The Decision-Maker’s Guide to Equity Compensation
Second Edition
Corey Rosen, Pam Chernoff, Elizabeth Dodge, Daniel N. Janich, Scott Rodrick, and Dan Walter
Published by the National Center for Employee Ownership at Smashwords
Copyright © 2007, 2011 by the National Center for Employee Ownership
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Contents
Introduction:
Creating an Equity Compensation Plan
That Works for Your Company
Corey Rosen
Corey Rosen
2. Unrestricted Stock Grants and Stock Purchase Plans
Scott Rodrick
3. Restricted Stock Awards and Restricted Stock Units
Corey Rosen
4. Phantom Stock and Stock Appreciation Rights
Corey Rosen
Dan Walter
6. ESOPs, Profit Sharing, and 401(k) Plans
Corey Rosen
7. Equity Interests in Limited Liability Companies
Daniel Janich and Corey Rosen
8. Deferred Compensation Issues
Corey Rosen
9. Accounting for Equity Compensation
Pam Chernoff and Elizabeth Dodge
10. Securities Law Considerations
Corey Rosen and Daniel N. Janich
11. Special Considerations for Public Companies
Corey Rosen and Pam Chernoff
12. Designing an Equity Incentive Plan
Corey Rosen
13. Deciding on Executive Equity
Corey Rosen
Preface
Providing employees with some kind of ownership or ownership right through equity compensation is a widespread practice in American business. There are many publications available detailing the legal, tax, accounting, and financial planning aspects of equity compensation, but, until now, none exclusively focused on helping people who are designing plans decide what kinds of equity to choose, and who should get how much and when. Are options a better fit than restricted stock? What are the pros and cons of phantom stock and stock appreciation rights? Should employees be able to buy stock? If so, how?
Aside from picking a form of equity, businesses must decide who will be eligible, what rules will govern how and when employees can get awards, how awards will be earned, what rights employees will have, how to provide liquidity for the awards, and many other critical issues. All too often, these decisions are made based on some rule of thumb (“10% is a good amount of equity to give out”), what someone has heard “everyone else” does, or what a consultant with limited experience advises (often what the consultant knows best, not necessarily what would work best).
Many technical issues have to be considered, such as the tax consequences of the plan, securities law rules, accounting issues, and contractual concerns. While these are important, plans should be primarily driven by corporate objectives for attracting, retaining, and motivating employees.
This book looks at these critical design issues, providing an easy way to compare different types of equity, think about different plan rules, and understand the key technical considerations in setting up and managing a plan.
Writing this book was a team effort by Corey Rosen and Scott Rodrick, both very experienced NCEO staff, and Pam Chernoff (a Certified Equity Professional [CEP]). In addition, Dan Walter, CEP, of Performensation authored the chapter on performance awards; Dan Janich of the Janich Law Group coauthored the chapters on LLCs and securities law; Elizabeth Dodge, CEP, of Stock & Option Solutions coauthored the chapter on accounting; and Alisa Baker of Levine & Baker provided a technical review of the chapter on stock purchase plans. Christine Zwerling, CEP, added valuable input for several of the book’s chapters. We very much thank these experts for their generous assistance. Any errors, of course, are ours.
NCEO members should feel free to call us to pursue any issues related to equity compensation in further detail. More technical material on all the subjects in this book can be found in other NCEO publications. Go to www.nceo.org for details.
About the Second Edition
For the second edition, we added new chapters on performance awards (chapter 5) and limited liability companies (chapter 6). With Pam Chernoff in the lead, we also revised every existing chapter to bring it up to date, clarify the existing material, and add new explanations where needed. (The accounting chapter, which now features Elizabeth Dodge as a coauthor, has been completely rewritten.) Additionally, most chapters now feature a section at the end with suggestions for additional reading.
Introduction: Creating an Equity Compensation Plan That Works for Your Company
Corey Rosen
In 2010, a national survey showed that 38% of the employees who worked for companies that have stock own at least some employer stock, or hold stock options or some other equity right. At the same time, equity compensation is making up larger and larger portions of executive pay, especially in larger companies. The growing importance of equity as an element of compensation is not surprising. Since the 1970s, inflation-adjusted wages have grown at less than 0.3% per year, and they declined 29% for males in the last decade, while inflation-adjusted returns on equity during that time have been about 7% per year. This disparity is a historical anomaly. In the past, wages and return on capital have grown more or less in tandem. There are lots of explanations for this—globalization’s downward pressure on wages, the economy’s shift from manufacturing to service industries, “winner take all” compensation structures, and others—but the result is that more people want to get a piece of the equity pie.
At the same time, companies have put more emphasis on equity pay as their cultures shift from traditional, hierarchical management to leaner and more open participative approaches in which more employees at all levels are given increasing responsibilities to make more decisions (or at least to have input into more decisions) about more things more quickly. Traditional control mechanisms—threats, close supervision, individual incentive pay, highly structured and simplified tasks—are giving way to engagement models that rely more on employees’ internal motivation. In effect, employees are being asked more and more to think and act like owners. In this environment, employees need a reason to care, and what better reason than to actually be owners?
