Embed Size (px)
Citation preview
Effective Equity Compensation Practices
Presented By:
Joshua AgenFoley & Lardner LLP
Amber Widener, CPAComStock Advisors
September 11, 2019
Today’s AgendaPublic v. private compensation practices
Purposes of equity-based compensation
Top 8 equity-based vehicles
Public v. Private Compensation PracticesTopic Public Private
Pay elements Standardized (base salary, annual bonus and long-term incentives)
Variable/customized (base salary, some form of incentive compensation)
Long-term incentives Annual grants; mix of stock options, restricted stock and/or performance shares
One time or irregular grants; single vehicle (for example, stock options alone)
Performance metrics Relative goals often used Operational goals or some measure of increase in enterprise value
Valuation Based on market price Independent appraisal or formula valuation
Liquidity Provided primarily by public market Provided primarily by company or other shareholders; may be limited
Pay governance Stock exchange rules focus on independent oversight, shareholder protection
Voluntary or required by owners
Benchmarking Typically on regular cycle, easy access to peer data
Less frequent and regular; difficult/costly to obtain peer data
Disclosure/Transparency SEC regulations require full disclosure of top executives’ pay
No disclosure required (except certain financial information to participants if thresholds are met)
Purposes of Equity-Based Compensation Incentive alignment Ownership mentality Succession planning Retention Recruiting Cash conservation Optimization of tax outcomes
Some Key Questions in Designing Equity-Based Compensation What are our goals? Who should be included? How much should we spend? Should we grant “real” or “phantom” equity? Which compensation vehicle best fits our goals,
participant expectations and company culture? What is the tax treatment? What is impact on the other equity holders in the
Company? What are the risks?
Top 8 Equity-Based Compensation Vehicles Real Equity
1. Nonqualified stock options (NQSOs)2. Incentive stock options (ISOs)3. Restricted stock4. Profits interests
“Phantom” Equity1. Stock appreciation rights (SARs)2. Phantom stock/restricted stock units (RSUs)3. Performance shares/units (PSUs)4. Sale bonus
Nonqualified Stock Options (NQSOs) Option to purchase shares of company stock at a
stated price (“exercise price”) over a given period of time, frequently ten years
No required terms and conditions– But will be subject to Code Section 409A if granted at a
discount to fair market value (“FMV”)– Importance of valuation to establish FMV– Watch out for backdating!
NQSO Key Advantages Service Provider
– Possibility of large gains; usually no limit on upside appreciation potential
– Can time exercise to maximize gains (if exempt from Code Section 409A)
– Tax deferral until exercise Company
– Noncash means of compensating and potential source of paid-in capital
– Alignment of interests with shareholders
NQSO Key Disadvantages Service Provider
– Gain at exercise is taxed as ordinary income, rather than a capital gain
– May need to borrow money or sell shares to finance option exercise and tax obligation
Company– Option holder gains may not parallel internal performance standards and/or
actual management performance
– Defers tax deduction
– Pressure to provide financing
– Issues around cash flow and valuation if will repurchase shares upon termination of employment
Incentive Stock Options (ISOs) – Special Rules Both plan document and award must meet
specified Internal Revenue Code requirements Plan requirements:
- # of shares reserved for issuance as ISOs- Employees eligible - 10-year term- Approved by shareholders
within 12 months of adoption
Other ISO Special Rules Award requirements:
- Only to employees- Exercise price of at least FMV (110% for 10% shareholders)- 10-year term (5 years for 10% shareholders)
No more than $100,000 may vest in any given calendar year (based on FMV of stock on the grant date)Example: On grant date, stock has FMV of $10. Employer grants ISOs with respect to 40,000 shares (aggregate of $400,000). Options vest 25% on each of the first four anniversaries of the grant date. Since only $100,000 is vesting in any given year, ISO limit is met.Excess is automatically NQSO.
ISOs –Tax Treatment
On the date of exercise, no tax consequences to employee– although spread counted for alternative minimum tax (AMT)
purposes Tax event occurs at time of stock disposition If the employee holds the stock for (1) one year
from the date of exercise and (2) two years from the date of grant, then at the time of disposition of the stock, excess of FMV over exercise price is taxed at capital gains rates
Incentive Stock Options –Tax Treatment (continued) Employer receives no tax deduction If employee does not hold stock for the two holding
periods, then taxed as a NQSO; employer can receive tax deduction
ISO Key Advantages Service Provider
– No tax at exercise (other than possible alternative minimum tax); taxation delayed until stock is sold
– Potential capital gains treatment
Company– Provides a noncash means of compensating employees and a potential
source of paid in capital
– Promotes shareholders’ interests by facilitating employee stock ownership (especially due to ISO holding periods) and ensuring that employee’s gains parallel shareholder gains
– Less pressure to help employees finance option exercises, since taxes are not owed until stock is sold
ISO Key Disadvantages Service Provider
– Various restraints are imposed to realize ISO tax treatment– Preference item for alternative minimum tax (AMT) purposes
that neutralizes tax benefits for many employees
Company– No corporate tax deduction is allowed if executive makes a
qualifying disposition– Potential dilution
Stock Option Valuation Treatment
Intrinsic Valuation Method Option Pricing Model Put/Call Provisions
* Applies to Phantom Equity as well
Restricted Stock An award of stock, typically with no or nominal cost to service
provider– Non-transferable (DLOM)– Subject to a substantial risk of forfeiture
As owners of the shares, service providers normally have voting and dividend rights even while shares are subject to restrictions
These restrictions typically lapse over a period of 3-5 years Company becomes “market”
– Ability or Desire to pay *– Shareholder going to get fair value?
