Compensating employees with equity compensation is not uncommon, particularly with start-up companies. Unfortunately, what also is not uncommon are unforeseen consequences detrimental to the business or employee when equity plans are poorly structured. Our panel of experienced attorneys will discuss a myriad of equity related issues, including: positive and negative aspects of stock options (ISOs or NQOs?); founders stock, restricted stock and 83(b) elections, as well as common pitfalls, including fair market value, change in control and permissible payment dates under Code Section 409A; which employees are given equity; what equity grant vesting and buyback restrictions are typical and why, and what impact does equity compensation have on mergers and IPOs?
Moderator:
Melvin J. Muskovitz
Dykema Gossett PLLC
Panelists:
Charles M. Russman
Bodman PLC
Margaret Hunter
Dykema Gossett PLLC
Business Law & Order - September 16, 2013 - What you don't know can cost you - Getting equity compensation right
1. Business Law & Order:
What you don’t know can hurt you –
Getting equity compensation right
September 16, 2013
2. GETTING EQUITY COMPENSATION RIGHT
SPARK Business Law & Order Program – September 16, 2013
Margaret Adams Hunter – Dykema
Charles M. Russman - Bodman
4. 4
Who Gets Equity Compensation?
• Those who impact value of company stock
– Founders
– Officers
– Key employees
• Some key employees may receive “synthetic equity” - cash
payments instead of stock, equal to increase in value of actual
shares without actually transferring shares
5. 5
Common Forms of Equity Grants
• Nonqualified Stock Options (NQOs)
• Incentive Stock Options (ISOs)
• Stock Appreciation Rights (SARs)
• Restricted Stock
• Restricted Stock Units (RSUs)
• Straight Stock Grants
• Phantom Stock
6. 6
Nonqualified Stock Options (NQOs)
• Granted to employees/independent contractor service
providers
• Service provider recognizes income equal to difference
between exercise price on Grant Date and fair market value
(FMV) on Exercise Date (Spread)
• Spread is taxed at ordinary income tax rates - considered
“wages” subject to FICA, FUTA and income tax withholding if
service provider is an employee
• Company receives tax compensation deduction equal to
amount of income recognized by service provider
• At disposition, service provider receives capital gain (CG) on
difference between exercise price and disposition price
7. 7
Incentive Stock Options (ISOs)
• Subject to Code Section 422
• Holding period for CG treatment = two years from Grant Date and
one year from Exercise Date
• Unless employee is subject to alternative minimum tax (AMT) in
year of exercise, tax is deferred until disposition date
• If holding period is met, employee receives CG on difference
between exercise price and disposition price; company receives no
tax deduction
• If holding period is not met, employee receives ordinary income in
year of disposition equal to difference between exercise price and
FMV at exercise (or sale price if lower); amount in excess of FMV at
exercise is gain; company receives compensation tax deduction =
ordinary income recognized by employee
• ISO income not deemed to be wages; not subject to FICA, FUTA or
income tax withholding
8. 8
ISO Requirements
• Only may be granted to employees (not independent contractors)
• Plan must be approved by shareholders with cap on available ISO
shares
• Plan cannot exceed 10 years
• Maximum exercise term = 10 years; 5 years for 10% shareholders
• Exercise price must equal or exceed FMV on Grant Date; exercise
price for 10% shareholders must equal or exceed 110% of FMV on
Grant Date
• Employee restricted from exercising more than $100,000 of ISOs
that first vest in one calendar year
• ISOs are nontransferable
• To retain ISO tax status, ISO must be exercised within 90 days after
employment termination; longer for death or disability
9. 9
ISOs v. NQOs
• Employees prefer ISOs for CG treatment and tax deferral until
disposition (unless AMT applies)
• Most valuable to employees when CG rates are much lower
than ordinary income tax rates
• Companies prefer NQOs for compensation tax deduction;
ISOs are much more expensive
• Due to corporate cost, NQOs are much more common
10. 10
Stock Appreciation Rights (SARs)
• Available for employees/independent contractors
• Payable in stock or cash
• Payment equals difference between FMV of shares on Grant
Date and Exercise Dates
• At exercise, service provider recognizes ordinary income on
spread - subject to FICA, FUTA and income tax withholding if
service provider is an employee
• Company receives compensation tax deduction equal to
ordinary income recognized by service provider
11. 11
Restricted Stock
• Grants to employees/independent contractors subject to
restrictions based on continued employment (time-vesting) or
attainment of performance goals
• Sometimes referred to as “performance shares” when
restrictions are based on performance goals
• Shares are restricted from transfer until restrictions lapse
• Typically, grants are straight compensation without payment
from service provider
12. 12
Restricted Stock - Taxation
• Service provider may file 83(b) election within 30 days after
Grant Date to be taxed currently at Grant Date FMV
• Otherwise, service provider is taxed at FMV when restrictions
lapse (usually higher FMV)
• Income is ordinary income, subject to FICA, FUTA and
income tax withholding to employee; company receives a
compensation tax deduction equal to ordinary income
recognized by service provider
13. 13
Restricted Stock Units (“RSUs”)
• “Synthetic” form of restricted stock
• Income is based on value of “hypothetic shares” of restricted
stock
• Usually payable in cash, sometimes in actual shares
• Subject to time-vesting or performance goals
• Not eligible for 83(b) election, as no property (i.e., no actual
shares) transfer at Grant Date
• Ordinary income to recipient at time of payment, subject to
FICA, FUTA and income tax withholding to employee
• Company receives compensation tax deduction equal to
income recognized by service provider
14. 14
Straight Compensation Stock Grant
• No payment required by employee/independent contractor
• Usually no attached restrictions
• Ordinary income to service provider at grant - subject to FICA,
