Strategically Structuring Ownership and Employment

08/02/2021

Introduction
This chapter offers basic information for small and mid-sized privately held companies2 about providing equity incentives for employees or other service providers.3 The intent of this chapter is to enable entrepreneurs to more effectively interact with company counsel in determining whether and how to set up equity (or similar) incentive plans. Topics addressed include basic structuring of equity incentives, tax planning, and limited securities compliance discussion.4

Why Give Equity Incentives?
Why give equity incentives to employees? One answer is that often cash is hard to come by in the early in the life of a company. Without cash, it can be difficult for a small business to attract and retain talent. Another reason is that it may pay, in terms of productivity enhancement and incentivizing greater effort, to align the interests of the employees with those of management, founders and investors by giving employees an equity stake in the success of the business.

On the other hand, each founder should address whether he or she wants to contend with the headaches, cost and complexity that result from granting equity or equity-related incentives to employees and other service providers. After understanding the structuring, tax and securities issues, and the added fiduciary responsibilities that result from giving equity to employees, many founders determine that the risks and complexities outweigh the hoped-for benefits. In fact, once employees themselves are exposed to the difficult decisions relating to equity incentives, even they may prefer simple cash compensation. Also, many founders place a higher value on their equity than would their employees. Thus, founders may give up, directly or indirectly through higher compliance costs, distraction of management attention and other concerns, far more through equity incentives than they would from paying simple tax-deductible cash bonuses.

Nevertheless, you may still desire to grant equity incentives to employees. Equity incentives can motivate employees for long-term performance in ways that cash cannot. You may be forced to pay below market salaries during the startup period, and a good way to retain and motivate key management positions is through equity compensation.

Who Should Receive Equity Incentives?
You may have read about people like Bonnie Brown, the masseuse who took a job at some company called “Google” that paid just $450 a week, but included a pile of stock options that she figured would never be worth anything.5 Deciding which of your employees will receive equity compensation is a decision that can have significant consequences. In the well-known example of Google, the founders may have been more generous than they needed to be. On the other hand, it is also possible for owners to be too stingy and fail to reward important employees with equity compensation, with the result that employees leave the company for better opportunities. Finding the right balance is a challenge.

An important consideration to keep in mind is that employees who receive equity compensation become more than employees; they become

part owners. This is often the point, to secure loyalty and motivation of such key personnel. As a fellow owner, a key employee can have the sense of control and responsibility that motivates the employee to work hard and stay committed to the company. On the other hand, if your relationship with the employee deteriorates, without a contract spelling out a means for the company to recover the equity from the employee, it can be more difficult to sever ties with an employee who is also an owner. To protect the company against ensuing problems, companies should give advance consideration to requiring vesting and imposing repurchase options, transfer restrictions and voting covenants on any equity to be granted to employees.

 

3. How Much Equity Should a Company Award to Employees?
How much of an employee’s total compensation should be composed of equity awards? This question has two parts: (1) first, how much of the company should the owners set aside to grant to employees, and (2) second, how much of an employee’s salary should be composed of equity incentive awards?

The ownership and board of a company must begin the process of choosing an equity incentive plan by deciding how much of the company they are willing to set aside to compensate certain key employees. Often, owners begin by looking at what they need to retain control of the company, and choose a somewhat arbitrary number that can be used as compensation. The first step in this process is often obtaining a valuation of the company. After all, if a board is going to consider setting aside 15% of the shares of the company as equity compensation, it needs to know what 15% of the company is worth. There are also various tax concerns discussed below that may make it advisable to obtain an independent valuation of the company.

The next question pertains to the percentage of an employee’s salary that should be composed of equity compensation. Many industries follow a percentage number to use as a guide (for example, 10%), which may be important to key employees or necessary to recruit or retain key people. The answer will depend on a number of factors, which may include industry norms, the company’s ability to pay the cash component of the employee’s salary, and the need to provide incentives. The less the company has the ability to pay the market level of cash salary, the more the company may have to make up for it in equity compensation.

Basic Types of Equity Incentive Awards
Many companies adopt a generalized equity incentive plan that authorizes the board to grant a variety of equity incentive awards. The company may only decide to grant one type of award, but a plan that allows the granting of a variety of types of awards provides flexibility to the company if needs change over time. This section discusses the different types of awards in a typical equity incentive plan.

