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Equity Compensation at Private Firms: How to Compete for Executive Talent
 

By Eric D. Schoenborn (assisted by James F. Podheiser and Steven Scolari), Stradley, Ronon, Stevens & Young LLP  1/15/2009

Private companies, including closely held and family-owned businesses, often find it difficult to attract and retain key management personnel. That's because executive talent is often lured away by publicly held companies offering company stock (equity) as a key component of total compensation packages. While the equity in a private company cannot be traded on a stock exchange and may not otherwise be marketable, there are various means by which private companies can provide long-term equity incentives that may also be liquid investments for employees.

The top concerns for the private company employer/business owner (i.e., the principal security holder) are giving up control and having to account to minority shareholders in managing the business. However, there are various means by which to provide long-term equity incentives to employees without ceding control to them.

This article summarizes how privately held companies can create long-term equity incentives for upper management while maintaining control over the ownership of the company. There are tax, legal and accounting implications for each of the compensation alternatives described below, and while some of these are noted, it's prudent to consult with a professional adviser to ensure that long-term equity compensation programs are designed properly to meet company goals.

Benefits of Equity Compensation

Most publicly held companies have three primary compensation elements: salary, annual bonus and long-term equity compensation (e.g., stock options or restricted stock awards). On the other hand, smaller private companies find it hard to recruit top-level management talent, as they typically do not offer the third element, long-term equity compensation. By offering equity compensation, a private company (i) provides an incentive for employees to perform in the best interest of the company, (ii) preserves capital by paying lower cash compensation, and (iii) can compete for talent with larger companies by holding out the prospect of significant appreciation in the value of the equity.1  

Types of Long-Term Equity Incentives

There are several long-term compensation tools that can be used to meet the goals and demands of the security holders of a closely held business. These may include any of the following:

Type of Award

Description

Benefits

Stock Options

Grants employees the right to purchase equity (stock) in the company at a predetermined exercise price during a set time period in the future.

Provides an incentive for employees because options allow them to benefit from the increase in value of the company. Also provide some liquidity to the company upon exercise.

Restricted Stock Awards

A grant of stock, which may be subject to forfeiture if certain future conditions are not met (e.g., continued employment for a period of time or achievement of certain performance goals such as revenue or net income).

Provides an incentive to employees, and helps to retain employees if accompanied by a forfeiture provision.

Equity Bonuses

Performance bonuses paid in the form of equity instead of cash.

Provides an incentive to employees to meet performance goals while minimizing cash outlays by the company.

Stock Purchase Plans

Permits employees to purchase equity in the company at a discount to fair market value.

Provides an incentive to employees by allowing them to participate in the growth of the company, while providing the company with some liquidity.

Stock Appreciation Rights (SARs)

Entitles employees to receive cash or stock in an amount equal to the excess of the fair value of the company’s equity on the date of exercise over the exercise price, which is typically equal to the fair value of the company’s equity on the date of grant.

Provides employees with the same financial gain as would a comparable stock option, without requiring a cash outlay upon exercise. Thus provides an incentive to employees and serves to retain them. If settled in cash, SARs will not give up any control of the company.

Phantom Stock Units

Entitles employees to receive cash or stock in an amount equal to the value of an equivalent number of shares of stock, or the appreciation in value of an equivalent number of shares of stock since the date that the units were awarded, upon the occurrence of one or more predetermined events (e.g., a change in control of the company, retirement at or after age 65, etc.).

Similar to SARs, but realization of value is tied to the occurrence of an event rather than the employee’s unilateral election.

The long-term incentives described above can be replicated to varying degrees if the company is a limited liability company or a partnership rather than a corporation.

Companies typically alleviate employees’ liquidity concerns by providing that the company or its security holders will repurchase any shares upon certain triggering events, such as demand by employees after a certain time period has elapsed or termination of employment in certain instances.

Employer Concerns

Several practical issues arise in connection with issuing equity to employees, including: (i) diluting current owners, which could reduce their control over management of the company; (ii) ensuring that the equity is not transferred to third parties who are not affiliated with the company or may not share the same views on the direction of the company; (iii) valuing a security that is not publicly traded; and (iv) funding the company’s repurchase of shares. These matters are discussed in more detail below.