Finally, employees are less loyal than they had been, in part because they believe employers are less loyal to them. According to a recent survey by job-placement firm Manpower, an astonishing 84% of employees planned to look for a new position in 2011, up from just 60% in 2010. The desire for better pay and better career opportunities, and unhappiness with their current jobs were (in that order) the main reasons. Even at the executive level, job tenure has become increasingly short, with average CEO tenure falling to about five years in public companies (comparable data are not available for private companies). Yet as employees have been given more responsibility, the costs of employee turnover have grown. When companies had mostly highly segmented, routine tasks, new employees could be trained quickly because there were so few things to learn. Now there is so much more to master, much of it company-specific, that even replacing line employees is very expensive, let alone key executives. A Mercer Human Resource Consulting study in 2005 found that 43% of respondents put the cost of training a new employee at $10,000; one-fifth put it at $30,000. Attracting and retaining good people, therefore, has become more essential than ever, yet also much harder. In an economy in which virtually every company proclaims “people are our most important asset,” a company’s actual treatment of employees may be the key differentiator between winners and losers.
Research on equity compensation plans indicates ownership can be a powerful tool in this effort. Turnover rates at companies with broad-based ownership plans are significantly lower than at companies without these plans. A study by WorldatWork found that, dollar-for-dollar, stock options were the most cost effective of several approaches to decreasing turnover. Research by the NCEO has shown that the more stock employees get in employee stock ownership plans (ESOPs), the less likely they are to leave. Turnover rates in 100% ESOP companies, in fact, are about half of that in comparable non-employee-owned companies. Employees also consistently report that, other things being equal, the more equity they have, the more they like their jobs regardless of whether the equity is in the form of options or in an ESOP.
There are many ways in which to share ownership with employees. These include stock options, restricted stock, restricted stock units (RSUs), and performance shares, all ways to provide employees with direct share ownership rights. Phantom stock is designed to give employees the equivalent value of ownership, but not actual shares. Stock appreciation rights (SARs) can be designed to pay out in either shares or cash. Tax-qualified employee stock purchase plans (ESPPs) and direct share purchase plans allow employees to purchase shares directly. And a form of retirement plan called an ESOP is funded by the company and provides ownership to most or all employees through a trust. How do you choose which one vehicle or combination of vehicles makes sense?
Cultural Concerns
Of course simply handing out equity is not a magic bullet. Effective ownership companies also create what we call “ownership cultures” by sharing information about company financial and substantive progress, providing structured opportunities for employees to have input into decisions affecting their work, and training them not just in their jobs but in how the company works. The NCEO has publications and other materials on creating such cultures; other NCEO publications provide in-depth looks at various kinds of plans and offer model plan documents. This book discusses the various forms of employee equity arrangements, including the basic tax, securities law, accounting, financial, and practical implications of each. We also discuss key issues in designing any kind of equity plan, such as who should get how much subject to what conditions. The chapters include recommendations for further reading.
Overview of Equity Alternatives
This book’s chapters explore the various forms of equity in more depth. It’s useful, however, to start with an overview. The remainder of this introduction looks briefly at the kinds of equity programs available.
Basic Forms of Individual Equity Plans
There are four basic kinds of individual equity compensation awards: stock options, restricted stock, stock appreciation rights (SARs), and phantom stock. Each of these kinds of awards can be used as performance awards or units, meaning they are granted or vest based on the achievement of performance goals. This approach is covered in a separate chapter. Each form provides employees with some special consideration in price or terms. We do not cover here simply offering employees the right to buy stock as any other investor would receive.
Stock options give employees the right to buy a number of shares at a price fixed at grant for a defined number of years into the future. As with other forms of stock awards described here, the right to exercise the award is usually available only after certain vesting requirements are met, most often working a certain number of years or meeting a performance target. Restricted stock gives employees the right to acquire shares by gift or purchase at fair market value or a discounted value. Employees can take possession of the shares, however, only once certain restrictions lapse, usually meaning once vesting restrictions are satisfied. Phantom stock pays a future cash or share bonus at a specified date equal to the value of a certain number of shares. Restricted stock units (RSUs) are essentially phantom stock awards settled in shares. SARs provide the right to the increase in the value of a designated number of shares, paid in cash or shares. Unlike phantom stock, SARs can be freely exercisable after vesting, although they sometimes pay out at a specific date or upon a specific occurrence. In addition, some companies grant bonuses in the form of company stock.
All of these individual equity award types can be provided to any employee on any terms the company chooses, with some very limited exceptions. Companies can make decisions about who gets the awards, how much they get (with some limits for one kind of stock option), how the company will make a market for the shares, and, within some limits, terms and conditions for the award (such as vesting and how long the award can be exercised). Generally, awards are taxable to the employee as ordinary income when the employee has a nonforfeitable right to them; the employer then gets a corresponding deduction. One kind of stock option, called an incentive stock option (ISO), allows an employee the possibility of paying only capital gains taxes on the award, but in that case, the company does not get a deduction. ISOs can be granted only to employees.
Stock Purchase Plans
Employees can purchase shares directly or through a specialized kind of plan for this purpose called an employee stock purchase plan (ESPP). When employees simply purchase shares directly, they use their after-tax dollars to do so. In some cases, the employer may make loans to the employee to buy the stock. Under the Sarbanes-Oxley Act of 2002 companies are not allowed to make loans to company insiders; however, they can provide loans to other employees. To avoid tax and securities problems, the loans should be recourse notes with an interest rate at or above the applicable federal rate. Companies can choose which employees can buy stock, based on whatever criterion they choose.