Restricted Stock Key Advantages Service Provider
– Service provider gets company stock – usually with voting and dividend rights – without personal investment
– Flexibility for tax at grant, if desired, and capital gains thereafter
Company– Alignment of interests with shareholders– Potential for forfeiture (if service provider leaves before
restrictions lapse) can aid retention– Provides form of incentive for companies with flat or declining
stock price
Restricted Stock Key Disadvantages Service Provider
– Shares can be forfeited if early taxation is elected; taxes will be lost as well if shares are forfeited
– Unless early taxation is elected, gain when restriction lapse is taxed as ordinary income, rather than as a capital gain
– Cannot time tax event
Company– May create adverse shareholder reaction due to appearance of
getting “something for nothing”– Service provider has stockholder rights, even while stock is
unvested
Profits Interests Actual equity in an entity taxable as a partnership
that has no value on grant, but shares in future profits and changes in value– Show there is no value or NOT a profits interest*
Common alternative when the entity granting the right is taxed as a partnership
Rights defined in LLC or partnership agreement Significant flexibility in how the rights are defined
and when and how grantee shares in future value Interests are commonly redeemed upon
termination of employment, but may be redeemed earlier
Profits Interests Key Advantages Service Provider:
– No tax on grant– Capital gains treatment on redemption– Right to share in cash distributions made to owners
Company:– No employment tax cost, although guaranteed payments may
be grossed up to protect the grantee– Provides real equity incentive to grantee that is the same as the
owners have
Profits Interests Key Disadvantages Service Provider:
– Some disadvantages from being taxed as a partner, including need to make quarterly estimated tax payments
– Recognize value only when employment terminates– Grant has no current value
Company:– Dilutive of current owners– Potential valuation issues at time of grant
Stock Appreciation Rights (SARs) Rights that permit the service provider to receive a
payment equal to the excess of the stock’s value at exercise over the grant price
Once exercisable, participants may control when to exercise outstanding SARs during the SARs’ term
Payment may be in cash and/or stock May be granted to employees or non-employees
Stock Appreciation Rights (continued) Will be exempt from Code Section 409A if:
– Never represent the right to receive more than the excess of the fair market value of company stock on the exercise date over the fair market value on the grant date
– The number of SARs is fixed on the grant date and– There is no deferral of income beyond the exercise date
Fair market value of stock must be determined pursuant to the Code Section 409A regulations
SAR Key Advantages Service Provider
– Possibility of large gains (although some plans cap gains)– Requires no personal investment and avoids cost of financing
option exercises– Avoids costs and risks of continuing to hold shares after
exercise– May be able to exercise to maximize gains
Company– Alignment of interests with shareholders– No need to assist service providers with financing since no
investment is required
SAR Key Disadvantages Service Provider
– Gains may be capped by company imposed maximums designed to limit accounting charges and potential cash drain
– No opportunity for capital gains– Ability of the Company to manipulate value at exercise
Sandbagging
Balance sheet
Company– Does not result in actual share ownership unless awards are
settled in stock– No paid-in capital
Phantom Stock/Stock Units Also referred to as cash-settled restricted stock
units (RSUs) Right to receive cash equal to the FMV of x number
of shares Form of deferred compensation Used when owner has no desire to grant ownership
rights to employees
Phantom Stock/Units Key Advantages Service Provider:
– Possibility of large gains– Taxation delayed until award is settled– Requires no personal investment
Company:– Promotes shareholders’ interest by ensuring that service
provider’s gains parallel shareholder gains– Focuses service provider attention on long term growth – No need to assist service providers with financing since no
investment is required– Forfeiture requirements for termination before settlement can
aid service provider retention– Service provider does not have stockholder rights
Phantom Stock/Units Key Disadvantages Service Provider:
– Gains may be capped by Company-imposed maximums designed to limit accounting charges and potential cash drain
– No opportunity for capital gains– Cannot time exercise to maximize gains
Company– Service provider gains may not parallel internal performance
standards and/or actual management performance– ERISA concerns if payout occurs only at termination of
employment or after long period (more than 10 years)– Flexibility limited by Code Section 409A
Performance Shares/Units (PSUs) A contingent grant of a right to receive a fixed
number of common shares at the beginning of a performance cycle, with the number of shares payable at the end of the cycle dependent on how well performance objectives are achieved– May or may not be dilutive until actually granted
The ultimate value of the performance shares depends on both the number of shares earned and their value at the end of the cycle
Duration of performance cycles varies, but is typically 3-5 years
Performance Share Key Advantages Service Provider:
– Possibility of large gains (including upside potential due to share price appreciation)
– Reward partially related to a measure over which service provider has some control
