Equity Compensation for Startups

Equity Compensation for StartupsNo cash? … No problem

Drexel Entrepreneurial Law ClinicPresenters: Robert Bean, Nick Bridge, Michael Delaney, Marco Di Prato

Panelists: Chris Miller (Pepper Hamilton), Steven Poulathas (Flaster Greenberg)

Clinic Director: Steve Rosard

#PTW15

@PhillyTechWeek

Thank You to Our Sponsors

Agenda

• Student lawyer introductions• Why give equity compensation• Types of equity compensation• Tax consequences• Regulatory obstacles

– Valuation – Securities Compliance

• Other considerations– How much equity to issue – Process of issuing – Documents – Vesting– Transfer restrictions – Buyback

• Q&A

Why Grant Equity Compensation?

• Align interests

• Attract & retain talent

• Improve productivity

• No cash

Equity Compensation Types:Corporations and LLCs

Corporate Equity

• Stock Awards

• Options

– Incentive Stock Options (ISOs)

– Non-Qualified Stock Options (NQSOs)

• Phantom Stock

• Stock Appreciation Rights (SARs)

Stock Awards & Options

Stock Awards

• Represent ownership in the corporation

• Typically subject to vesting– “Restricted Stock Award”

Stock Options• Right to buy company stock in the future

at a specified price• Options also typically subject to vesting• Not a shareholder until exercise• ISO – favorable tax treatment

– IRC § 422– Only for employees– Pursuant to approved plan– $100,000 annual limit– Non-transferable – 10 yr. term max– Exercise price must be at least FMV– Holding periods

• NQSO– Any option other than an ISO

Phantom Stock & SAR

Phantom Stock

• Account credited with hypothetical or "phantom" shares

• Increases or decreases, based on the company’s stock and phantom dividends

• No exercise, settled upon vesting

• Settled in cash or stock

Stock Appreciation Right

• Contractual right to receive cash or stock equal to the appreciation in value of the company’s stock from date of grant

• No cost to exercise, unlike an option

• Settled in cash or stock

LLC Equity Alternatives

• Capital Interests

• Profits Interests

• Units Options

• Phantom Units

Capital Interests and Profits Interest

Capital Interests

• Stock award

• An immediate ownership interest in the LLC’s assets and future profits

• May be voting or nonvoting

Profits Interest

• Hybrid

• An interest in the LLC profits and/or appreciation in value.

• Valuation required at grant

Option and Phantom Units

Unit Options

• Same idea as C-corps

• Alternative to outright interest

• Exercise price can equal the FMV on the date of grant

• Option to acquire profits interest or a capital interest

Phantom Units

• Contractual rights that look and feel like equity

• Really a bonus plan under which the bonus amount is calculated using a formula related to the LLC’s financial results

Tax Consequences

Tax Consequences

Stock Award

• Ordinary Income = Fair Market Value – Amount paid

• Corresponding deduction– Same time and amount of

ordinary income recognized by recipient

Restricted Stock Award

• No tax at grant because subject to a “substantial risk of forfeiture”

• Tax at vesting

• Unless, 83(b) election is made

• Pay tax up front, start holding period

Tax Consequences - Options

NQSO

• No tax at grant or vesting

• Tax at exercise = FMV at exercise – exercise price

• Corresponding deduction

ISO• No tax at grant, vesting, or

exercise

• Tax upon sale– If holding period is met, capital

gain = sale price – exercise price

– If sold before holding period met:• Ordinary Income = FMV at exercise

– exercise price.

• Any amount above FMV at exercise is capital gain

• However, benefits often Illusory

• No deduction unless there is a disqualifying disposition

Tax Consequences – Cont’d

Phantom stock

• No tax at grant

• No tax at vesting if in compliance with 409A

• At settlement, if compliant with 409A, ordinary income = FMV of stock or cash received

• Corresponding deduction

SAR

• No tax at grant or vesting

• On exercise, ordinary income = amount of cash received or FMV of the shares received.

• Corresponding deduction

• 409A

Tax Consequences – Capital Interests

Tax Consequences to Recipient

• Taxable event upon vesting or lapse of substantial risk of forfeiture (or 83(b) election)

• Compensation income

• Income = FMV of interest minusany amount paid for interest

• Treated as a member of the LLC

Tax Consequences to LLC

• Entitled to a deduction equal to the amount of income recognized by the recipient

Tax Consequences – Profits Interests

Tax Consequences to Recipient

• Generally, not taxable if the receipt is contingent upon providing of services for the benefit of the LLC in a member capacity or anticipation of being a member.

