Start-up companies frequently use stock-based compensation to incentivize their executives and employees. Stock-based compensation provides executives and employees the opportunity to share in the growth of the company and, if structured properly, can align their interests with the interests of the company’s shareholders and investors, without burning the company’s cash on hand. The use of stock-based compensation, however, must take into account a myriad of laws and requirements, including securities law considerations (such as registration issues), tax considerations (tax treatment and deductibility), accounting considerations (expense charges, dilution, etc.), corporate law considerations (fiduciary duty, conflict-of-interest) and investor relations (dilution, excessive compensation, option repricing).
The types of stock-based compensation most frequently used by private companies include stock options (both incentive and non-qualified) and restricted stock. Other common forms of stock-based compensation a company may consider include stock appreciation rights, restricted stock units and profits interests (for partnerships and LLCs taxed as partnerships only). Each form of stock-based compensation will have its own unique advantages and disadvantages.
A stock option is a right to buy stock in the future at a fixed price (i.e., the fair market value of the stock on the grant date). Stock options are generally subject to satisfaction of vesting conditions, such as continued employment and/or achievement of performance goals, before they may be exercisable. There are two kinds of stock options, incentive stock options, or “ISOs,” and non-qualified stock options, or “NQOs.” ISOs are a creation of the tax code, and, if several statutory requirements are met, the optionee will receive favorable tax treatment. Because of this favorable tax treatment, the availability of ISOs is limited. NQOs do not provide special tax treatment to the recipient. NQOs may be granted to employees, directors and consultants, while ISOs may only be granted to employees and not to consultants or non-employee directors.
Generally, there is no tax effect to the optionee at the time of grant or vesting of either type of option. Regardless of whether an option is an ISO or an NQO, it is very important that an option’s exercise price be set at not less than 100% of the fair market value (110% in the case of an ISO to a 10% stockholder) of the underlying stock on the date of the grant in order to avoid negative tax consequences.
Upon exercise of an ISO, the optionee will not recognize any income, and if certain statutory holding periods are met, the optionee will receive long-term capital gains treatment upon the sale of the stock. However, upon exercise, the optionee may be subject to the alternative minimum tax on the “spread” (i.e., the difference between the fair market value of the stock at the time of exercise and the exercise price of the option). If the optionee sells the shares prior to meeting such statutory holding periods, a “disqualifying disposition” occurs and the optionee will have ordinary income at the time of sale equal to the “spread” at the time of exercise plus capital gain or loss equal to the difference between the sale price and the value at exercise. If the shares are sold at a loss, only the amount of the sale in excess of the exercise price is included in the optionee’s income. The Company will generally have a compensation deduction upon the sale of the underlying stock equal to the amount of ordinary income (if any) recognized by the optionee if the holding period described above is not met, but the Company will have no compensation deduction if the ISO holding period is met.
At the time of exercise of an NQO, the optionee will have compensation income, subject to tax withholding, equal to the option’s “spread” and taxable at ordinary income rates. When the stock is sold, the optionee will receive capital gain or loss treatment based on any change in the stock price since exercise. The Company will generally have a compensation deduction at option exercise equal to the amount of ordinary income recognized by the optionee.
For start-up and early stage companies, stock options create significant incentives for executives and employees to drive the company’s growth and increase the company’s value, because stock options provide optionees the opportunity to share directly in any and all up-side above the option’s exercise price. These incentives also serve as a strong employee retention tool. On the other hand, stock options limit or eliminate most down-side risk to the optionee, and, in certain circumstances, may encourage riskier behavior. Additionally, it may be difficult to recapture the performance incentives that stock options provide if the value of the stock falls below the option exercise price (i.e., the options are “underwater”). In many cases, an employee will not exercise an option until the time of a change in control, and, while not the most tax efficient result for the optionee (all proceeds will be taxed at ordinary income tax rates), this delayed exercise will permit the optionee to recognize the full spread of his or her award with little or no down-side risk.
Start-up and early stage companies may also elect to grant so called “early-exercise” or “California style” options. These awards, which are essentially a hybrid of stock options and restricted stock, permit the grantee to exercise unvested options to purchase shares of restricted stock subject to the same vesting and forfeiture restrictions.
Restricted stock is stock sold (or granted) that is subject to vesting and is forfeited if the vesting is not satisfied. Restricted stock may be granted to employees, directors or consultants. Except for payment of par value (a requirement of most state corporate laws), the company may grant the stock outright or require a purchase price at or less than fair market value. In order for the risk of forfeiture imposed on the stock to lapse, the recipient is required to fulfill vesting conditions that may be based on continuing employment over a period of years and/or achievement of pre-established performance goals. During the vesting period, the stock is considered outstanding, and the recipient can receive dividends and exercise voting rights.