Many ESPPs, by contrast, are designed to meet the requirements of Section 423 of the Internal Revenue Code (for simplicity, in this chapter we will refer to plans that comply with Section 423 as ESPPs and to those that don’t as direct stock purchase plans). Under that tax code section, the plan must be available at least to all full-time employees except for those who would, after the ESPP grant, own 5% or more of the company; they must be excluded. However, the company can restrict participation to those who have been employed for at least two years and/or those who work more than 20 hours per week or more than five months per year. The plan must be offered on the same basis to all employees who participate, and no employee can acquire more than $25,000 in stock in one year, based on the stock’s fair market value on the first day of the offering period. Employees typically agree to have some of their after-tax pay reserved to save toward purchasing shares during an “offering period” that can last for a few months to a few years. Companies can (but are not required to) allow employees to buy stock at either the lower price at the beginning or end of the offering period and at up to a 15% discount off the fair market value on which the purchase price is based. If the stock price is $10 at the start of the offering period when the employee begins to set pay aside, and the employee buys stock at the end of, say, six months, when it is worth $12, he or she might be able to buy it for as little as $8.50 (i.e., 15% off the $10 price from the beginning of the offering period); if it drops to $6 at the end of six months, the employee could buy it for $5.10 (i.e., 15% off the $6 price at the end of the offering period). If certain requirements are met, the employee can usually receive better tax treatment than with a nonqualified ESPP.
Any kind of stock purchase plan must comply with state and federal securities laws. These laws generally provide exemptions from stock registration requirements for offers to employees meeting certain rules, rules almost every closely held company can meet without compromising what it wants to do with the plan. But all plans offered broadly to employees must provide for detailed financial disclosure and investment risk discussion. Moreover, if companies end up with 500 or more shareholders, they can become de facto public companies. For these reasons, ESPPs are primarily, albeit not exclusively, found in public companies.
ESOPs, 401(k) Plans, and Profit Sharing Plans
ESOPs, 401(k) plans, and tax-qualified profit sharing plans are all covered by the Employee Retirement Income Security Act (ERISA). All provide means for employees to accumulate assets on a tax-favored basis over the term of their employment. Employers get tax deductions for their contributions to these plans, and employees don’t pay taxes on the money they or their employers contribute to their accounts until they withdraw the money. All of these plans operate through trusts overseen by plan fiduciaries charged with operating them in the best interests of plan participants, and they all are subject to a variety of rules to assure that the benefits of the plan are provided to all qualified employees and on a basis that does not discriminate against lower-level employees. While benefits in the plan can be based on relative compensation (within limits) or on how much employees choose to defer, all employees with at least 1,000 hours of service in a year must be eligible to participate in the plan, and their benefits must be vested over not more than three to six years, depending on the plan and how vesting occurs.
More than 11,000 companies provide ownership to employees through ESOPs, a very specific creature of U.S. tax law with very specific rules and benefits. Unfortunately, this term is often incorrectly used to refer in a generic sense to any kind of ownership plan. Sometimes a stock option plan will be called an “ESOP” as though it were an acronym for “employee stock option plan” instead of for “employee stock ownership plan.” (Other countries sometimes use the term in different contexts—for example, “employee share option plans” in India are referred to as ESOPs, but are not the same as U.S. ESOPs.)
Almost all U.S. ESOPs are found in closely held companies. They are generally entirely funded by the employer. They provide a variety of tax benefits to everyone involved. In addition to the employer’s ability to deduct contributions to the plan, the business owners who sell their stock to the ESOP can in some circumstances defer taxation on the money they receive from the sale. S corporations that have ESOPs avoid taxes on profits attributable to the ESOP’s share of ownership. As a result, S corporations that are 100% owned by their ESOPs do not pay federal income taxes. C corporations can deduct from their taxes both the principal and the interest on any loans their ESOPs had to procure to pay for the shares.
Although ESOPs are most commonly used to provide a market for the shares of a selling owner in a closely held corporation, they can also be used to finance growth or just to provide employees with an ownership interest in the company. They cannot, however, be set up in LLCs or partnerships because they must own employer stock, not some equivalent.
Employers that want to offer company stock in tax-qualified retirement plans can also use 401(k) plans and profit sharing plans as vehicles for employee ownership. Companies can simply make their contributions to the plans in the form of shares, provided they can establish a fair market value for the stock (such as by having an appraisal or being publicly traded), but in 401(k) plans they must allow employees to diversify out of company stock after they’ve held it for three years. Employees can also buy company stock in a 401(k) plan, subject to securities law requirements that may make this difficult in closely held companies. They cannot, however, be forced to hold company stock in their 401(k) accounts. This book discusses ESOPs in more detail than 401(k) or profit sharing plans, because ESOPs are clearly the most tax-favored and effective means to use an ERISA-qualified plan to share ownership broadly.
Kinds of Equity
Companies can offer employees a variety of kinds of equity in their plans, with some restrictions. ESOPs, for instance, must own stock with the highest combination of voting and dividend rights (typically Class A common) or stock that is convertible into that class of stock. Profit sharing and 401(k) plans cannot own options or other forms of equity rights. The necessity that the ESOP get shares that carry voting rights (or shares convertible into such shares) is, as we will see later, not really a problem and should not be a factor in choosing or not choosing an ESOP as it does not mean that owners who want to maintain control of the company must cede that control to workers.
