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January 27, 1998
I. INTRODUCTIONEquity compensation is a topic of critical concern to many privately held companies, particularly those that are considering the possibility of an initial public offering ("IPO"). For some companies, like Microsoft, the primary reason for the IPO is to provide liquidity with respect to equity compensation awards previously granted to employees. In many other companies, while the equity compensation program may not be the driving force behind the IPO, the program is viewed as a valuable tool that promotes employee loyalty and influences employees to perform in ways that contribute to company growth. These companies want to ensure that the perceived benefits of equity compensation are preserved, and even enhanced, in the "going public" process.
This Monograph discusses many of the practical and legal aspects of equity compensation that are of importance to emerging growth companies. It discusses the reasons why emerging growth companies adopt equity compensation programs, provides an overview of the various types of equity-based compensation programs that are commonly used by growth-oriented companies and considers the important tax, accounting and securities law aspects of these programs.
II. WHY GROWTH COMPANIES LIKE EQUITY COMPENSATION
Many people are surprised to learn that employees now control about 9% of all corporate equity in the United States. Although equity ownership programs for top executives of publicly-traded companies seem to receive the most publicity, employee ownership is by no means limited to a narrow class of corporate executives. Up to 17 million employees currently participate in broad-based employee ownership plans.
The popularity of employee stock ownership programs is attributable in significant part to the perception that employee equity ownership has a favorable impact on corporate performance. This perception is supported by empirical data. A Coopers & Lybrand survey of America's fastest growing companies reported a 39% higher revenue growth rate in companies with employee stock option programs than in the companies that did not offer stock options to employees. Moreover, the revenue growth rate in companies with broad-based stock option programs was 51% higher than in companies with management-only plans.
The convergence of two important factors is likely to spur even more rapid growth in employee ownership programs. The first factor is the reduction of the rate of taxation of long-term capital gains. On August 5, 1997, President Clinton signed into law the Taxpayer Relief Act of 1997. One of the key provisions of this Act is the reduction in the maximum tax rate on net capital gains. In general, the top tax rate on net capital gains is reduced from 28% to 20%. This new rate applies only to assets held more than 18 months. The 28% rate continues to apply to securities held longer than one year but not more than 18 months. Effective in 2001, the rate will drop to 18% for assets acquired after 2000 and held more than 5 years. Even lower rates are available for individuals in the 15% federal tax bracket.
Unfortunately, it is not always possible to design and operate employee stock compensation programs in a way that enables employees to take full advantage of the capital gains tax break. However, the lure of a significantly lower tax bill for employees will undoubtedly influence corporate decision makers as they design compensation plans in the future.
The second factor that may stimulate further growth in employee ownership is the useful role such programs can play in building employee loyalty and encouraging long-term retention of employees. The Chairman of the Federal Reserve Board, Alan Greenspan, has observed that the United States is in the midst of a fundamental structural change from an industrial-based economy to a structure of production that is idea-determined. The "Information Age" economy places a premium on developing and utilizing knowledge, much of which resides in the heads of employees. The most successful enterprises are likely to be those which create cultures that attract and hold highly skilled and knowledgeable employees.
Building a loyal workforce may be problematic given today's fluid labor markets. Unlike the early years of the post-World War II economy, when workers had reasonable expectations of lifetime employment with the same company, today there is a constant "churning" of the workforce. In the 12-month period ended June 30, 1995, according to the American Management Association, 50% of all large and mid-sized companies eliminated jobs. Of course, many of these same companies were simultaneously adding employees in other positions and other companies helped to pick up the slack, but the point is that employee turnover was widespread.
Thus, employers are in a difficult position: they have weakened the ties of job security and loyalty but they more than ever depend on their skilled employees for their success. In this environment, employers may not be able to build Information Age workforces using Industrial Age compensation systems. Entrepreneurially-oriented pay systems of the future will undoubtedly include employee stock ownership as a fundamental component. In other words, companies will hold on to human capital by linking it to financial capital.
This is not to say that equity ownership programs are a panacea for all companies trying to strengthen the link with their employees. Obviously, such programs will be most effective in the context of rising markets generally and growth-oriented companies in particular. In the right environment, however, equity ownership programs are powerful tools for motivating and retaining employees.