Company– Alignment of interests with shareholders– Unlike purely stock based devices, awards can also be linked
to the planning process and attainment of strategic business goals
– Forfeiture requirements for mid-cycle termination can aid service provider retention
Performance Share Key Disadvantages Service Provider:
– Gains could be zero if performance targets are not met, even with share price appreciation
– Gains may be capped by company imposed maximums to limit accounting charges and cash flow drain
– No opportunity for capital gains during performance period
Company:– Choice and design of financial targets may be difficult– Service provider gains do not necessarily parallel shareholder
returns (because of other performance objectives), which could create shareholder relations problems
Sale Bonus A contingent right to a cash bonus upon a sale of
the Company The ultimate value can be a fixed dollar amount or
can be made dependent on the sale price of the Company received in the sale as well as the individual service provider’s percentage interest
Shareholders should consider “take-aways” from value *
Sale Bonus Key Advantages Service Provider:
– Possibility of large gains – Reward partially related to a measure over which service
provider has some control (maximizing sale price)– Requires no personal investment– Taxation delayed until sale event
Company:– Promotes shareholders’ interests since service provider gains
are related to value realized on sale– No need to assist service providers with financing since no
investment is required– Forfeiture requirements for pre-sale termination can aid service
provider retention
Sale Bonus Key Disadvantages Service Provider:
– No opportunity for capital gains during performance period– Sale price may not be within service provider’s control– Sale may lead to termination of employment– Sale bonus will likely be parachute payment for tax purposes
(potentially incurring a 20% excise tax)
Company:– May focus service provider exclusively on sale at expense of
other goals– Sale bonus may be a parachute payment for tax purposes
(potentially incurring limit on deductibility)
ATTORNEY ADVERTISEMENT. The contents of this document, current at the date of publication, are for reference purposes only and do not constitute legal advice. Where previous cases are included, prior results do not guarantee a similar outcome. Images of people may not be Foley personnel.© 2019 Foley & Lardner LLP
Questions?Joshua AgenOf CounselFoley & Lardner [email protected]
Amber Widener, CPAManagerComStock [email protected]
Appendix – Tax Treatment
NQSO Tax Treatment Service Provider
– No tax consequences at grant or vesting– At exercise: excess of FMV over option price is ordinary
income and subject to FICA and withholding (if employee)– At sale: any appreciation or depreciation from exercise is
capital gain or loss
Company– No tax consequences at grant or vesting– At exercise: deduction for amount recognized by option holder
in year option holder is taxed– At sale: no tax consequences
Restricted Stock – Tax Treatment General tax rule
– When stock vests, FMV is taxable as compensation income– Withholding taxes due for employees
Section 83(b) election– Tax is payable at the time of grant; future appreciation is capital
gains – Must make election within 30 days of grant date– If forfeit stock, not reversible– Good idea for companies with
low-value stock
Tax Treatment of Profits Interests Service Provider:
– At grant: No tax consequences– Annual: Allocation of income or loss on an annual basis in
accordance with distribution threshold in governing documents as long as value has not decreased
– At redemption: Normally will be long term capital gain Company:
– At grant: No tax consequences– At redemption: No tax consequences unless equity is forfeited
and capital accounts allocated to other members
Tax Treatment of Profits Interests (continued) FICA: Grantee of the profits units will be treated as
a partner, not an employee. Income allocated to the grantee and compensation paid as guaranteed payments will be subject to self-employment tax
Guaranteed payments may be treated as compensation if grantee employed by separate entity
SAR Tax Treatment Service Provider:
– At grant: No tax consequences– At exercise: Value of the rights is taxed as ordinary income
and is subject to FICA and income tax withholding (if employee)
Company:– At grant: No tax consequences– At exercise: Tax deduction is allowed for the amount of the
service provider’s taxable income from SARs
Phantom Stock/RSU Tax Treatment Service Provider:
– At grant: No tax consequences.– At vest: FICA due– On payment date: Value of the units is taxed as ordinary
income and is subject to income tax withholding (if employee) Company:
– At grant: No tax consequences– On payment date: Tax deduction allowed for the amount of the
Service Provider’s income from the units
Performance Share Tax Treatment Service Provider:
– At grant: No tax consequences– On payment date: Ordinary income tax is owed on the value of
the award (whether paid in cash or unrestricted stock). This income is subject to FICA and income tax withholding (if employee)
Company:– At grant: No tax consequences– On payment date: Tax deduction allowed for the amount of the
Service Provider’s income from the award
Sale Bonus Tax Treatment Service Provider:
– At grant: No tax consequences– On payment date: Ordinary income tax is owed on the value of
the payment. This income is subject to FICA and income tax withholding (if employee)
Company:– At grant: No tax consequences– On payment date: Tax deduction allowed for the amount of the
service provider’s income from the bonus
