. The $50-million computer company provided Klein with a 10-year convertible subordinated debenture paying 8.75% interest. Klein borrowed, at 9% interest, $1.35 million of the debenture's purchase price from his employer. In accordance with a prearranged schedule, he can convert the debenture to common stock at $3 a share, a sizable discount from the marker price of 6 1/4 that Masscomp shares were fetching this spring.
The company loan is just one of the ways businesses can tailor a debenture package to an executive's needs. But the basic elements still provide for a handsome deal. The share price is set at the time the debenture is issued, so if the company's stock appreciates, the executive comes away with valuable common stock acquired at a discount. If the price falls, the executive still has an interest-paying investment.
Unlike a qualified stock option plan, there is no dollar limit on the amount of stock purchased with a convertible debenture. Also, Internal Revenue Service private letter rulings indicate that the agency wouldn't tax Klein on the profit realized when he converts the debt to common stock. Taxes would be due only when the stock is sold.
Robert Schmidt, Masscomp's vice-president of finance, says that companies need to minimize the effect that compensation packages have on their bottom lines, but they also must protect key executives from adverse tax liabilities. "It really is a balancing problem you have to deal with when trying to attract senior management," he says. One way to avoid unwarranted scrutiny, he believes, is to make loans to top executives conditional on their ability to repay from their own net worth rather than securing them with the stock.
Since neither the IRS nor the accounting profession has issued an official opinion on convertible subordinated debentures, some consultants and lawyers remain leery of promoting them too heavily. Says Louis Marett, a lawyer who specializes in compensation issues for Nutter, McClennen & Fish in Boston, "Everyone's proceeding with caution."