III. SHAREHOLDER DILUTION FROM STOCK COMPENSATION PROGRAMS
Equity compensation grants increase the number of a company's shares that may be outstanding. While such grants are usually structured so as not to result in a shift in actual voting control of the company, stock dilution does inevitably reduce the "share of the pie" allocable to other company stockholders. It also has an impact on reported earnings per share of the company.
The potential dilution from equity compensation programs is often referred to as "overhang." Overhang is calculated by dividing the number of shares available for issuance under the equity compensation program by the total shares outstanding. Of course, proponents of equity compensation programs would argue that such programs are not at all dilutive because the company growth stimulated by employee ownership more than compensates for the otherwise dilutive impact of the issuance of additional shares.
For public companies, dilution from equity compensation plans can be an important issue because some institutional investors have a limited tolerance for dilution. A recent survey by the Investor Responsibility Research Center showed that when total dilution from equity compensation programs, i.e., the overhang, would exceed 10% of the outstanding shares, 30% of the institutions surveyed would automatically vote against adoption of a new equity compensation plan.
While the attitude of institutional investors toward dilution has undoubtedly caused many public companies to focus more on the dilution issue, it appears not to have had much of an impact on the actual practices of many emerging growth companies. Surveys have shown that the median dilution from equity compensation programs is well in excess of 10%. Among technology companies, overhang percentages are substantially higher. Clearly, companies are structuring their plans more by reference to perceived business needs than in response to general guidelines developed by institutional investors and others.
IV. COMMON TYPES OF EQUITY COMPENSATION PLANS
A. Stock Option Plans
Stock option plans have historically been the most widely used method of providing employees with an opportunity to acquire an equity interest in their employer. A stock option is the right to buy a fixed number of shares of stock at a fixed price for a fixed period of time. In most cases, the right of an employee to exercise his or her stock options is subject to a vesting schedule.
From a taxation standpoint, there are two types of stock options: incentive stock options ("ISOs") and nonstatutory stock options ("NSOs"). ISOs are options that satisfy the requirements of Section 422 of the Internal Revenue Code and NSOs are options that do not meet those requirements (or that meet the requirements but are designated as NSOs rather than ISOs).
ISOs and NSOs are not subject to any nondiscrimination rules. Therefore, stock option programs can be, and most often are, targeted to specific employees or employee groups; however, stock option programs can be offered to a broader group of employees, if desired.
1. Incentive Stock Options
a. Description. In order to qualify as an ISO, a stock option must satisfy certain statutory requirements set forth in Section 422 of the Internal Revenue Code. If any of these requirements is not met, the option will be treated for tax purposes as an NSO. The most important of these requirements are that:
- The employer's shareholders must approve the stock option plan providing for ISOs within twelve months before or after employer adopts the plan.
- The option exercise price must be at least 100% of the fair market value of the underlying stock at the time of grant.
- The term of the option cannot exceed 10 years.
- The optionee must be an employee of the corporation that granted the option, its parent corporation, or one of its subsidiaries. An optionee may, however, exercise the option within three months after he ceases to be an employee or within twelve months after he separates from service because of disability. Following the optionee's death, the optionee's estate may exercise the option and receive the same tax treatment as the optionee would have received, as long as the option was an ISO in the hands of the optionee at his death.
- The total fair market value (at the time of grant) of the stock with respect to which ISOs become exercisable (vest) for the first time in any calendar year may not exceed $100,000 for any employee.
- No disposition of the shares acquired through exercise of the ISO may be made within two years from the date of the granting of the option or within one year after the acquisition of the shares through exercise of the ISO.
b. Federal Income Tax Treatment. An employee does not recognize taxable income when an ISO is granted to the employee. Also, the employee does not recognize income at the time the ISO is exercised. Instead, taxation is delayed until the stock acquired upon exercise of the ISO is sold. However, the bargain element on the exercise of an ISO (i.e., the excess of the value of the stock received over the amount paid for the shares) is an "item of adjustment" for purposes of the employee's alternative minimum tax calculation (discussed below).