    Control. Since the company will likely be providing a minority interest, the probability that this will take away control is minimal. Nevertheless, minority security holders can create disturbances from time to time and can be a distraction. Accordingly, resale provisions should be put in place that would be triggered upon departure of an employee. Also, a nonvoting equity interest, such as a Class B nonvoting interest can be issued. Alternatively, stock appreciation rights that are settled in cash can be awarded, which provide no rights to management but merely the right to cash, based on the appreciation in the value of the company.

    Resale restrictions. The company will not want employees to transfer their equity to third parties. Accordingly, each employee must enter into certain agreements with buy-sell provisions that will require them to sell their equity back to the company under certain circumstances. These circumstances include termination of employment, sale of the company by the majority security holder (i.e., drag-along rights), insolvency of the employee, etc. These transfer restrictions are also important to ensure compliance with securities laws.

    Valuation of equity. A company also needs to determine its fair-market value in order to issue equity and/or make repurchases. There are various means of doing this, including periodic (e.g., annual) determination by a valuation expert, book value, and a formula based on a multiple of revenues or net income. The method chosen will depend on the industry, the preferences of the security holders and the amount of time and money they wish to spend.

    Funding repurchases. Certain smaller companies may not have sufficient cash flow to fund repurchases by the company. This can be handled in many ways, including making payments over time above certain dollar amounts, using certain insurance vehicles if the repurchase occurs in connection with the death or disability of the security holder, or placing contractual limits on the dollar amount of repurchases that can be made in any year (absolute amount or percentage of annual revenues or net income). The company may also consider a line of credit to assist during seasonal periods when working capital may be low.

Legal, Tax and Accounting Issues

The type of equity incentive, the type of payments and the persons who are offered these incentives will be influenced by various legal, tax and accounting laws. An overview of some of the more common issues is included below, but it is advisable to consult with legal, tax and accounting professionals to ensure that all laws and regulations are complied with and a tax-efficient award is chosen for the benefit of the company and its employees.

Legal

    Corporate laws. Several corporate law issues need to be considered in connection with issuing equity interests. For instance, proper consideration must be received by the company for issuance of the equity under the law of the state of formation, and some states prohibit loans to officers (which may impact how an equity purchase by an officer is financed). In addition, corporate laws may disallow an absolute restriction on transfers of equity by a security holder, which would require creating reasonable buy-sell provisions — such as a right of first refusal upon a holder’s receipt of a bona fide third-party offer for his or her equity interest. Fiduciary duties must also be considered, including avoiding conflicts of interest and wasting of company assets.

    Securities laws. Companies will need to comply with federal and state securities laws that govern the sale of securities, including dealing with the threshold question of whether the grant of an equity award will require registration under the Securities Act of 1933 (Securities Act) or is exempt. Many companies fall into the trap of assuming that only public companies need to comply with securities laws; even private companies granting equity awards will need to register their offering of securities to employees or find an exemption from registration.2 If structured properly, these offerings to employees can fit within an exemption that will not require registration of the securities with federal or state regulators.3 Set forth below are a few of the federal exemptions that may be relied upon:

        1. No “sale.” Registration is not required when there is no “sale” of a security as defined under the Securities Act. This exemption may be used for a properly structured equity bonus where the employee is not required to make a payment to receive the award.

        2. Section 4(2) or Regulation D. If awards are made to a limited number of employees who are knowledgeable about the company and have a high level of investment sophistication to be able to fend for themselves, then an exemption under Section 4(2) of the Securities Act may be available. Section 4(2) exempts “transactions by an issuer not involving any public offering.” However, “public offering” is not defined under the federal securities laws, which creates ambiguity in certain offerings. For more certainty, companies may rely on the safe-harbor exemptions provided by Regulation D, adopted pursuant to the Securities Act, which provides an exemption for limited offerings based on the number of persons, the offering amount and purchaser qualifications.4

        3. Rule 701. This rule exempts equity awards to employees of nonpublic companies pursuant to a compensatory employee benefit plan. The maximum amount or sales price of equity securities that can be sold in any consecutive 12-month period is the greatest of the following:

            a. $1 million.

            b. 15 percent of the total assets of the company.

            c. 15 percent of the outstanding amount of the class of securities of the company being offered pursuant to the Rule 701 exemption.

