Employee equity incentives

Employee Equity Incentives
Presented by Bart Greenberg
Haynes and Boone, LLP

Tech Coast Venture Network
Monthly Workshop Series
May 5, 2011

© 2010 Haynes and Boone, LLP

What Considerations Typically
Influence Plan Design?

June 3, 2010 Employee Equity Incentives

Business Purpose for the Plan
 Recruit and retain scarce talent
 Motivate employees to perform
 Align employee interests with owners
 Create a compensation “fill-gap”
 Facilitate succession planning


Ownership and Management
 What is the current ownership structure of the
Company?
 Are these owners willing to dilute their
ownership position?
 Is voting control an issue?
 How will the extension of equity be viewed by
the existing management?


Legal Form of the Company
 Sole Proprietorship
 Partnership
 General
 Limited
 Corporation
 S Corporation
 C Corporation
 Limited Liability Company
 Limited Liability Partnership
 Professional Businesses


Capital Needs of the Company

 Does the Company need capital?
 Will the Company be seeking outside
investors?
 How would prospective investors view the
plan?


Company’s Financial Situation

 What is the financial condition of the Company?
 Is the Company generating profits?
 What is the cash position of the Company?
 Will it be cost effective for the Company to
implement and administer the plan?
 What are the costs to the Company?
 What are the costs to the employee?
 How will the proposed plan affect the Company’s
financial statements?


Future Growth Plans
 What is the growth projection for the
Company?
 Start-up with great growth potential
 Mature company with slower growth
 How will liquidity of the investment be
obtained?
 Cash award or redemption
 Liquidity event of Company


Company Culture
 What is the Company’s culture?
 Individual-based compensation approach;
or
 Broad-based compensation approach
 How will the plan be perceived by employees?
 Is it designed to reinforce the Company
culture?
 Will it be perceived by employees as being
fair?


Industry Norms

 Employee desires, expectations and needs
 What is the competitive landscape?


Tax Considerations
 What are the available tax incentives for the
Company?
 Deductibility of the award
 Obligation to withhold
 What are the available tax incentives for the
Employee?
 Will there be recognition of income?
 Capacity to pay withholding obligations
 Compensation income vs. capital gains


Tax Considerations (cont.)

 Pitfalls to avoid
 Deferred compensation taxation (Section 409A)
 Parachute payment taxation (Section 280G)


Specific Plan Design Issues


Types of Plans

 Direct Stock Purchases
 Stock Options
 Phantom Stock and Share Appreciation Rights


Direct Stock Purchases


Eligibility and Participation

 Typically, individual-based approach
 Potentially, broad-based approach via stock
purchase plan


Size of Grant
 Typically, case by case
 Could be limited by securities requirements
 Section 25102(o) limits pools to 30% of outstanding
shares unless approved by 2/3 of outstanding shares
 Rule 701 limits aggregate sales price or amount of
securities being sold in reliance on Rule 701 during
any 12 month period to:
 $1 million (aggregate exercise price on date of
grant);
 15% of total assets; or
 15% of outstanding securities


Size of Grant (cont.)

 Could be limited by other concerns
 Carve-outs to application of anti-dilution
provisions
 Exceptions to preemptive and other similar
rights


Type of Grant

 Unrestricted
 Not subject to forfeiture

 Restricted
 Subject to forfeiture


Tax Treatment
 Unrestricted
 Ordinary income to the extent FMV exceeds
purchase price
 The Company has a reciprocal compensation
deduction
 Any profit at sale will be afforded capital
gains treatment


Tax Treatment (cont.)

 Restricted
 Recognition of ordinary income as and
when restrictions lapse
 If, however, Section 83(b) election is made,
see “Unrestricted”


Payment of Purchase Price
 All cash
 All note
 If permitted pursuant to a stock purchase
plan; or
 If adequately secured by collateral other than
shares
 Sarbanes-Oxley prohibition on loans to top-
level officers should be considered


Payment of Purchase Price (cont.)

 Combination of any of the above
 Other types of legal consideration
 Labor or Services Actually Rendered
 Debts or Securities Cancelled
 Tangible or Intangible Property
 Section 83(b) election may be challenged if
significant portion of payment (typically 80%
or more) consists of a nonrecourse note


Vesting
 Passage of Time
 Performance Based
 Individual Performance
 Company Performance
 Combination of Time and Performance Vesting
 Acceleration of Vesting
 Determination of Triggers
 Accounting Considerations


Purchase Price

 Subject to securities requirements and tax issues,
no restrictions


Voting Rights

 Full voting rights at time of purchase
 Consider protective provisions
 Tag-a-long rights
 Drag-a-long rights

 Potential limitations on voting rights
 Use of non-voting stock
 Grant of revocable or irrevocable proxy
 Use of shareholders’ or voting agreement


Securities Requirements & Filings

 If individual-based approach, could be subject to
investor suitability requirements

 If broad-based approach and subject to Section
25102(o), plan could must provide for delivery by
Company of annual financial statements


Securities Requirements & Filings (cont.)