If the employee does not dispose of the stock acquired by exercising the ISO prior to the later of (1) one year from the date of exercise of the ISO and (2) two years from the date the ISO was granted, any gain realized on a later disposition of the stock will be a long-term capital gain. If the shares are held for more than 12 months but not more than 18 months following exercise, a 28% capital gain rate applies. If the holding period exceeds 18 months, the gain will generally be taxed at a rate of 20%.
If the employee disposes of stock acquired through the exercise of an ISO prior to satisfying the holding periods described above (this is called a "disqualifying disposition"), he or she will recognize ordinary income (currently taxed for federal income tax purposes at a maximum rate of 39.6%) in the year of sale. The amount of ordinary income recognized will equal the fair market value of the stock on the date of exercise minus the exercise price, but the ordinary income will not exceed the gain amount realized on disposition of the stock. Any gain realized from the disqualifying disposition in excess of the amount required to be recognized by the employee as ordinary income will be treated by the employee as capital gain. This capital gain will be short-term, except in the unlikely (in the context of a disqualifying disposition) event that the one-year long-term capital gain holding period (measured from the date of exercise) is met at the time of sale.
An ISO does not provide the employer with a tax deduction upon the grant or exercise of an ISO. However, if a disqualifying disposition of ISO stock occurs, the employer may deduct an amount equal to the ordinary income recognized by the employee.
Although an employee incurs no regular tax consequences from exercising an ISO, such an exercise does result in an increase in the alternative minimum taxable income (AMTI) of the employee by the amount of the bargain purchase element of the transaction. This is the amount by which the fair market value of the shares acquired, measured at the time of exercise, exceeds the exercise price of the option. If, however, a disqualifying disposition of the ISO occurs in the same year that the ISO is exercised, the AMTI accrued from initially exercising the ISO is eliminated. If a disqualifying disposition occurs in a tax year other than the year in which the ISO was exercised, the employee is subject to both alternative minimum tax (AMT) in the year of exercise on the bargain purchase element and ordinary income tax in the year of sale on the same amount. Any AMT paid may be used as a credit against regular tax liability in a future tax year to the extent that the employee's regular tax liability exceeds the AMT liability in that future year.
The AMT impact of ISOs can have a significant effect on the after tax benefit of an ISO to an employee. Without proper tax planning, the AMT liability can substantially eliminate the tax benefits the employee anticipated having by being granted ISOs rather than NSOs.
2. Nonstatutory Stock Options
a. Description. NSOs are options that do not satisfy the ISO requirements or that meet the ISO requirements but are designated as NSOs rather than ISOs. For example, a stock option having an exercise price below the fair market value of the underlying shares on the date of grant of the option cannot be an ISO, and therefore, is an NSO. Also, stock options granted to non-employees, including members of a company's board of directors, are NSOs because such options do not meet the ISO requirement that optionees be employees of the company.
b. Federal Income Tax Treatment. As with ISOs, an employee granted an NSO does not generally recognize taxable income at the time of such grant. Upon the exercise of the NSO, however, the employee will generally recognize ordinary income in an amount equal to the difference between the exercise price of the option and the fair market value of the shares purchased on the date of exercise. Appreciation in value of the shares after the date ordinary income is recognized by the employee to the date the stock acquired upon exercise of the option is sold is taxed as short-term or long-term capital gain, depending upon whether the one-year capital gain holding period (measured from the exercise date) is met at the time of sale. If the shares are held for more than 12 months but not more than 18 months following exercise, a 28% capital gain rate applies. If the holding period exceeds 18 months, the gain will generally be taxed at a rate of 20%.
An employer that grants NSOs to an employee is entitled to an income tax deduction in the year the employee recognizes ordinary income. The amount of this deduction is equal to the compensation income recognized by the employee.
3. Deciding Whether to Use ISOs or NSOs
Traditionally, most employers have favored NSOs over ISOs because the primary disadvantages of ISOs (the lack of flexibility and the general unavailability of a deduction for the employer) have generally outweighed the tax advantages to employees, which are: (1) the ability to defer the taxable event beyond the option exercise date to the date the option stock is sold, and (2) the opportunity to have taxed as long-term capital gain all appreciation in value of the option stock that occurs after the grant date of the option. Also, many employees are indifferent to the ISO/NSO distinction because they intend to sell, rather than hold, the shares they acquire upon exercise of options, so that ISO tax treatment would not be available to them in any event.