Private companies must also comply with state securities laws (or “blue sky” laws) requiring the registration of securities or find exemptions therefrom. This analysis is usually performed once the state of residence is determined for each employee expected to be offered securities.

While many states have an employee benefit plan exemption, if company employees reside in a large number of states, a company may wish to rely on the Rule 506 exemption under Regulation D, as this generally provides an exemption from the registration provisions of state blue sky laws per the Securities Act. Regardless of the exemption, a filing with the state securities regulators may be required (e.g., some states require a short “notice” filing if the company is relying on Rule 506).

Tax

The tax treatment of the various awards can vary widely for both the employee and the company and, in some circumstances, will depend on actions or elections taken by the employee. Some potential tax issues include:

    1. Ordinary income vs. capital gains. Under current law, the federal income tax rate on ordinary compensation income and short-term capital gains can be as high as 35 percent, whereas the tax rate on long-term capital gains is generally 15 percent. When an employee exercises an option to acquire an equity interest in the company (other than an incentive stock option as described below), the excess of the fair market value of the equity at the time of exercise over the exercise price of the option is taxed at ordinary tax rates.
    Similarly, the gain realized upon the exercise of a SAR, the value of an equity interest received as a bonus, or the realization of value from a phantom equity award is taxed at ordinary tax rates. On the other hand, future appreciation in value of equity after an option has been exercised, or after receipt of an equity bonus award, will be taxed at lower long-term capital gains rates when the equity is sold, if it is held for at least one year after exercise or receipt before being sold.
    Depending on the circumstances, an important consideration in designing a long-term incentive program for employees may be to give employees as much opportunity as possible to have at least some portion of the value of their equity taxed at lower long-term capital gains rates.5

    2. Incentive stock options. The most common concern is whether a stock option should be structured as an incentive stock option (ISO) or not (e.g., a nonqualified stock option). An ISO provides certain tax benefits to the employee upon exercise and sale of the underlying stock if provisions of the Internal Revenue Code (IRC) are met. However, if ISO treatment is obtained, the company will not be able to claim deductions attributable to these awards.

    3. Alternative minimum tax. In general, an employee does not have a taxable event upon exercising an ISO. However, the excess of the value of ISO stock over the exercise price of the ISO will be included as ordinary income for purposes of determining whether the employee is subject to the federal alternative minimum tax (AMT) for the year in which the exercise occurred. This is a very complicated subject, but as many readers likely know, many more taxpayers are currently subject to the AMT than Congress envisioned.

    4. Section 83 elections. Section 83 of the IRC governs the taxation of property received as compensation for services. If the property in an employee’s hands is subject to a substantial risk of forfeiture (e.g., due to vesting requirements), Section 83 allows the employee to either (i) defer recognition of tax on the value of the property until the risk of forfeiture lapses or (ii) elect immediate taxation, which converts potential future appreciation to capital gains.

    5. Section 1202 preferential tax treatment for “Qualified Small Businesses.” As an incentive to invest in small businesses, under certain circumstances only 50 percent of the gain realized on the sale of stock of certain types of small business corporations held for at least five years will be subject to federal income tax. This opportunity is available to employees who receive stock in a qualifying corporation as part of their compensation. Therefore, the requirements and benefits of Section 1202 of the IRC should be considered when designing any long-term incentive program.