 Rule 701 requires additional disclosure (plan
summary, risk factors and financials) if sales
exceed $5 million during any 12 consecutive
months


Stock Options


 A broad-based approach through use of plan

 Potentially, individual-based approach through:

 Limited grants of options under plan
 Grant of options outside of any plan


Size of Option Pool
 Typically, case by case
 Could be limited by securities requirements
 Section 25102(o) limits pools to 30% of outstanding
shares unless approved by 2/3 of outstanding
shares
 Rule 701 limits aggregate sales price or amount of
securities being sold in reliance on Rule 701 during
any 12 month period to:
 $1 million (aggregate exercise price on date of
grant);
 15% of total assets; or
 15% of outstanding securities


Size of Option Pool (cont.)

 Could be limited by other concerns
 Carve-outs to application of anti-dilution
provisions
 Exceptions to preemptive and other similar
rights


Size of Option Grant
 Typically, left to the discretion of the board


Type of Options

 Incentive stock options
 Grantee must be an employee
 Exercise price must be > FMV
 Other statutory requirements
 Nonqualified stock options
 Any option other than an incentive stock
option


Tax Treatment
 No tax deduction for the Company at grant or
exercise
 Capital gains treatment to optionee upon sale
of stock
 Potential AMT liability to optionee at time of
exercise
 In the event of a disqualifying event, see
Nonqualified stock options



 Tax deduction at exercise in amount equal
to “spread”
 Ordinary income to optionee in amount of
spread at exercise
 Potential ordinary income at grant if
negligible exercise price



 [Potentially] subject to deferred compensation
taxation (accelerated taxation, interest charge
and 20% excise tax) if exercise price < FMV


Exercise Price

 Incentive stock option
 Must be FMV at time of grant (110% if 10%
shareholder)

 Nonqualified stock option
 For tax purposes, no restriction (however, may
be subject to deferred compensation taxation
under Section 409A if < FMV)


Vesting
 Passage of Time
 Performance Based
 Individual Performance
 Company Performance


Vesting (cont.)

 Combination of Time and Performance Vesting

 Acceleration of Vesting
 Definition of Triggers
 Accounting Considerations


Term and Termination
 No option may be granted after 10th
anniversary of Plan
 Limitations on periods after termination of
employment by which option must be
exercised
 Section 25102(o) provides that no option may
be granted after 10th anniversary of Plan
 Section 25102(o) limits periods of time by
which option must be exercised


Payment of Shares
 All cash
 All note
 If permitted pursuant to a stock option
plan; or
 If adequately secured by collateral other
than shares
 Sarbanes-Oxley prohibition on loans to top-
level officers should be considered


Payment of Shares (cont.)

 Other types of legal consideration
 Labor or Services Actually Rendered
 Debts or Securities Cancelled
 Surrender of Option Shares
 Tangible or Intangible Property


Voting Rights

 Full voting rights at time of purchase

 Consider protective provisions
 Tag-a-long rights
 Drag-a-long rights

 Potential limitations on voting rights
 Use of non-voting stock
 Grant of revocable or irrevocable proxy
 Use of shareholders’ or voting agreement



 If individual-based approach, could be subject to
investor suitability requirements
 If broad-based approach and subject to Section 25102(o),
plan must provide for delivery by Company of annual
financial statements


Securities Requirements & Filings (cont.)

 Rule 701 requires additional disclosure (plan
summary, risk factors and financials) if sales
exceed $5 million during any 12 consecutive
months

 The number of option holders should be closely
watched so that the company does not trigger
reporting requirements when the exercises occur.


Phantom Stock and
Share Appreciation Rights



 Typically, individual-based approach

 Potentially, broad-based approach through plan


Size of Grant

 No restrictions


Tax Treatment
 Company has tax deduction on date of
payment in amount equal to appreciation
 Ordinary income to employee at time of
payment
 Deferred compensation taxation (accelerated
taxation, interest charge and 20% excise tax)
may apply


Accounting Treatment

 Benefits must be entered as an expense and
book liability for accounting purposes when
and as accrued


“Exercise Price”
 No restrictions


“Payment for Shares”
 No actual payment is made

 Employee receives cash award equal to
difference between unit value and FMV


Voting Rights

 None



 In general, as no equity is involved, securities
laws are not applicable

 However, there is a new trend to settle with
shares, not cash, which raises security law
issues


Questions?


Thank you!

Bart Greenberg
Haynes and Boone, LLP
(949) 202-3037
bart.greenberg@haynesboone.com


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