However, recently, ISOs have become more popular because of the reduction in the long-term capital gains tax rate, discussed above. The increased differential between the ordinary income tax rate and the capital gains tax rate has given individuals a stronger incentive to minimize ordinary income and maximize capital gain; consequently, stock compensation is more strongly preferred than cash compensation, and, from the standpoint of employees, ISOs may be preferred over NSOs.
B. Restricted and Unrestricted Stock Plans
1. Description
Some companies, rather than giving employees options to buy stock in the future, actually issue or sell stock to employees currently. In some cases such shares are issued subject to vesting conditions (restricted stock) and in other instances the shares are issued without such conditions (unrestricted stock). The employees may be required to pay for the stock or the shares may be issued as a bonus to employees.
Restricted and unrestricted stock programs are most often seen in companies with low current equity values (e.g. a start-up company) but with expectations of significant future growth. Due to the low current value, employees can purchase stock at an affordable price or shares can be issued as bonuses with a manageable tax cost. Because the shares are issued up-front, with proper tax planning, all future appreciation in value can be eligible for taxation at the low long-term capital gains rate.
This compares favorably to NSOs, which typically have a large ordinary income component. A similar tax result can be achieved with ISOs, except that, as discussed above, the alternative minimum tax can reduce or eliminate the tax benefits associated with ISOs.
In the typical restricted stock plan, stock is purchased by or awarded to an employee subject to the condition that the employee remain employed by the company for a stated number of years and/or that the employee achieve stated performance goals before his ownership rights and right to transfer the stock vest (become fixed). If the employee terminates employment prior to the passage of the stated number of years, or the employee fails to achieve the stated performance goals, the employee must return the stock to the employer (if the stock was purchased, the employee may be entitled to the return of his or her purchase price). However, prior to forfeiture or vesting, the employee owns the stock and has all of the rights accorded to any other shareholder. For example, the employee can vote the stock and has a right to receive dividends.
2. Federal Income Tax Treatment
If stock is issued without forfeiture restrictions (unrestricted stock), the recipient must recognize income taxable, at ordinary income rates, in an amount equal to the fair market value of the shares on the date of issuance. Generally, there are no tax consequences associated with the award of restricted stock. Rather, when there is no longer a substantial risk of forfeiture--based upon the lapse of the forfeiture period or the achievement of stated performance goals--the employee must recognize ordinary income in an amount equal to the fair market value of the stock at that time (less any amount the employee pays for the shares), and the employer may take a corresponding deduction. If the stock vests in increments, the employee recognizes a proportionate amount of ordinary income as the stock vests (based upon the market value of the stock at the time of vesting) and the employer may take a corresponding deduction.
Upon sale of the stock, the employee recognizes capital gain income to the extent that the amount realized exceeds the sum of amount of ordinary income previously subject to taxation and any amount the employee paid for the stock, but the employer receives no further tax deductions. The capital gain is long-term only if the employee holds the shares for at more than one year after the vesting date. The 20% tax rate is available if the shares are held for more than 18 months after vesting.
Under Section 83(b) of the Internal Revenue Code, an employee may elect to report as ordinary income the entire fair market value of the restricted stock at the time it is received, rather than when the restrictions lapse. This closes the compensation element of the transaction at grant and causes the employee's capital gain holding period to begin at grant rather than later when the stock vests. If such an election is made by the employee, the employer is permitted to take a corresponding deduction. This may be an attractive alternative to employees who believe that the value of the stock may appreciate significantly during the forfeiture period--the appreciated value is taxed at the capital gains tax rate rather than the ordinary income tax rate. However, if the employee makes such an election and subsequently forfeits the shares, he or she is not entitled to a tax deduction for the loss.
V. FINANCIAL ACCOUNTING ISSUES
A. Stock Options
Historically, employers favored stock option plans over other forms of equity-based compensation partly because of the favorable accounting treatment accorded stock options: in general, employers are permitted to grant stock options without a direct charge to the employer's earnings on its income statement, provided that the exercise price of the options is at least equal to the fair market value of the underlying shares of stock on the date of grant of the options. Adding certain features to options can, however, change the accounting treatment, so a careful review of accounting considerations should be conducted prior to the actual grant of options. The Financial Accounting Standards Board had proposed to change this favorable accounting treatment and impose an earnings charge even for market-priced options. Fortunately for employers, that proposal was abandoned, so that options remain favored from an accounting standpoint. However, footnote disclosure of option values is required.