As noted above, an employee will realize taxable compensation income upon exercising an option to acquire stock or other equity (other than an ISO) or a SAR, upon receiving a stock or other equity bonus, or when the risks of forfeiture of any previously received stock or other equity lapse. However, even though the employee may not receive any cash, the company would be required to withhold federal income tax and FICA tax, as well as any applicable state and local taxes, on the amount of that compensation. When designing any long-term incentive program, the company must develop a mechanism to enable it to comply with its tax withholding obligations under the law.6

Accounting

Details on the accounting treatment of various equity awards are beyond the scope of this article. It should be noted, however, that the granting of awards may be treated as an expense in the company’s income statement that will reduce earnings. Financial Accounting Standards Board Statement No. 123(R), Share-Based Payment, requires this expense. Companies should consult with their accountants before implementing any equity award program, to ensure that they understand the accounting implications, which could have an adverse impact on their ability to meet certain financial covenants in outstanding loan agreements.

Conclusion

Equity-based compensation is typically used by publicly traded companies as the long-term component of a total compensation program but is often ignored by private companies. Nevertheless, successful private companies are competing with public companies for the same management talent. Accordingly, private companies seeking to grow their business should also consider equity-based compensation for their employees and can employ some of the protective measures described in this article to retain control of the company and minimize potential problems associated with creating minority shareholders.

Footnotes:

1. The roadmap for wealth has been paved by the thousands of employees of Google Inc., United Parcel Service, Yahoo Inc., eBay Inc., Microsoft Corp. and others who became millionaires due to stock options and other employee equity awards granted to them when the company was privately held.

2. By way of example, the initial public offering (IPO) of Google Inc. was delayed following an investigation and charges filed by the Securities and Exchange Commission and the California Department of Corporations related to Google's failure to register or find an exemption for more than $80 million in stock options issued to employees in the two years preceding the IPO.

3. It should be noted that these are exemptions only for the sale from the company to the employee, but do not provide an exemption for the resale of these “restricted securities” by the employee. There are further exemptions that an employee may be able to rely on to sell the securities and an attorney for the company should be consulted before these sales occur.

4. The general terms of these exemptions are as follows:

Rule 504. Offering of up to $1 million in any 12-month period.
Rule 505.
Offering of up to $5 million in any 12-month period if certain information is provided and purchaser qualifications are satisfied (including sales to 35 or fewer employees who are not “accredited investors”).
Rule 506.
Unlimited offering amount if certain information is provided and purchaser qualifications are satisfied (including sales to 35 or fewer employees who are not “accredited investors” but who have a minimum level of investor sophistication).

With regard to employees, a person would be an “accredited investor” if they (a) have a net worth, either individually or jointly with their spouse, that exceeds $1,000,000 (which includes homes and automobiles) at the time of purchase; (b) have individual income for each of the two most recent years that exceeds $200,000, and a reasonable expectation of reaching the same income level in the current year; (c) have joint income with their spouse for each of the two most recent years that exceeds $300,000, and a reasonable expectation of reaching the same income level in the current year; or (d) are a director, executive officer or general partner of the company, or a director, executive officer or general partner of a general partner of the company.

5. If the company is a partnership or a limited liability company that is treated as a partnership for federal tax purposes, it may be possible to provide an employee with the opportunity to be taxed at long-term capital gains rates on the full value of an equity award if the award consists of a mere profits interest in the company. A profits interest is a form of equity interest in the company that entitles the recipient to participate in future earnings and appreciation in the value of the company only after the interest is awarded.

6. For example, in the case of a stock option, the company could impose a condition that the option may not be exercised unless the employee delivers to the company an amount of cash that is sufficient to both pay the option exercise price and cover the company’s tax withholding obligation in connection with the exercise. Alternatively, the employer could buy back for cash a sufficient number of shares of stock acquired upon exercise of the option, so that the amount of cash necessary to satisfy the withholding obligation is available.

Eric D. Schoenborn is a partner in the Business Department of law firm Stradley, Ronon, Stevens & Young LLP and is the chair of Stradley's Publicly Held Companies Practice Group. The author expresses his appreciation to James Podheiser, a partner in the Tax Department of Stradley, for his preparation of the tax section of this article. The author also expresses his appreciation to Steven Scolari, a partner in the Business Department and chair of Stradley's Closely Held/Family Owned Business Practice Group, for his review and comments on earlier drafts.

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