A recipient of restricted stock is taxed at ordinary income tax rates, subject to tax withholding, on the value of the stock (less any amounts paid for the stock) at the time of vesting. Alternatively, the recipient may make a tax code section 83(b) election with the IRS within 30 days of grant to include the entire value of the restricted stock (less any purchase price paid) at the time of grant and immediately begin the capital gains holding period. This 83(b) election can be a useful tool for start-up company executives, because the stock will generally have a lower valuation at the time of initial grant than on future vesting dates.
Upon a sale of the stock, the recipient receives capital gain or loss treatment. Any dividends paid while the stock is unvested are taxed as compensation income subject to withholding. Dividends paid with respect to vested stock are taxed as dividends, and no tax withholding is required. The company generally has a compensation deduction equal to the amount of ordinary income recognized by the recipient.
Restricted stock can deliver more up-front value and downside protection to the recipient than stock options and is considered less dilutive to stockholders at the time of a change in control. However, restricted stock may result in out-of-pocket tax liability to the recipient prior to the sale or other realization event with respect to the stock.
Other Stock-Based Compensation Considerations
It is important to consider vesting schedules and the incentives caused by such schedules before implementing any stock-based compensation program. Companies may elect to vest awards over time (such as vesting all on a certain date or in monthly, quarterly, or annual installments), based on achievement of pre-established performance goals (whether company or individual performance) or based on some mix of time and performance conditions. Typically, vesting schedules will span three to four years, with the first vesting date occurring no earlier than the first anniversary of the date of grant.
Change in Control
Companies should also be particularly mindful of how awards will be treated in connection with a change in control of the company (e.g., when the company is sold). Most broad-based equity compensation plans should give the board of directors significant flexibility in this regard (i.e., discretion to accelerate vesting (fully or partially), roll over awards into awards of acquirer’s stock or simply terminate awards at the time of the transaction). However, plans or individual awards (particularly awards with senior executives) may and will often include specific change in control provisions, such as full or partial acceleration of unvested grants and/or “double trigger” vesting (i.e., if the award is assumed or continued by the acquiring company, the vesting of some portion of the award will accelerate if the employee’s employment is terminated without “cause” within a specified period after closing (typically from six to 18 months)). Companies should carefully consider both (i) the incentives and retentive effects of their change in control provisions and (ii) any investor relations issues that may arise through the acceleration of vesting in connection with a change in control, as such acceleration can lower the value of their investment.
There are a number of protection provisions that a company will want to consider including in their employee equity documentation.
Limited Window to Exercise Stock Options Post-Termination
If the employment is terminated with cause, stock options should provide that the option terminates immediately, and is no longer exercisable. Similarly, with respect to restricted stock, vesting should cease and a repurchase right should arise. In all other cases, the option agreement should specify the post-termination exercise period. Typically, post-termination periods are typically 12 months in the case of death or disability, and 1-3 months in the case of termination without cause or voluntary termination.
With respect to restricted stock, private companies should always consider having repurchase rights for unvested as well as vested stock. Unvested stock (and vested stock in the event of a termination for cause) should always be subject to repurchase either at cost, or the lower of cost or fair market value. With respect to vested stock and stock issued upon exercise of vested options, some companies will retain a repurchase right at fair market value upon termination under all circumstances (other than a termination for cause) until the employer goes public; other companies only retain a repurchase right under more limited circumstances, such as voluntary termination of employment or bankruptcy. Companies should generally avoid repurchasing stock within six months of vesting (or exercise) in order to avoid adverse accounting treatment.
Right of First Refusal
As another means to ensure that a company’s stock remains only in relatively few friendly hands, private companies often have a right of first refusal or first offer with respect to any proposed transfers by an employee. Generally, these provide that prior to transferring securities to an unaffiliated third party, an employee must first offer the securities for sale to the company-issuer and/or perhaps other shareholders of the company on the same terms as offered to the unaffiliated third party. Only after the employee has complied with the right of first refusal can the employee sell the stock to such a third party. Even if an employer was not contemplating a right of first refusal, outside venture capital investors are likely to insist on these types of provisions.
Drag Along Rights
Private companies should also consider having a so-called “drag-along” right, which generally provides that a holder of the company’s stock will be contractually required to go along with major corporate transactions such as a sale of the company, regardless of the structure, so long as the holders of a stated percentage of the employer’s stock is in favor of the deal. This will prevent individual employee shareholders from interfering with a major corporate transaction by, for example, voting against the deal or exercising dissenters’ rights. Again, venture capital investors often insist on this type of provision.