There is no such voting rights requirement for stock option, restricted stock, performance share, or stock purchase plans. Although they all typically provide the right to buy or own common stock, they could just as well offer preferred shares or some other variety of common stock. (Preferred and super common stock typically have higher dividend and/or liquidation rights; in a few cases, special classes of common stock with special voting rights have been created.) The shares may or may not have voting rights, although the existence or lack of these rights may affect how the shares are valued. A company that does not have stock because it is an LLC or a partnership, for example, can offer ownership by granting partnership rights or units instead of stock.
The issue of whether unvested or unexercised equity awards can pay dividends is specific to each type of vehicle and thus is discussed in the individual chapters. In some cases, dividends paid on such awards lead to steep taxes for the award recipient under the tax rules governing deferred compensation.
Making the Decision
The chapter on designing equity plans will help readers think through the various issues involved in choosing a plan or plans and deciding on their features. Before thinking through the nitty-gritty of plan details, however, spend some time thinking about what the plan is for. Is it for business transition? Is it to reward all employees or just some? Is it to motivate employee behavior, and if so, is it aimed at some people or everyone? What kind of ownership rights are you prepared to share (plans can be designed to provide almost none, some, or all of the rights)? Do you want ownership to be a right of employment, or should there be hurdles to getting it? Does it matter to you whether employees actually become shareholders or is your primary concern that they be rewarded for gains in the company’s share price?
Table I-1 looks at the various reasons why a company might set up an employee-ownership plan on the column side of the table and the attributes of plans owners may want on the row side. You can use it as a guide to help think through some of the key issues in picking a plan.
After learning about the basics of equity plans, the next step should be to talk to other businesses about their experiences with sharing ownership. If you do not know any companies that share ownership, you can go to a conference where companies with various sorts of plans, from ESOPs to options, are represented (such as the NCEO’s annual conference) or, if you are an NCEO member, call us for suggestions. Finally, when you are ready to proceed, make sure you find qualified professional advisors who actually have set up many of the specific kinds of plans you choose.
In other words, make this decision as seriously as you would any other essential strategic decision, such as selling the company, making an acquisition, or going into a new line of business. Ownership is a powerful tool that can work very well or very badly. It needs to be carefully thought through.
The Plan of This Book
The following chapters look at several key issues:
• Considerations in choosing and designing any equity plan
• Stock options
• Stock grants, stock purchase arrangements, restricted stock, and restricted stock units
• Phantom stock and stock appreciation rights (SARs)
• Performance awards
• ESOPs, profit sharing, and 401(k) plans
• Equity compensation in limited liability companies
• Deferred compensation rules
• Accounting issues
• Securities law considerations
• Special considerations for public companies
• Designing an equity incentive plan
• Issues in providing equity compensation to executives
In chapters on specific forms of equity compensation, we discuss their tax and legal implications and look at plan design alternatives.
We hope you find the book useful. It draws on 30 years of experience at the National Center for Employee Ownership. We can always learn from your comments, however, and warmly invite them.
Chapter 1: Stock Options
Corey Rosen
Stock options are still the most popular form of equity compensation. Part of options’ popularity stems from the fact that until 2006, companies did not have to show any charge to earnings on their income statements for stock options that had fixed terms, vested over time, and had set exercise prices at grant. Other forms of equity compensation, including performance-vested options, did require a charge to earnings. While this was simply an accounting procedure—it did not affect the company’s taxes or its cash flow—it did provide better “optics” for investors, making companies’ income statements look better than they might have otherwise. Since 2006 almost all forms of equity compensation have required a charge to earnings, and other approaches—particularly grants of restricted stock and restricted stock units—have gained traction, but options, partly because of their familiarity, remain the most common equity strategy.
Stock options provide an employee (or other service provider) the right to purchase shares at a specified price for a set number of years into the future. When an employee exercises the option, the company must make that number of shares available, either by buying them from existing owners or issuing shares. This chapter explores the different kinds of stock options, how they work, how they are taxed, and what you should think about in deciding whether to grant options or other forms of equity compensation.
How Options Work
Basics
A few key concepts help explain how stock options work:
• Option: A contract between a company and an employee granting the employee the right to buy a specific number of the company’s shares at a fixed price within a certain period of time.
• Exercise: The purchase of stock pursuant to an option.
• Exercise price: The price at which the stock can be purchased. This is also called the “strike price” or “grant price.” In most plans, the exercise price is the current fair market value of the stock at the time the grant is made.
• Spread: The difference between the exercise price and the market value of the stock.
• Option term: The length of time the employee can hold the option before it expires.
• Vesting: The requirement that must be met in order to have the right to exercise the option—usually continuation of service for a specific period of time or the meeting of a performance goal.
A company grants an employee options to buy a stated number of shares at a defined grant price. The options vest over a period of time or once certain individual, group, or corporate goals are met. Some companies set time-based vesting schedules but allow options to vest sooner if performance goals are met. Once vested, the employee can exercise the option at the exercise price at any time over the option term up to the expiration date. For instance, an employee might be granted the right to buy 1,000 shares at $10 per share. The options vest 25% per year over four years and have a term of 10 years. If the stock price goes up, the employee will pay $10 per share to buy the stock. If it goes down, the employee will not be able to exercise the options. If the stock goes to $25 after seven years, and the employee exercises all options, the spread between the exercise price and the exercise date fair market value is $15 per share.