• Not a taxable event if certain conditions are met. – Not related to a substantially certain

and predictable stream of income

– Not sold within 2 years

– Not a LP interest in a publicly traded P

Restricted Profits Interests

• If subject to vesting, still not a

taxable event if:– The 3 conditions are met

– Recipient treated as an owner from the date of grant

– No deductions made based on the profits interest at grant or vesting

• Although not required, still a good idea to make an 83(b) election

Tax Consequences – Profits Interests

Tax Consequences to LLC

• No deduction available

• Redemption or sale of profits interests affected by short term or long term capital gain

Restricted Profits Interests

• Same as previous slide

Tax Consequences - Membership

• Treated as a partner rather than an employee

• Form 1065 and Schedule K-1

• LLC not subject to withholding

• Self-employment taxes

Tax Consequences –Unit Options and Phantom Units

Tax Consequences on Options

• Same concerns as C-corp options

• Upon exercise of an option to acquire a capital interest, same tax result as with NQSO; LLC gets a corresponding tax deduction

• Exercise of an option to acquire a profits interest is generally not taxable and thus no deduction for LLC

Tax Consequences to Phantom Units

• If set up correctly, taxed like phantom stock

• Recipient subject to tax upon receipt of payment

• LLC receives a tax deduction

§409A

• Applies to non-qualified deferred compensation

– Any income earned, but not paid in same year

• Options, SARs, Phantom Stock/Units

• Penalty for non-compliance:

– Immediate tax upon vesting, which is subject to a 20% excise tax (in addition to the ordinary income tax) plus interest and possibly an additional state tax penalty

§409A Compliance

• Applicable exemptions:– Exercise price for options and SARS should be set at > FMV at grant date. – Settling of phantom account within 2 ½ months following year of vesting

• Permissible Payment Triggers/Events– Separation from service – Death– Disability– Change of control– Unforeseeable emergency– Specified date or a payment schedule under which neither of

the parties can affect the timing of the payments• Acceleration not permitted• Election to defer must be made before performing the services

Corporate Comparison

Stock Grant- Real equity- Entire value of stock- Corresponding deduction

Phantom Stock- Contractual, not equity- Entire value of stock- Subject to §409A- Corresponding deduction

Options- Real equity (when exercised)- Appreciation in value only- Must pay to exercise- ISO: favorable tax treatment to holder

(although often illusory), possibly no deduction

- NQSO: ordinary income, deduction- Subject to §409A

SAR- Contractual, not equity- Appreciation in value only- Subject to §409A- Corresponding deduction

LLC Comparison

Capital Interests- Share the whole pie- Members- Taxable event on grant or vesting - Capital gains, maybe- Corresponding LLC deductions

Profits Interests- Share future pieces of pie - Members- Not a taxable event- Capital gains, maybe - No LLC deductions - Complex valuation and accounting

Unit Options- Can be capital or profits- Nonmember until exercise - Nontaxable until exercise - Ordinary income - Corresponding LLC deductions- Subject to §409A

Phantom Units - Disguised bonus plan - Nonmember status remains- Nontaxable until payment- Ordinary income- Corresponding LLC deductions- Avoids accounting complexities - Subject to §409A

Startup Valuation

More An Art Than a Science

Valuation - Introduction

• Why perform a valuation?

– Avoid future repercussions for noncompliance

• IRS scrutiny

• Investor/buyer due diligence

• Two levels of valuation:

– Ordinary Valuation: When issuing Profits Interest, Restricted Stock Units, Common Units/Stock

– §409A Valuation: When issuing Options, Phantom Equity, Stock Appreciation Rights

Valuation - Ordinary

• How to perform an ordinary valuation?

– Independent Appraisal

– Internal Valuation

• Must be good faith number based on

reasonable metrics of company value

• What is the optimal number?

– As low as reasonably possible

Valuation – §409A

• A non-publicly traded company must determine the fair market value of its stock by reasonable application of a reasonable valuation method.