FUTA and income tax withholding if employee
• Company receives compensation tax deduction equal to
income recognized by service provider
15. 15
Phantom Stock
• Another form of “synthetic” award
• Similar to SARs, but payments usually are in cash and not
shares
• Frequently used by privately-held companies that do not want
to lose control of actual shares but want key employees to
participate in appreciation in value of shares
• Upon receipt of payment, service provider receives ordinary
income equal to FMV of payment, subject to FICA, FUTA and
income tax withholding if employee
• Company receives compensation tax deduction equal to
income recognized by service provider
18. 18
Code Section 409A
• Regulates nonqualified deferred compensation, including
equity that constitutes nonqualified deferred compensation
• Broad definition of nonqualified deferred compensation –
usually compensation earned in one year that is paid in a later
tax year, unless exemption exists
19. 19
Code Section 409A Exemptions
• ISOs are exempt from 409A if granted at FMV but using a
stricter FMV definition than Code Section 422
• NQOs and SARs also usually exempt if granted at 409A FMV
• Restricted Stock is exempted from 409A
• Short-Term Deferral Exemption if compensation is paid within
2-1/2 months after later of calendar year or fiscal year when
vesting occurs
• RSUs are not exempted from 409A, although usually qualify
for Short Term Deferral Exemption
20. 20
Code Section 409A - Requirements
• If no 409A exemption, compensation must comply with 409A
• Limited 409A payment times
– Fixed payment date
– Separation from service
– Change in Control (409A definition)
– Disability (409A definition)
– Death
– Financial Hardship (extreme 409A definition)
• Payment date and form of payment generally must be set
before compensation services are rendered; limited ability to
change later, which generally extends payment date at least
five years
21. 21
Failure to Satisfy Section 409A Requirements
Deferred compensation subject to:
• Ordinary income tax
• 20% excise tax
• Interest at IRS underpayment rate, plus one percent,
retroactive to later of deferral or vesting date
23. 23
Golden Parachute Rule
• Aggregate compensation (including equity) paid or
accelerated to top executives due to a change in control (CIC)
is subject to a 20% excise tax if golden parachute cap is
exceeded
• Excise tax applies when aggregate CIC amount equals or
exceeds 3x employee’s average W-2 compensation for five
calendar years preceding calendar year of CIC
• When excise tax applies, employee pays ordinary income tax,
plus excise tax on amount that exceeds 1x five-year average;
company loses compensation tax deduction on amount in
excess of employee’s 1x five-year average
24. 24
Golden Parachute Cap
• Must be set below 3x employee’s five-year W2 average
• Common Golden Parachute Caps
– 2.99 x employee’s five-year W-2 average
– 3x employee’s five-year W-2 average minus $1.00 (usually
provides higher amount than 2.99 cap)
25. 25
Parachute Payment Exemptions
• Payments from a company that was sub-s immediately prior
to the change in control; and
• Payments from a non-publicly traded company if immediately
prior to CIC, shareholders of 75% of the voting stock approve
the parachute payments after receipt of required disclosure
27. 27
Common Equity Sources
• Original Equity – Founders Themselves
• Later Equity Investors
– Angel Investors/Angel Groups
– Venture Capitalists
– Private Equity (PE) Groups
• Initial Public Offering (IPO)
28. 28
Founders Stock
There is no required form of Founders Stock
•Frequent Characteristics: (set by Articles/Bylaws)
– Granted to a company’s early employees
– Issued at a low par value (if state has par value)
– Subject to a vesting schedule
– Convertible to another type of stock; i.e., preferred
– Additional voting rights
– Other preferential rights; i.e., preferred liquidation
– Tax issues if value is set too low
29. 29
Well-Known Examples of Founders Stock
• The “FF class” – Created by Sean Parker (Napster/Powerset)
– Permits an earlier cash-out
– Convertible to any future class of stock on occurrence of
certain conditions
– Capped at 10-15% of a founder’s shares
• “Class F” common stock
– Super-voting stock: 10 votes per share vs. 1 vote per
share for Class A common stock
– Requires approval of the majority of Class F shareholders
for certain fundamental decisions
– Class can name director to Board who has two votes
30. 30
Consequences of Founders Stock
• Advantages to Founding employees
– Greater control
– Economic payout
– Substitute for compensation in early stages
• Disadvantages to later investors
– Obstacle to desired equity investment structure
– Could lead to early exit of founding employees
31. 31
Typical Angel Investors
• Definition: a person providing capital, in the form of debt or
equity from his or her own funds to a private business owned
and operated by someone who is neither a friend nor a family
member of the investor
• Individual angel investors often join angel groups to pool
funds, evaluate projects, and provide mentoring and contacts
to their funded projects
• Typical angel investor characteristics:
– Wealthy: frequently “accredited” under SEC net worth
definition
– Business background: commonly has business or
entrepreneurial experience
32. 32
Later, Pre-IPO Investor Groups
• Typically require preferential stock rights for themselves
– Preferred stock or new designated series stock with additional
rights to investor group that avoid/limit equity dilution from
later rounds of financing
– Additional rights typically involve early distribution payment
dates and first payment upon dissolution or liquidation
• Investor groups require top officers to purchase stock to get “skin
in the game”
• Most equity granted to officers/key employees subject to
attainment of designated performance goals and is subject to
buy-back rights, including right of first refusal to investor group if
stock recipients terminate employment
34. 34
Margaret A. Hunter (“Meg”)
Dykema
39577 Woodward Ave., Suite 300
Bloomfield Hills, MI 48304
mhunter@dykema.com
(313) 568-6788
Charles M. Russman
Bodman PLC
201 W. Big Beaver Rd.
Suite 500
Troy, MI 48084
crussman@bodmanlaw.com
(248) 743-6039