Kinds of Options
Options are either incentive stock options (ISOs) or nonqualified stock options (NSOs), which are sometimes referred to as nonstatutory stock options. When an employee exercises an NSO, the spread on exercise is taxable to the employee as ordinary income, even if the shares are not yet sold. The company can deduct a corresponding amount. There is no legally required holding period for the shares after exercise, although the company may impose one. Any subsequent gain or loss on the shares after exercise is taxed as a capital gain or treated as a capital loss when the optionee sells the shares. The gain or loss is long-term if the shares have been held for more than a year, or short-term if they have been held for a year or less.
An ISO enables an employee to: (1) defer taxation on the option from the date of exercise until the date of sale of the underlying shares, and (2) pay taxes at capital gains rates, rather than ordinary income tax rates, if certain conditions are met:
1. The employee must hold the stock for at least one year after the exercise date and for two years after the grant date.
2. Only $100,000 worth of stock can first become exercisable in any calendar year. This is measured by the stock’s fair market value on the options’ grant date. It means that only $100,000 in grant price value can become eligible to be exercised in any one year. If there is overlapping vesting, such as would occur if ISOs are granted annually and vest gradually, companies must track outstanding ISOs to ensure the amounts that become vested under different grants will not exceed $100,000 in value in any one year. Any portion of an ISO grant that exceeds the limit is treated as an NSO.
3. The exercise price must not be less than the fair market value of the company’s stock on the date of the grant. IRS guidelines must be followed to assure that the value set for the shares is fair market value.
4. ISOs can be granted only to employees.
5. The option must be granted pursuant to a written plan that must be approved by shareholders within 12 months before or after the board of directors adopts it. The plan must specify how many shares can be issued under it and identify the class of employees eligible to receive grants.
6. Options must be granted within 10 years of the plan’s adoption by the board of directors, and each option must be exercised within 10 years of its grant date.
7. If, on the grant date, an employee owns more than 10% of the voting power of all outstanding stock of the company, the ISO exercise price must be at least 110% of the fair market value of the stock on that date and the option may not be exercisable for more than five years.
If all the rules for ISOs are met, then the eventual sale of the shares is called a “qualifying disposition,” and the employee pays long-term capital gains tax on the total increase in value between the grant price and sale price. The company does not receive a tax deduction for a qualifying disposition.
A sale before the holding period has elapsed is called a “disqualifying disposition” because it disqualifies the option from favorable tax treatment. In that case, the option recipient must pay ordinary income taxes on the lesser of the spread between the exercise price and the exercise date fair market value or the spread between the exercise price and the sale price. If the stock price rises between the exercise date and the sale date, then the difference between the stock’s prices on those two dates is taxed at capital gains rates. If the stock is sold at a loss, no taxes are due.1 Both the ordinary income tax and capital gains taxes must be reflected on the employee’s tax return for the year in which the stock is sold.
An employee who exercises an ISO but does not sell the shares in the year of exercise does, however, face a possible alternative minimum tax (AMT) liability. The spread on the option at exercise is a “preference item” for purposes of the AMT. So even though the shares may not have been sold, the exercise means the employee must add back the gain on exercise, along with other AMT preference items, to see whether an AMT payment is due. Employees can avoid the AMT liability by selling their shares in the calendar year in which they exercise, although this disqualifies the ISO and subjects the spread on exercise to ordinary income tax. An alternative strategy is to sell enough stock to cover the projected AMT, then hold onto the remaining shares long enough to meet the ISO holding period. The worst-case scenario is when an employee exercises an ISO in one year, then sells the shares in the next, but before satisfying the holding period requirement. In that case, both AMT and income tax are triggered.
Private companies need to consider the AMT issue carefully before issuing ISOs. Employees who exercise their options will often face an AMT obligation but, lacking a market to sell shares, not have the cash to pay the tax. If the company’s value declines, they could end up paying the AMT on gains they can never realize.
The company does not take a tax deduction when there is a qualifying disposition. If, however, there is a disqualifying disposition, most often because the employee exercises and sells before meeting the required holding periods, the company can claim a tax deduction in the amount the employee must claim as ordinary income.
Deferred Compensation Issues and Stock Valuation
ISOs are not subject to the deferred compensation rules connected to Internal Revenue Code Section 409A, nor are NSOs if they are issued at or above fair market value. It is essential that companies comply with the rules for setting fair market value for option grants to ensure that the awards are made at a price the IRS will consider to be an accurate value. This book’s chapter on deferred compensation discusses this issue in detail. The bottom line for option holders is that awards the IRS considers to have been granted at a discount will result in the option being subject to Section 409A. If the discounted option grant does not comply with the Section 409A requirements, then the recipient will be assessed a 20% penalty plus interest in addition to regular income taxes at the time the option vests.
For publicly traded companies, 409A allows the use of any reasonable method for deriving fair market value from stock market transactions, including the last sale price before grant, first sale price after grant, closing price on the trading day before or after grant, or using an average price over a period of up to 30 days before or after the grant as long as an irrevocable commitment to grant the right is made before the averaging period begins.
