Published in the MIT Enterprise Forum Reporter, September 21, 2006
To succeed, every company must attract and retain qualified employees, consultants and advisors. Towards that end, equity compensation is a critical part of compensation packages for most emerging companies. As a company structures the equity component of a compensation package, it needs to address at least two questions: What type of equity award should be granted - incentive stock option, non-qualified stock option, or restricted stock? And, what are the terms of the equity award? This article addresses these questions.
There are two basic forms an equity award can take: stock option and restricted stock.
Stock Options. Stock options are a common type of equity compensation, representing the right to purchase common stock at an exercise price per share specified in the option grant agreement.
Incentive Stock Options ("ISOs"). ISOs are commonly used by start-ups, though only employees may receive them. ISOs must, among other things, have an exercise price at least equal to the fair market value ("FMV") of the stock at the time of grant (or 110% of the FMV if the employee is a 10% owner) and may not be exercisable for more than ten years from its grant date (or 5 years if the employee is a 10% owner). In addition, a stock option will not qualify as an ISO if the underlying stock has a value exceeding $100,000 as of the grant date. For example, if an employee is granted an option to acquire stock worth $500,000 on the grant date and the option is immediately exercisable, only 20% of that option ($100,000/$500,000) may qualify as an ISO. The advantage of an ISO to an employee is that there is no tax upon exercise, but only after the employee sells the acquired shares. Upon sale, the amount by which the sale price exceeds the exercise price is taxed as long-term capital gain. This is subject to two caveats:
Nonqualified Stock Options ("NQOs"). NQOs are often used when ISOs are unavailable, such as when the recipient is not an employee. The recipient of a NQO generally reports ordinary income upon exercising the NQO in the amount by which the value of the shares received (as determined at the time of exercise) exceeds the exercise price of the NQO. If a NQO is granted with an exercise price that is less than its FMV, the recipient may be subject to tax and a penalty under recently enacted Section 409A of the Internal Revenue Code ("409A") (a discussion of Section 409A is beyond the scope of this article). The recipient then receives the underlying stock with a FMV basis and a holding period beginning on the date of exercise. As a result, the recipient of a NQO generally reports the pre-exercise appreciation in the value of the underlying stock as ordinary income upon the exercise of the NQO and the post-exercise appreciation in the value of the underlying stock as capital gain (long-term if the stock is held for more than a year after exercise) upon the subsequent sale of the stock.
Restricted Stock. As an alternative to stock options, companies sometimes offer restricted stock as part of a compensation package. Restricted stock means stock that the company issues subject to the company's right to repurchase some or all of the stock at the price paid if the recipient ceases providing services to the company. In contrast to the rights of an option holder, a holder of restricted stock has all of the rights of a stockholder, including voting rights. As a result, restricted stock is typically reserved for key employees.
A recipient of restricted stock generally has two tax options. On the one hand, a recipient may make a "Section 83(b) election," in which case the recipient is taxed upon receipt of the stock and will report as ordinary income the amount by which the FMV at the time of receipt exceeds the amount paid. A recipient then takes a FMV basis in the stock and the long-term capital gain holding period begins. As a result, upon the subsequent sale of the restricted stock, the holder making a Section 83(b) election reports the post-issuance appreciation in the value of the stock as capital gain (long-term if the stock is held for more than a year). If it is expected that the stock will appreciate significantly, it generally makes sense to make a Section 83(b) election (which must be made with thirty days after receipt of the stock to be valid).
On the other hand, a recipient may forego a Section 83(b) election, in which case the recipient reports ordinary income in an amount equal to the amount by which the FMV of the stock at the time of vesting exceeds the price paid. Accordingly, the recipient's basis in the stock becomes the FMV at the time of vesting, with the holding period beginning at the time of vesting. As a result, the holder of restricted stock who foregoes making a Section 83(b) election reports pre-vesting appreciation in the value of the stock as ordinary income upon vesting and post-vesting appreciation in the value of the stock as capital gain (long-term if the stock is held for more than a year after vesting) upon the sale of the stock.