Introduction to Stock Options
Stock options are a popular equity compensation award in C corporations. Stock options are essentially a contract between the company and the employee that provides the employee the opportunity to purchase a number of shares of the company stock at a set price for a fixed time. Here are some important terms to understand about stock options:

  • Vesting: Usually the options are subject to a period of restriction on either exercisability or ownership of the option (or both) which is known as “vesting.” Different companies and industries choose to have different vesting schedules. Vesting of options over time protects the company and incentivizes the employee to remain.
  • Exercise: The employee can “exercise” her stock options, and purchase the stock from the company for the “exercise price” that is determined at the time of the grant of the options.6 The exercise price is usually equal to the fair market value at the time of the grant of the stock options.
  • Option Term: An employee must exercise her options before they expire at the end of the “option term” (option grants typically have a 10 year term).
  • Spread: When an employee exercises her option, the “spread” is referred to as the increase in fair market value over the exercise price.
  • Liquidity: Liquidity is often referred to as the ability to sell the shares received upon exercise. As discussed below, legal or tax restrictions, or the lack of a market, can affect the liquidity of options and other equity awards.

Companies like the motivational effect of stock options; the options are only worth something if the company increases in value. Below is a discussion of the two main types of stock options: incentive stock options and non-statutory stock options.

Incentive Stock Options (ISOs)
All stock options are meant to “incentivize” employees. However certain stock options qualify for preferential tax treatment under the tax code, and are defined as “incentive stock options” (also called “statutory stock options” or “ISOs”).7 ISOs have two principal tax benefits: (1) they allow the employee to defer the tax on the spread (the difference between the exercise price and the fair market value at the time of exercise) until after the employee sells the underlying shares, and (2) they allow the employee to qualify for the lower capital gains tax rate on the spread instead of the income being taxed at the ordinary income rate. In order to qualify a plan to grant ISOs, the plan and the stock options issued thereunder must be designed and operated in a matter that complies with a list of requirements, including the following:

  • Corporations Only. Only corporations can grant options that qualify as ISOs.8 S-corporations can issue ISOs, but keep in mind that S-corporations can only issue a single class of stock to all its shareholders.
  • Employee vs. Independent Contractor. Only employees can be granted ISOs. Independent contractors can only be granted nonqualified options.
  • Holding Period: In order to qualify for long-term capital gains taxation, the optionee must hold the stock received from exercise of the option for at least one year following exercise of the option, and two years following the option grant date.9
  • $100,000 Limit: An employee can exercise only $100,000 worth of ISOs during any calendar year,10 as measured by the fair market value on the grant date for the option.11
  • 10% Ownership Rule: If at the time the option is granted, the employee owns more than 10 percent of the voting power of the stock of the company (or of its parent or a subsidiary corporation), then the exercise price must be 110% of the fair market value on the grant date.12
  • Shareholder Approved Plan: The options must be granted pursuant to a plan approved either before the grant or within one year thereafter by the stockholders that, among other things, fixes the aggregate amount of shares to be issued pursuant to the plan.13
  • Exercise Period: The option must be granted within 10 years from the date the shareholders adopt the stock option plan,14 and the option cannot be exercisable after the expiration of 10 years from the date the option is granted.15
  • Exercise Price: At the time of grant of the option, the exercise price cannot be less than the fair market value of the stock.16 This is discussed further below in the section on NSOs.

     

  • Option Transfer Restriction: The terms of the option cannot allow the employee to transfer the option before exercise, except through a will.17
  • No Company Tax Deduction: The company cannot take a tax deduction when an employee complies with the ISO rules.

    Many restrictions must be met to qualify options as ISOs. And the tax benefits of ISOs (you can defer the tax normally imposed after exercise until after disposition of the stock, if ever, and the gain is taxed at long-term capital gain instead of ordinary income rates) can be less than imagined because of the alternative minimum tax (AMT).18 For private companies, where there is no market to sell the shares received upon exercise, an employee could face an income tax liability without any cash to pay the tax.