For privately held companies, the final regulations do not mandate the use of an independent appraiser; however, the person charged with determining the fair market value must have sufficient knowledge, experience, training, or education to be qualified to do the appraisal. The NCEO strongly recommends using an independent appraiser to shift the burden of proof from the granting company to the IRS if the valuation is challenged. In the past, many privately held companies picked a number for the share price that seemed “right,” or used a number from an old valuation or other seemingly reasonable source without putting much thought into the process. None of these approaches will be sufficient now. While the rules allow for any reasonable method of valuation, a formal appraisal is not only safer but provides a more precise assessment of just how much value the company is sharing.
Exercising an Option
There are several ways to exercise a stock option: by using cash to purchase the shares, by tendering shares the optionee already owns directly to the company (often called a stock swap), or by working with a stock broker to do a same-day sale (this is often called cashless exercise, although that term actually includes stock swaps and a few other forms of exercise as well). Any one stock option plan may provide for just one or two of these alternatives or may allow many of them. Private companies frequently restrict the sale of the shares acquired through exercise until the company is sold or goes public, so same-day sale transactions are typically excluded from private company plans or restricted until after the company goes public.
The most common form of exercise of an option in a closely held company is simply for the employee to pay cash for the shares. If the options are NSOs, the employer will also have to withhold the taxes the employee owes upon exercise. Many employers allow employees to use some of the option shares to pay for this obligation, but the company must ensure it has enough cash available to submit to the tax authorities.
In a same-day sale, the employee works with a stock broker, usually a “captive broker” designated by the company. The optionee notifies the company and the stock broker of the desire to exercise, the company provides the broker with confirmation that the employee has exercisable options, and the broker sells the shares. From the sale proceeds, the broker delivers the option price plus any withholding taxes to the company and delivers the remaining proceeds, minus any broker commissions, to the employee. Although called a “same-day” sale, the settlement process can take up to three days after the sale date.
In a stock swap, the employee simply exchanges shares he or she already owns for the option shares. For instance, if the employee has the right to exercise options for 1,000 shares at $10 each, and the current share price is $25, the employee would exchange 400 shares to exercise those 1,000 options. That’s because the 400 shares the employee owns are worth $10,000, which is the amount needed to cover the exercise price. The employee would come out of the transaction owning 1,000 shares, instead of just 400 shares. However, the employee might choose to turn in enough shares to cover any taxes that are due as well, if the plan allows it. Stock swaps are more commonly used with ISOs where taxes do not have to be paid at the time of exercise.
Where the Shares Come From
Companies can settle option transactions by either issuing new shares or buying them back from existing shareholders. Issuing new shares is dilutive in terms of the percentage of ownership held by existing owners; buying back shares is anti-dilutive, but is a nondeductible expense that reduces the overall value of the company. Public companies tend to buy back shares if they have extra cash and believe their stock is a good value. Closely held companies, having less opportunity to buy back shares, usually just issue additional shares.
Accounting
Accounting rules for equity compensation plans that became effective in 2006 require companies to use an option-pricing model to calculate the present value of all option awards as of the date of grant and show this as an expense on their income statements. The expense should be adjusted based on vesting experience (so shares that will never vest do not count as a charge to compensation). The accounting chapter of this book discusses stock option accounting in more detail.
Securities Law Issues
Another chapter of this book looks at securities issues in detail. In brief, however, stock options are subject to securities law considerations. For public companies, options must comply with insider trading rules, proxy reporting rules, short-swing profits rules, rules regarding resale of securities after an IPO, and other requirements of being a public company. Privately held companies become subject to these reporting requirements once they have 500 or more shareholders and more than $10 million in assets. Compensatory employee stock options do not count toward the 500-shareholder limit. However, an employee who exercises options and holds the shares does become a shareholder for these purposes.
Public companies must register their option grants in a simplified filing, Form S-8. Public companies must also gain shareholder approval for their stock option plans and then for any material changes they make to their plans, make detailed disclosures about options and other equity awards for top executives, and give shareholders an advisory vote on executive pay packages at least once every three years. (Shareholders decide how frequently these votes should be held.)
Securities registration is a bigger issue for closely held companies. A number of exemptions are available; the most commonly used is Rule 701 under the Securities Act of 1933. Rule 701 allows companies to offer unregistered securities to employees and other service providers under written compensation plans as long as the amount sold in a 12-month period does not exceed the greater of (1) $1 million; (2) 15% of the issuer’s total assets; or (3) 15% of the outstanding securities of that class. Other limited exemptions from registration are available as well. However, even if an exemption is available, companies must comply with anti-fraud rules requiring them to provide certain financial information to option holders.
Should You Use Options or Something Else?
How They Reward
Even with a level accounting playing field, options are still appealing to many companies and investors who like the idea that employees are rewarded only if the share price goes up. From an employee standpoint, options are especially enticing in growth-oriented companies. Analysts often say that options are a highly leveraged award. What they mean by this is that the value of each option grant can go up very quickly relative to its grant value. If my employer outright gives me one share of stock worth $100 on the grant date, and I sell it five years later for $150, I am $150 richer. If the stock drops to $50, I am still $50 in the clear since I invested nothing. However, if my company decides to grant me an option award, I will probably ask for the right to buy more than one share at $100. In many companies, that works out to about three options for each actual share granted. To understand this, ask yourself how much you would pay today for the right to buy three shares of a company’s stock at $100 per share any time between four years from now and 10 years from now. You obviously would pay a lot less than $100 because the stock price could go down, in which case that right to purchase shares would be worthless.