Exercise/Purchase Price. The price at which a recipient may exercise an option or purchase restricted stock is determined by the board of directors of the company at the time of grant. In the case of an ISO, the exercise price must be at least equal to the FMV of the stock on the date of grant. In the case of a NQO, given Section 409A, the exercise price should be at least equal to the FMV of the stock on the date of grant. In the case of a restricted stock grant, the purchase price is often equal to the FMV of the stock on the date of grant. As discussed above, to the extent the purchase price of the restricted stock is below the FMV on the date of grant, the difference will be taxed as ordinary income for the year of the grant if the recipient makes a timely Section 83(b) election.
Vesting. In the case of an option, "vesting" permits the recipient to exercise an option and thereby purchase the underlying stock at a price fixed on the grant date. In the case of a restricted stock award, where stock is issued outright to a recipient, "vesting" terminates the recipient's obligation to sell the stock back to the company at the price paid (so called "reverse-vesting"). There are four essential elements to address regarding vesting:
Duration of vesting. An equity award typically vests over a fixed period of time, with founders typically vesting over three to five years. Employees, consultants and advisors typically vest over four to five years, with four years being most common.
Vesting schedule. An equity award typically vests over a fixed period of time pursuant to an agreed upon schedule. For example, an equity award could vest monthly over four years, meaning in the case of an option that 2.083% of the original number of shares granted would vest each month until the four-year anniversary of the date of grant. A common feature of vesting schedules is so-called "cliff vesting," which requires a minimum period of time to lapse before any shares vest. For example, in order to motivate an employee to remain with a company for at least a year, an option could provide that 25% of the shares vest on the one year anniversary of an employee's date of hire with the remaining shares vesting on a more frequent schedule thereafter. Another variation is performance-based vesting, where the underlying shares vest only upon the completion of individual or company performance-based criteria (i.e.: profits, revenue or other operational or financial milestones).
Termination. There are four basic circumstances under which an employee might leave a company: (1) resignation (for no reason or for good reason), (2) termination (for cause or without cause), (3) death, and (4) disability. In the event an employee resigns voluntarily or is terminated for cause, typically no additional stock vests. However in the case of a key employees, it can be argued that if the key employee is terminated without cause or resigns for good reason (in other words, is "forced out"), there should be some compensation to the employee, both out of fairness and so as to minimize the potential conflicts among board members (many of whom are stockholders). Under these circumstances, occasionally key employees are able to negotiate for partial or even full acceleration, with an additional six to 12 months acceleration being fairly common. In the event of death or disability, a key employee is often provided with six-month acceleration as a good will gesture in a time of hardship.
Change of Control. In certain circumstances a key employee may be successful in negotiating accelerated vesting upon a change of control of the company, with one-year or 50% accelerated vesting being the most common. Occasionally key employees will negotiate for full acceleration upon a change of control, and it is often a reasonable starting point for negotiation. After all, if a key employee's leadership and contribution to company growth are expected to ripen the company for sale, this should be rewarded. However, there may be reluctance to allow full acceleration upon a change of control because arguably the value of the company diminishes if a key employee's stock vests fully upon a change of control (since the employee will have less incentive to work for the acquirer after the acquisition). As an alternative to full acceleration, some key employees negotiate "double trigger" acceleration, under which shares vest fully if the key employee is let go or resigns for good reason within one year after the change of control. It should also be noted that the value of any acceleration upon a change of control can be a "parachute payment" under certain "golden parachute" tax rules (a discussion of those rules is beyond the scope of this article).
Conclusion. Carefully structured compensation packages, including well-designed equity compensation components, will contribute to a company's success by enabling it hire and keep talented employees, consultants and advisors. The good news is that equity compensation can be structured in many creative ways designed to meet a company's business objectives and its personnel's tax goals.
For more information on equity compensation, please contact Emily Hayes. Jonathan Gworek and Chip Wry also contributed to this article.
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