• What’s Reasonable?– Must take into account all available

information that is material to the

value of the company

• Two Relevant Safe Harbors– Independent Appraisal

– Illiquid Startup Valuation

Valuation – §409A Illiquid Startup Valuation

• Valuation satisfies §409A if:– It is prepared by someone who is reasonably qualified

based on significant knowledge, experience, education or training

• Who Qualifies for this Exception?– Startups that

• Have been conducting business for

less than ten years

• Have no publicly traded securities

• won’t be acquired within 90 days or go public within 180 days, and

• Have common stock that is not subject to obligations to purchase the stock

Valuation – What Factors do I Need to Consider?

• Hard Numbers– Historical profits, tangible assets, cash flow and

liabilities

• Soft Numbers– Income and cash-flow projections

• Intangible Assets– Patents, brand names, quality or reputation of

management, location, goodwill

• Other– Market value of stock or equity interests of

similar companies, evaluation of the state of the industry

Securities Compliance

Restricted Securities: Cannot Be Issued, Except When They Can.

Securities – How Do They Affect Me?

• Every offer or sale of a security must, before it is offered or sold in a state, be registered or exempt from registration under both federal securities laws, and the laws of the state(s) in which the security is offered and sold

• If an offering fails to comply, the company risks the following:– Recipient sues company for:

• Rescission of the of the equity grant• Damages if the investor sold thesecurities for less than he bought them

– Damaging chances of future investment or sale

Securities – Exemptions for Employee Compensation

SEC Rule 701 Exemption

• Allows limited amounts of equity to be issued as employee compensation

State Securities Exemptions

– Laws of Recipient’s state of residence apply to equity grants

– PA Blue Sky laws have an exception where securities that are being issued in good faith reliance that the transaction qualifies for an exemption under SEC Rule 701

Securities – What Offerings Qualify Under Rule 701?

• Offerings over any consecutive 12-month period, the sum of which do not exceed the greatest of:

– $1 million in aggregate sales price

– 15% of the total assets of the company

– 15% of the outstanding amount of the

class of securities being offered

• What is the Aggregate Sales Price?

– The sum of consideration paid in exchange

for the equity

Determined when an option is granted

Granting Equity: Other Considerations

How Much Equity to Issue

• Will vary throughout the different stages of a company’s growth• Non-Founder employee ownership typically ranges from 10-20%

• Early employees granted equity in terms of points i.e., 1%, 2%, 5%, 10%

• After core group of employees assembled, Company should grant equity in amounts based on the dollar value of equity

Process of Issuing Equity

• After determining what type of equity to issue the company will have to:– Approve issuances pursuant to organizational documents

• May require approval of existing members and/or a Board of Directors

– Determine Fair Market Value of company

– Ensure compliance with regulations

– Execute Documents

What Documents do you need?

Company will need to

• Document granting the particular incentive equity such as:

– Profits Interest Grant

– Restricted Unit Grant Agreement

– Option Agreement/Option Exercise Agreement

• Documents related to particular relationship – Employment Agreement,

– Advisory Agreement,

– Independent Contractor Agreement

• 83(b) Election

Vesting – A Primer

• What is Vesting?– Contractual device preventing transfer of equity to the

employee until certain time or performance based conditions have been met

• Common Forms– Time Based Vesting– Performance Based Vesting

• Why do I Want Vesting?– Incentivize employees to stay– Improve productivity– Keep control of equity

Vesting – Acceleration

– What is Acceleration?

» When the unvested equity awards become vested on the occurrence of certain events following the buyout but before the end of the applicable full vesting period.

• Types of Acceleration:

– Single Trigger – Acceleration based on a single event, like company sale

– Double Trigger – Acceleration based on two events, such as company sale and termination of service

• Should there be Acceleration on a Sale?

Transfer Restrictions

• Right of First Refusal– Contractual right prohibiting equity holder from selling equity to a

third-party without first giving the company and/or Members of a company the opportunity to purchase equity on same terms

– Requirements:

• Bona Fide Offer

• Written Notice to Company and Members

• Period of time for Company and/or Members to exercise this right

Buyback rights

• Provides the company the right to repurchase equity issued in certain circumstances - such as termination, with or without cause, death/disability, or other involuntary transfers

• Termination for cause– Generally, for a discounted price

– “For Cause” generally includes:• Intentional wrongdoing by the employee.

• Fraudulent conduct by the employee.

• The employee's theft of company property.

• The employee's substantial failure to perform job duties.

• Intentional breach of company policies by the employee.

– What about poor performance?

Any Questions?

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