So say you get three options at $100 per share and the price goes to $150 five years later, as in the example above. If you exercise the options and sell the shares, your return is 3 x $50, or $150, a 50% return. On the other hand, if the stock goes down, unlike in the example above, your option is worthless. So options leverage future growth at a much higher multiple than do straight grants. Whether that is good or bad for your investors and for your employees depends on your growth prospects. That is why some mature companies have switched to restricted stock, a kind of full-value stock grant, instead of options. At the other extreme, if your company is just getting started and its stock value is very low anyway, options don’t have much downside risk. Most companies are somewhere in the middle and must figure out how to make the choice between these two approaches, or decide how to provide some of one and some of the other.
Dilution
When options are accounted for, each option is worth only some fraction of a full-value share grant. But when investors measure dilution from the issuance of equity awards, options count exactly the same as share grants. Although options are not included in the calculation of regular earnings per share, all outstanding options—even unvested options—are included in the number of shares outstanding in calculating diluted earnings per share. However, the company is allowed to subtract the number of shares it would be able to buy back with the exercise proceeds and tax savings it would realize if all options were exercised. Options appear more dilutive than they are in an economic sense compared to share grants. For instance, if a company has to issue three options to provide the same economic value at grant as one actual share, the dilution from the options appears to be greater, but the economic cost to the company at grant is, by definition, the same because the option grant number has been specifically calibrated to be equal to the same ultimate cash cost to the company as the stock grant.
This matters much more to public companies, of course, which worry about investor perceptions. Closely held companies are in a much better position to explain these issues to investors.
Complexity
Options are somewhat more complex than their closest equivalent, stock appreciation rights (SARs), which pay holders the appreciation in the share price between the grant date and exercise or payout date. The main difference between the two is that while the recipient of a stock option must pay money to the company to exercise the option, the exercise of a SAR occurs at no cost to the recipient. And unlike stock options, SARs cannot be structured as a tax-qualified form of equity compensation.
Deciding on Option Rules
The introduction to this book discusses how to decide who gets how much equity under what conditions. In addition to the issues raised there, which apply to all kinds of equity awards, there are two specific considerations for options that deserve special attention.
Vesting
Options that vest based on continued service over a specified period of time are most common. However, performance-vested awards have become a favorite of equity compensation consultants and shareholders, who like the way these requirements mean the options deliver no value unless certain corporate, group, or individual goals are met. A key consideration is whether the award should vest only upon achievement of a target or whether vesting should occur on some future date even if the goal is not met. Time-based vesting obviously rewards tenure, something most companies want to encourage and may seem more certain to employees than meeting performance goals. Employees may discount the value of a time-vested option grant less as a result. Some closely held companies do not allow vesting until a liquidity event. Pros and cons of this are discussed below.
Exercise
Some closely held companies grant options that will not vest until the company is sold or goes public. For a company that has a clear plan to do that within the next few years, this makes sense, assuming employees know that the company is planning such a liquidity event. After all, it normally is unsettling to employees to know that in a few years the company may be sold. They naturally worry that their jobs will disappear. But assuming employees understand and accept this uncertainty, vesting upon a liquidity event helps preserve needed cash while still providing employees with both an incentive to remain with the company and a promise of a reward that seems reasonably close at hand. On the other hand, if the company even might stay private for more than few years, grants that will not vest if there is no sale or IPO can cause problems. Employees tend to undervalue future benefits, and the more uncertain they seem, the less they value them. That means you’ll have to give away more options to get the same incentive. Moreover, some people you want to motivate may not think they are likely to stay this indefinite period of time, in which case the option awards do nothing to motivate them—even though, in fact, they may end up being there when the liquidity event occurs. It is worth considering, then, providing vesting after some period of time, such as four or five years, perhaps with a requirement that anyone who wants to sell those shares must first offer them to the company. It is also possible to provide for vesting after a certain amount of time has elapsed or upon a sale or IPO, whichever comes first.
Closely held companies that do allow exercise before a liquidity event may want to let employees conduct cashless exercises in which the company withholds a number of shares equal to the exercise price and associated taxes. This avoids the need for employees to come up with enough cash to execute the exercise. A cashless exercise of an option has a similar effect to a stock appreciation right, discussed in a later chapter.
Employees who are required to pay cash to exercise NSOs will also have to produce enough cash to cover the taxes associated with the exercise, but they will have no cash from stock sale proceeds to deal with them. Companies can handle the cash needs by paying a special bonus, but that itself is taxable. Companies could settle the option exercise in shares net of taxes, although that still leaves the issue of where the employee gets the cash to exercise in the first place.
Conclusion
Options remain as popular as they are for good reasons. They are not right for every company, however. Just because most other people use options does not mean options are the right approach for your company.
Additional
reading in NCEO publications
(available at www.nceo.org):
The Stock Options Book by Alisa J. Baker
Chapter 2: Unrestricted Stock Grants and Stock Purchase Plans
Scott Rodrick
This chapter discusses outright, unrestricted grants or sales of stock to employees. “Unrestricted” in this context means only that the grant is not subject to forfeiture if certain restrictions are not met. A separate chapter discusses what are formally called “restricted stock” arrangements, i.e., stock awards or sales that are granted subject to restrictions, such as performance or vesting criteria, and are subject to forfeiture if those criteria are not met. (Also do not confuse this meaning of “restricted” with references to shares that are “restricted securities” in that they have not been registered under the Securities Act of 1933 and/or have restrictions placed on them, such as a requirement that they be sold back to the company.)