    Non-Qualified Stock Options (NSOs)
    Options that do not qualify as incentive stock options under Code Section 422 are referred to as “non-qualified stock options” (NSOs). NSOs do not have to meet any of the requirements listed above for ISOs. However, if the options have an exercise price that is below the fair market value of the stock on the date the options are granted (“discounted options”), there will be significant tax and penalties due under Code Section 409A.19

    In order to avoid the penalties of Section 409A, the company must provide evidence that the options were not issued at a discount to fair market value. For private companies, this means obtaining a valuation by an independent appraiser at least annually.20

    NSOs generally do not have any tax consequences when they are granted, if the exercise price is not less than the fair market value. At the time of exercise, the employee will be taxed on the spread between the exercise price and the fair-market value. This income will be taxed at the ordinary income rates. Upon disposition of the stock after exercise of the option, any appreciation would be eligible for capital gains treatment. The company is eligible for a tax deduction equal to the amount of income incurred by the employee taxed as ordinary income.

    There are many reasons why companies favor NSOs over ISOs. From the company’s perspective, there is less compliance and associated paperwork than with ISOs, and the company gets a tax deduction that it wouldn’t receive with ISOs. Employees sometimes favor NSOs because the preferential tax treatment afforded to ISOs comes with too many strings attached. And the tax treatment itself may not be good at all if it triggers payment under the alternative minimum tax. For these reasons, the majority of stock options that are issued are NSOs.

    Unrestricted Stock
    Unrestricted stock refers to the simple practice of granting shares of stock to an employee as compensation for services, without vesting restrictions. The stock can be granted as a normal part of a salary (such as receiving a certain number of shares with each paycheck) or as a reward for achieving certain performance metrics.

    Although unrestricted stock has no vesting, the shares can still be subject to certain restrictions on transferability. For example, the company could require that the shares be resold to the company if the employee quits, or at least provide the company with a right of first refusal. Some companies choose to restrict the voting rights by either requiring that the shares be voted as directed by the CEO or by creating a separate class of nonvoting shares to grant to employees.

    The tax consequences of unrestricted stock grants are straightforward. The employee recognizes ordinary income in the amount of the value of the stock at the time of grant, except to the extent income is offset by a payment from the employee to the company equal to the value of the stock purchased.21 The accompanying tax bill is perhaps the biggest disadvantage to unrestricted stock grants. The company can choose to provide an amount of cash to the employee to cover the tax liability (of course, that cash bonus is also subject to tax). The company must report the stock grant and any cash bonus on the employee’s Form W-2. The company can deduct the amount of the stock grant as a business expense. Companies choose unrestricted stock grants because they are simple for employees to understand, and have the benefit of a resulting in an immediate ownership stake. Although most companies value the incentives that come with the vesting schedule of options or restricted

    stock, some companies value the simplicity of unrestricted stock.

    Restricted Stock
    Restricted stock awards (RSAs) are similar to unrestricted stock, but are subject to a vesting period or other milestone achievement. Companies that prefer to impose a vesting requirement appreciate the effect of the vesting schedule to incentivize employees to remain with the company. As discussed above in the section on “Vesting Incentives,” the vesting schedule can either be based on time schedule or based on performance metrics, or even a combination of both. Although it is less common, some companies require the employee to purchase the stock, normally at a discount. However, the shares are granted to the employee on a grant date, and subject to a vesting period.

    After grant, but before the vesting period lapses, RSAs are often held in escrow, and the employee is usually entitled to receive any applicable dividends and voting rights. Similar to restricted stock awards are restricted stock units (RSUs). When a company grants RSUs, the employee receives a right to receive the shares after the vesting period lapses, so the shares don’t actually transfer until after the vesting period ends. Since the employee does not yet own the stock, RSUs don’t allow the employee to enjoy any dividends or voting rights.

    The tax consequences of restricted stock are fairly straightforward. An employee that receives restricted stock is not taxed at the time of grant, assuming that the stock is still subject to a vesting period, which the IRS calls a “substantial risk of forfeiture.”22 Thankfully, the IRS does not impose a tax on the value of the stock when it could turn out you never meet the vesting requirements and actually gain full ownership of the stock. After the vesting period ends, the employee is taxed on the value of the stock (at ordinary income tax rates), and the company is eligible for a tax deduction for the same amount.