B. Restricted and Unrestricted Stock
The employer must charge against its earnings, as a compensation expense, the fair market value of the shares at the time they are issued, less any amount that is paid by the employee. If the shares are subject to vesting restrictions, however, this earnings charge may be spread over the vesting period.
C. The Cheap Stock Problem
As noted above, the proper financial accounting for both stock options and restricted and unrestricted stock depends, in large part, on the determination of the "fair market value" of the subject shares of stock at a particular time. Thus, in order to determine the financial statement impact of equity compensation awards, a company must make determinations from time to time of the fair market value of its equity securities. If the company subsequently decides to go public, and files a registration statement with the Securities and Exchange Commission (the "SEC"), the SEC accounting staff will review the prior determinations of fair market value and require the company to make adjustments to its financial statements if the staff believes the financial statements were prepared on the basis of incorrect assumptions regarding fair market value.
For example, assume a growing company that is looking to go public in the near future grants a series of stock options to employees for a total of 200,000 shares at an exercise price of $3.00 per share. A year later the company files a registration statement with the SEC in anticipation of an initial public offering. The SEC accounting staff reviews the option information in the registration statement and determines that the fair market value of the company's stock at the time the options were granted was actually $9.00 a share. The staff will inform the company that it must restate its financial statements to reflect a compensation expense of $6.00 per share (the $9.00 fair market value per share minus the $3.00 exercise price), or an aggregate expense of $1,200,000 (200,000 shares x $6.00 per share). It is permissible to spread this expense over the option vesting period.
This "cheap stock" issue is currently a priority with the SEC accounting staff. The staff now routinely reviews all registration statements for information concerning option grants during the 12 to 18-month period prior to the proposed initial public offering. The staff will typically require the company to offer a justification for its fair market value determinations. Thus, companies planning for an IPO should develop procedures for determining the fair market value of company stock for purposes of financial accounting for equity compensation awards. The most desirable, but also the most expensive, approach is to obtain periodic independent appraisals of stock value. This approach will make it difficult for the staff to challenge the company's accounting for stock awards. A less expensive approach is for the company to adopt a standard valuation formula that can be applied as necessary to determine fair market value. In any event, the company should maintain detailed records with regard to its determinations of fair market value.
VI. SECURITIES LAWS ISSUES
A. Stock Registration Issues
Stock compensation programs generally involve the offer and sale of securities by a company. Under the Securities Act of 1933, as amended (the "1933 Act"), such offers and sales must be registered with the SEC unless an exemption from registration is available. Historically, most stock offerings to employees by privately-held companies were conducted in reliance on a "private placement" exemption. However, there is now a special registration exemption in Rule 701 of the SEC for offers and sales of securities by privately-held companies pursuant to the terms of compensatory benefit plans or written compensation contracts. There are dollar limitations on the amount of securities that can be offered by a company under Rule 701. The aggregate offering price of a company's securities offered and sold under Rule 701 in any 12-month period may not exceed $5,000,000. A lower limitation may apply in some circumstances. Companies operating stock compensation programs in reliance on the Rule 701 exemption should take great care to ensure that the dollar limitation and other requirements of the Rule are complied with in all respects. State "blue sky" law registration issues should also be considered.
B. Resale of Securities by Employees
As noted above, any pre-IPO offers and sales of securities to employees will be conducted in reliance on an exemption from registration under the 1933 Act. This means that any securities acquired by employees prior to the IPO will be "restricted securities" that generally may be resold only in compliance with Rule 144 of the SEC under the 1933 Act. Rule 144 has five basic requirements:
- Holding Period. A one-year holding period is required for restricted securities.
- Current Information. Specified current information about the issuer must be publicly available at the time of sale. In general, this requirement is met if the company has been subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the "1934 Act"), for at least 90 days and has timely filed all required reports with the SEC.
- Manner of Sale. The securities must be sold in ordinary brokers' transactions or directly to a market-maker.