For many people, outright grants or sales to employees seem the most natural thing to do when establishing an employee stock plan. However, as noted below, individual grants or sales to employees bring complications with them. And although formal employee stock purchase plans (ESPPs) for a company’s workers are very common in the U.S., they are found almost solely in public companies. This chapter discusses direct stock grants, stock sales, and stock purchase plans, and then addresses special liquidity, valuation, and securities issues that closely held companies face when implementing plans like these.
Direct Stock Grants (Stock Bonuses)
Conceptually speaking, perhaps the simplest form of equity compensation is a direct, unrestricted stock grant to an individual employee. These are often called “stock bonus” programs, a term that, like “restricted stock,” can have more than one meaning. The other meaning of “stock bonus” is the stock bonus plan, a defined contribution retirement plan (akin to a 401(k) plan) that covers a broad group of employees and provides benefits in the form of company stock. This section discusses stock bonuses in the first sense, i.e., shares of company stock given to individual employees.
Structure and Use of Direct Stock Grants
Direct stock grants are straightforward and, unlike stock plans that are tax-qualified under the Internal Revenue Code (the Code), such as Section 423 ESPPs, discussed later in this chapter, or employee stock ownership plans (ESOPs), discussed later in this book, they have no particular legal requirements or restrictions on their use. The company can give them to a single person, to a group or groups, or to all employees. Direct stock grants can be used in a variety of ways as the company pleases. For example, a grant can be given as a bonus, as an adjunct to other stock arrangements (such as giving employees a free share of stock for every share they buy through a stock purchase program), or even as part of the salary at a cash-starved startup company.
The shares that are granted may be “restricted” in the sense of transferability restrictions, such as that the shares can be resold only to the company, that they must be resold to the company when employment terminates, or that the company has a right of first refusal when the shares are sold. This allows a private company to keep stock “in the family” (literally or figuratively) and avoid ex-employees or unwanted outsiders gaining ownership and perhaps some degree of control.
Since a direct stock grant makes the employee a shareholder, that person now will have the same voting rights and other privileges as do other shareholders of that class of securities. For a given employee, employee group, or everyone receiving stock grants, the company may wish to use shares with certain voting attributes or even create a new class of shares with the desired attributes. Even in S corporations, which are limited to one class of stock, it is permissible to have “differences in voting rights among the shares of common stock.”2 Typically, a company would limit the voting rights granted to employees because it was sensitive to control issues. However, the experience of many employee ownership companies, such as ESOP companies (which must pass through at least a minimum subset of voting rights to ESOP participants), is that this is not a big issue. Employees generally have no desire to use their voting rights to turn the company upside down and, in any event, would typically not own enough stock to do so. Also, excessively limiting voting rights may send the wrong message to employees: “We want you to think and work like an owner, but we don’t trust you.”
Aside from voting rights, the company should consider what other rights the shares will have. Will they pay dividends, and if so, at what rate? Will the stock have special preferences in liquidation? Will it have “tag-along rights” that ensure that minority shareholders receive the same price as majority shareholders if the company is sold? Note that the presence and nature of these rights may affect not only the long-term financial benefits of the shares but also the fair market value of the shares at grant.
Coupling the Stock Grant with a Cash Bonus or Loan to Finance the Tax Obligation
As discussed below, the employee is subject to tax when the shares are awarded. Since the employee may keep the shares for some time, this means that as a practical matter, the employee may need money to pay the tax. Also, the company may wish to help finance the tax bill in one way or another in order to make the stock grant more of an incentive and less of a burden.
One way for the company to help finance an employee’s tax bill is to couple the stock grant with a cash bonus. It is important to remember that this cash bonus is itself taxed (as noted below).
Alternatively, the company may loan employees the money to pay tax and provide for repayment by making deductions from subsequent paychecks. However, loans to directors and executive officers in public companies are illegal under Section 402 of the Sarbanes-Oxley Act of 2002. (Rule 3b-7 under the Securities Exchange Act of 1934 broadly defines “executive officers” as including any officer or other person who performs a policy-making function.) Although Sarbanes-Oxley does not apply to private companies, in some situations it may be viewed as setting the standard for corporate behavior in the matters it covers, for example in an ESOP-owned company (where the managers and directors are accountable to a broad group of owners3) or if the company plans to go public and thus soon will be subject to Sarbanes-Oxley. In such settings, a private company may be influenced by Sarbanes-Oxley when deciding whether and how to make loans to directors and executives.
Aside from Sarbanes-Oxley considerations, the “imputed interest” rules under Code Section 7872 also raise possible issues for loans. The imputed interest rules are complicated, but they generally provide that certain below-market-rate loans, including those between an employer and an employee (or between a company and a shareholder), are treated as if the discount from the market rate had been transferred from the lender to the borrower, and retransferred by the borrower to the lender as interest. This means that the forgone interest is treated as compensation paid to the employee and is taxed. (Similarly, the corporation is taxed as well.) For employer-employee loans, however, there is a de minimis exception where the aggregate outstanding amount of loans between the borrower and lender does not exceed $10,000, so long as a principal purpose of the loan is not to avoid federal taxation.4 Given the complexity of the rules and the possible taxes involved, loans to employees should be carefully structured with the imputed interest rules (including all the details that are not discussed here) in mind.