    An employee can make a special election, however, after an RSA is granted to voluntarily accelerate any tax due upon grant of the restricted stock. Named after its place in the tax code, this election is called a “Section 83(b) Election.” Why would an employee make an election to accelerate taxes? Although the election accelerates the tax due (usually a bad thing), any appreciation on the stock after the election is eligible for preferential capital gains treatment, which is lower than ordinary income rates. The election must be made within 30 days of grant.23 There are risks to the employee if the stock declines in value or the employee never fulfills the vesting restrictions. No loss is allowed under Section 83(b) if the stock is forfeited or not received.24 Employees should weigh carefully the risks and rewards of making the Section 83(b) Election with their tax advisor.

    There are several reasons why companies choose restricted stock over stock options. For starters, stock options can easily become worthless if the value of the stock falls below the exercise price, while whole shares that are granted with restricted stock usually retain some value, even if it declines. In addition, because restricted stock retains some value, less shares are required to be granted, as opposed to stock options. A rule of thumb is that each restricted share is worth about three options.25 As a result of this reality, stock options appear to result in more dilution on a company’s earnings per share ratio than restricted stock.

    Phantom Stock
    Some companies want to tie part of an employee’s compensation to stock performance, but don’t want to actually transfer shares to employees. With phantom stock, the employee does not actually receive stock, but instead receives a phantom grant of hypothetical shares of the company. After the end of a vesting period or the passing of a certain event (e.g., a performance metric achieved, sale of the company, IPO, etc), the employee receives the value of the shares in cash. Thus, a grant of phantom shares itself has no value until the occurrence of events triggering a payment under the plan.

    The tax consequences of phantom stock are similar to receiving a cash bonus. The employee recognizes ordinary income in the amount of the cash received at the time it is received which is reported on the employee’s Form W-2, and the IRS will require income and employment tax withholding. The company is allowed a tax deduction for the same amount.

    Although it may take some education, employees generally appreciate phantom stock and RSAs because “cash is king,” and it can be seen as superior to other stock awards that are not liquid.

    Companies that choose phantom stock generally do so because they are reluctant to issue stock of the company to employees. This could be because of concerns about additional dilution, or perhaps staying under the 100-shareholder limit for S-corporations. The downside to the company is that it is obligated to make a big cash payout to the employee if there is a significant appreciation in the company’s value.

    Direct Stock Purchase Plans
    Some businesses want to provide a way for their employees to invest in the company, to raise capital and to allow employees to make a contribution to the future of the company. Smaller, private companies may use direct stock purchase plans to accomplish this goal. In direct stock purchase plans, the shares are normally purchased for their fair market value (without a discount), and thus generally there are no adverse tax consequences (of course, the employee will eventually have tax liability on the gain from her re-sale of the stock). The company is not responsible for any employment taxes. As discussed above with respect to unrestricted stock, some companies can choose to require that the stock be resold to the company or at least a right of first refusal in order to allow the company to keep the stock out of the hands of unwanted outsiders.

    Incentive Awards for Limited Liability Companies
    Limited liability companies (LLCs) are the most popular form of business entity for small businesses. This is primarily because LLCs are not taxed separately (at the company level) but instead their income is allocated to the “members” and payable only by them, and thus the “company layer” of taxation is removed. LLCs also enjoy flexibility as to how they share profits of the business among members (who may be capital members and/or only profits interest members). LLCs are advantageous for these reasons, but structurally they are also very different than corporations. Although they do not issue stock, they are able to issue units of LLC member interests or options therefore (or restricted units) and can generally replicate almost any form of equity incentive that is available in a C corporation (other than ISOs).

    Capital Interests
    The simplest equity compensation award to an employee would be a grant of a capital interest in the LLC, without any restrictions or vesting period. A capital interest is an equity interest in both the profits and the assets of the LLC (very similar to stock in a corporation). Accordingly, LLCs with significant assets or profits will want to think carefully about the value of the interest they intend to grant to employees.

    The employee is taxed at the ordinary income rate on the value of the capital interest on the date of grant, and the IRS will require income and employment tax withholding. If the capital interest is subject to restrictions such as a vesting period, the employee will be taxed upon the lapse of the vesting period or other restrictions, unless the employee made a Section 83(b) Election within 30 days of the grant date. The Section 83(b) Election is a trade-off that requires the employee to be taxed on the value of the interest at the time of grant at ordinary income tax rates, but allows any subsequent appreciation to be taxed at capital gains rates (see additional discussion of this election above under the heading “Restricted Stock”). A Section 83(b) Election made at the grant of a capital interest will cause the employee to be treated as a partner for tax purposes, and be allocated a share of the profits or losses of the partnership on a Schedule K-1.