- Form 144. The seller must file a Form 144 with the SEC at the time the order is placed with the broker, unless the amount of securities sold or to be sold during any three-month period does not exceed 500 shares and the aggregate sales price does not exceed $10,000.
- Volume Limitation. The amount of securities which can be sold in any three-month period may not exceed the greater of (i) one percent of the outstanding securities or (ii) the average weekly reported volume of trading in the such securities for the four calendar weeks preceding the week of the sale.
Although securities issued under Rule 701 are treated as "restricted securities" for purposes of SEC Rule 144, such securities, if held by a non-affiliate of the company, can be resold without regard to Rule 144 (other than the manner of sale requirement) beginning 90 days after the company becomes subject to the reporting requirements under the 1934 Act. Affiliates may also resell their Rule 701 stock, but they continue to be subject to the volume limitation, manner of sale restriction and notice requirement of Rule 144. It should be noted, however, that in most IPO situations, employees are subject to lock-up arrangements that prevents them from selling their shares for some specified period of time following the IPO.
After a company completes its IPO, it will no longer be necessary to rely on an exemption from registration for offers and sales under equity compensation plans. Public companies can register such plans on Form S-8, a simplified registration form adopted by the SEC to facilitate securities offerings by public companies to employees and other service providers.
C. Section 16 Insider Trading
The provisions of Section 16 of the 1934 Act apply to a public company's officers and directors and beneficial owners, directly or indirectly, of more than 10% of any class of the company's equity securities. Section 16(a) of the 1934 Act requires insiders to file reports with the SEC concerning the company securities they own and any changes in their ownership. Section 16(b) requires an insider to pay to the company any profit the insider is deemed to have realized on a purchase followed by a sale, or on a sale followed by a purchase, of company equity securities within any six-month time period. Certain purchases or sales of a company's securities are "exempt" from Section 16(b) liability and are referred to as "exempt" transactions or exempt purchases or sales; however, even though exempt transactions will not subject an insider to Section 16(b) liability, they must generally be reported under Section 16(a).
The SEC rules provide a limited exemption for transactions by an officer or director during the period prior to the company's registration of securities under the 1934 Act. Under this limited exemption, officers and directors who engage in transactions before registration need not report the transactions unless they subsequently engage within six months in one or more other transactions after registration that are reportable on the initial Section 16 transaction report required to be filed after registration. The effect of this exemption is to shield from reporting and liability some, but not all, pre-registration transactions by officers and directors. Careful planning prior to an IPO is necessary to avoid costly and embarrassing violations of the Section 16 requirements.
Once the company completes its IPO, most transactions that occur under stock compensation plans are eligible for exemption under Rule 16b-3 of the SEC. In general, the companies seek to insure applicability of this exemption by having transactions approved in advance by the company's board of directors or by a committee of the board composed solely of two or more "non-employee directors." A director will qualify as a "non-employee director" if he or she:
- is not currently an officer or employee of the company or a parent or subsidiary;
- does not directly or indirectly receive any compensation from the company or a parent or subsidiary for services rendered in any non-director capacity that would exceed $60,000;
- does not possess an interest in any other transaction for which disclosure would be required under certain rules of the SEC; and
- is not engaged in a business relationship with the company which would be disclosable under the SEC disclosure requirements.
VII. OTHER CONSIDERATIONS
A. Internal Revenue Code Section 162(m)
Section 162(m) to the Internal Revenue Code imposes a cap of $1 million per tax year on the deductibility by a publicly traded company and its subsidiaries of compensation paid to any "covered employee." Covered employees are the company's Chief Executive Officer and the four other highest paid employees who are employed on the last day of the fiscal year. Usually this is same group of five individuals who are the named executives in the public company's annual proxy statement.
The compensation taken into account includes any cash or property received by a covered employee for services performed in any taxable year which would be deductible for a tax year were it not for the cap, but does not include commission payments, tax-qualified retirement plan distributions or non-taxable fringe benefits.