    The company is allowed a tax deduction for a corresponding amount. Before the existing members of an LLC grant a capital interest to an employee, they will want to obtain a valuation of the company to avoid transferring to the employee any pre-grant appreciation in the value of the company.

    Profits Interests
    Another type of equity compensation award for LLCs is a profits interest. Unlike a capital interest, a profits interest does not give the holder a share of the company’s assets (which would be distributed, for example, after a liquidation) or any right to receive income earned by the company before the date of the grant. A profits interest only entitles the employee to a share of the company’s future profits earned, or future appreciation in value realized, after the date of grant of the profits interest. The profits interest can be granted without restriction, or subject to vesting requirements.

    If the profits interest fits within the safe-harbor criteria outlined by the IRS, there will be no tax upon the grant of the profits interest if under the terms of the profits interest grant, the profits interest has no value at the time of grant.27 In addition, to meet this safe harbor, the profits interest must (1) be received by the employee in her capacity as a member or in anticipation of becoming a member, (2) the profits interest cannot be related to a substantially certain and predictable stream of income, and (3) the profits interest cannot be taken with an intent to sell it within two years after it is received.28 The other members of the LLC would not be eligible for any tax deduction if the new member is not taxed after receipt of the profits interest.29 If the profits interest is vested, or even if it is unvested and the employee has made a Section 83(b) Election, the employee will be treated as a partner and receive tax allocations of profit or loss on a Schedule K-1.

    There are administrative burdens to LLCs granting profits interests. Similar to capital interests, the LLC needs to do a valuation of the company (usually by a third-party appraiser) at the time of each grant of the profits interest. There will also be a need to adjust the capital accounts of the old members to ensure that the new member does not receive any pre-grant value in the company. The cost and time that it takes to undertake these valuations discourages LLCs from frequent grants of profits interests, but profits interests are becoming increasingly popular because they permit an incentive to be granted without triggering income tax to be paid by the employee or the company as a result of the grant itself.

    Securities Law Considerations
    The securities laws pertaining to the issuance of stock and other securities are extensive, and a detailed discussion is outside the scope of this chapter. However a few issues should be highlighted. Generally, federal securities laws provide that a company cannot offer securities unless a registration statement is filed with the Securities and Exchange Commission (SEC) under the Securities Act of 1934 unless there is an applicable exemption. Because registration with the SEC is very expensive and onerous process, startup companies almost always seek capital in the initial phases through an available exemption.

    Rule 701 is a federal exemption from the registration requirements, which allows private companies to offer and grant unregistered securities to employees under non-capital-raising plans. Rule 701 is the most commonly used exemption used in connection with securities offered to employees as equity compensation. Many states have adopted state- law counterpart exemptions for use in situations in which the federal Rule 701 is relied upon. Rule 701 has limitations: The total amount of securities sold under Rule 701 cannot exceed the greater of (1) $1 million, (2) fifteen percent of the total assets of the company, or (3) fifteen percent of the outstanding amount of securities of that class. Alternatively, for grants of incentives that do not comply with Rule 701, compliance with Regulation D, Rule 506, can be used (even along-side one or more Rule 701 grants) to exempt such other incentives from registration requirements under the securities law.

    Federal securities laws also require a company to register its shares (i.e., to “go public”) when they exceed the 500-person threshold. In summary, when a company has any class of security held by five hundred or more persons, and the Company owns more than $10,000,000 in assets, the company must “go public” and register its shares under the Securities Exchange Act of 1934 and file periodic reports whether it wants to or not.30 Option holders are not counted toward this number. Certain companies such as Facebook have been forced to go public because of this rule.

    Conclusion
    The decision whether to offer equity incentive awards should be undertaken with a careful consideration of the costs and benefits. Which employees should receive awards, and how much of their compensation should be composed of equity incentive awards, are equally important decisions. There are many different types of equity incentive awards, and it may seem difficult to decide which type of award is right for your company and employees. A competent advisor can assist in these decisions and implement a plan that works for your business.

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