There is an important exception from the deductibility limit of Section 162(m) for "performance-based" compensation. To qualify for the performance-based compensation exception, a compensation arrangement must generally satisfy four requirements:
- the payment of the compensation must occur solely upon the attainment of non-discretionary performance goals;
- the goals and other material terms of the compensation arrangement must be disclosed to the shareholders and approved by a majority of the shareholders in a separate vote prior to the payment of the compensation;
- a compensation committee of the board of directors, composed solely of two or more "outside directors" (i.e. directors who are not current employees of the company, are not former employees who receive compensation for prior services, have not been officers of the company and do not receive "remuneration" from the company in a capacity other than as a director) must have established the performance goals; and
- the compensation committee must certify, prior to the payment of compensation, that the performance goals have been attained.
Stock options can qualify for the performance-based compensation exception because they tie the amount of compensation paid to executives to an independent measure of corporate performance--the company's stock price. To qualify for the exception, stock options must be granted:
- by a compensation committee of two or more "outside directors;"
- under a plan that sets forth the maximum number of shares to be awarded to any executive under the plan during a specified period;
- at an exercise price not less than the fair market value of the underlying shares; and
- under a plan approved by the shareholders.
Regulations of the Internal Revenue Service contain a "grandfather" provision that temporarily protects newly-public companies from the reach of Section 162(m). If the IPO prospectus discloses information concerning compensation plans and agreements that exist at the time of the IPO, then those plans and agreements are exempt from Section 162(m) until the first shareholder meeting at which directors are elected that occurs after the close of the third calendar year following the calendar year in which the IPO occurs (i.e., this is basically three years of grandfather protection). The grandfather protection will expire before the three-year period has elapsed if either (i) the compensation plan or agreement expires or is materially modified or (ii) all employer stock or other compensation that has been allocated under the plan or agreement has been issued or paid.
This grandfather protection under Section 162(m) for IPO companies applies to all types of compensation, whether or not performance-based. Given the breadth of this exemption, companies planning for an IPO should consider ways in which the exemption can be used to maximum advantage.
B. Stock Restrictions and Liquidity
Most private companies that adopt equity compensation plans attach restrictions to the shares issuable under the plans. These restrictions are usually incorporated into the stock compensation plan itself or are set forth in a separate stockholders' agreement. The most common restrictions are a right of first refusal (a right of the company to match any offer to buy the shares that the employee receives from a third party) and a company call option (a right on the part of the company to repurchase the shares upon the employee's termination of employment). These restrictions enable the company to control who owns its shares.
A key consideration in the design of a stock compensation program for a privately-held company is the extent to which participating employees will have liquidity with respect their plan shares. After all, employees can benefit from ownership of company stock only to the extent that there is a market for the shares that enables the employees to convert stock into cash. Companies have taken a variety of approaches to this issue. Some companies believe that employees participating in a stock compensation plan should be no better off from a liquidity standpoint then are the principal shareholders of the company. The principal shareholders will generally have liquidity with respect to their investment only if the company is sold or goes public. Therefore, in those companies, nothing special is done to provide employees with liquidity with respect to their shares beyond ensuring that they will have the same liquidity opportunities as other company shareholders in the context of a sale of the company or an IPO.
Other companies believe that the stock compensation plan will provide a more tangible benefit for employees if they are able to realize some liquidity before the company is sold or goes public. In these situations, it is typical for the corporate sponsor to agree to purchase stock from employees. This can be done on a scheduled basis using a percentage of company revenue and profit each year, can be on an unscheduled basis as the company's cash flow permits or can simply be a commitment by the company to repurchase shares from employees for the fair market value of the shares when and as the employees leave the company. Alternatively, some companies have established an internal market that allows employees to trade shares among themselves. Companies should take care in the design of any stock repurchase program as some such programs can have a negative financial accounting impact.
Richard E. Wood is a partner in the Pittsburgh office of Kirkpatrick & Lockhart LLP. His practice involves executive compensation and qualified and non-qualified retirement plans. He has designed employment and severance agreements, incentive arrangements, stock compensation plans and deferred compensation plans for executives of private and public companies of all sizes. Mr. Wood also has had extensive experience with the employee benefit plan aspects of corporate transactions as well as with leveraged buyouts and other transactions involving employee stock ownership plans. He received his B.A. from Clarion University of Pennsylvania, his Masters degree from the University of Missouri, and his J.D. from the University of Pittsburgh. He can be reached at (412) 355-8676.
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