Sharing Equity With Employees: Options, Restricted Stock, Phantom Stock, and Stock Appreciation Rights

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Sharing Equity With Employees Options,
Restricted Stock, Phantom Stock, and Stock
Appreciation Rights

• Corey Rosen
• National Center for Employee Ownership
• www.nceo.org

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Key Decisions in Equity Sharing

• Deciding how much equity to share
• Deciding who will get how much with what terms
• Allocation
• Vesting
• Sale of stock rules
• Deciding how to make shares liquid
• Choosing a form or forms of equity

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Models for Deciding How Much Equity to Share

• Approaches
• Fixed percentage of the company (such as 10)
• Individual percentage of the company based on
  surveys
• Dynamic model based on sharing a percentage of
  growth targets

• Pros and Cons
• Simple and intuitive
• 10 of one company is not 10 of another
• Doesnt accommodate growth easily
• May be what people expect
• Seems market based
• Doesnt accommodate growth easily
• Hard to equate value across companies
• Less certain about how much will be shared
• Focuses on sharing value, not percentages
• Changes entitlements to incentives

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Deciding Who Gets How Much

• Approaches
• Using surveys
• Percentage of compensation
• Merit assessment
• Egalitarian

• Pros and Cons
• Market-based (in theory)
• Hard to find truly comparable companies
• Your other compensation and your corporate
  philosophy may be very different
• Consistent with your assessment of employees
  overall contribution
• May seem more equitable to broad employee
  population
• Doesnt recognize special roles or abilities
• Based on actual contributions
• Can be difficult and controversial to implement
• All in this together
• Top performers may see it as unfair

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Vesting, Exercise, and Share Sale Rules

• Vesting can be gradual, cliff, or only on a
  liquidity event
• If only at a liquidity event, will employees
  over-discount the value of the reward?
• Will employees be able to exercise before a
  liquidity event?
• If they can, and have to pay taxes, will they
  resent this?
• Can employees sell the shares to anyone or will
  the company have a right of first refusal?

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Liquidity

• Value for the shares must be established. If the
  company is public, a rule must be set as to what
  price (such as average price for the day)
  governs. If private, some form of reasonable
  valuation method must be employed.
• Company can be sold or go public, but this may be
  impractical or too far off in the future. Company
  can also buy back shares and/or arrange informal
  markets between employees.

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Choosing an Instrument

• Stock options
• Restricted stock
• Phantom stock
• Stock appreciation rights
• Other approaches

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Stock Options

• Rapid growth of plans giving stock to most or all
  employees from 1 million employees in 1992 to 12
  million in 2001. This number has now dropped to
  about 9 million due to accounting rules changes
  and shareholder pressure for reduced dilution.
• Most common in technology companies, but most
  people getting them actually work for
  non-technology companies.
• Most common in pre-IPO, pre-sale, and public
  companies or as a tool to compensate key employees

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What is a Stock Option?

• Right to buy shares at a price fixed today for a
  defined number of years into the future
• Can be granted on a discretionary basis
• Different kinds of options have different kinds
  of tax treatment

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ISOs and NSOs

• Spread on nonqualified options (NSOs) is taxed at
  exercise as ordinary income and is deductible to
  the employee.
• Employee who gets an incentive option (ISO) is
  not taxed on exercise, but rather at sale, and
  then the spread is taxed as a capital gain.
• ISO must be held one year from exercise and two
  years from grant. Spread is not deductible to
  company.

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More ISO Rules

• Grant at fair market value 10 shareholders must
  receive grant at 110 of FMV
• Not more than 100,000 can first become
  exercisable in any one year
• Not more than 10-year term
• Only employees can hold ISOs (automatically
  convert to nonqualified options if not exercised
  within 90 days of termination)

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The Dreaded AMT

• The spread on the exercise of an incentive stock
  option is subject to Alternative Minimum Tax.
• Many, if not most, ISO recipients will be subject
  to the AMT, meaning they will have to pay tax in
  the spread with their next return even though
  they have not sold their shares.

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Nonqualified Options Rules

• Can be granted to anyone
• Can have any terms the company chooses
• Can be transferred, but the tax obligation rests
  with optionee

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Restricted Stock

• Right to buy or be granted stock
• Stock only transfers when restrictions lapse,
  such as meeting performance or vesting targets.
• Taxed as ordinary income when restrictions lapse
  unless 83(b) election made

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83(b) election

• Election to be taxed on value of benefit at time
  of grant (may be zero if stock purchased for FMV)
• If stock never transferred, taxes cannot be
  recovered.
• If stock is transferred, gain from FMV at time of
  grant to FMV at time of sale is taxed as capital
  gain.
• When employee realizes ordinary income, employer
  gets a corresponding tax deduction.

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Phantom Stock and SARs

• Phantom stock is the right to the value of a set
  number of shares, subject to some restriction
  lapsing (vesting, performance, etc.) Usually paid
  in cash, not shares.
• Stock appreciation rights (SARs) are the right to
  the increase in the value of a number of shares.
• Both are taxed as ordinary income when paid.

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Stock Settled SARs

• Essentially the same as a stock option, except
  that, typically, when they vest the employee
  would exercise the SAR rather than wait for some
  additional term
• Less dilutive than options

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Accounting Issues

• Companies must record the estimated present value
  of all equity awards at the time of grant.
• Formula considers volatility, dividends, risk-
  free interest rates, exercise and current price,
  and expected life of award
• Amounts can be adjusted to forfeitures.

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Deferred Compensation Rules

• If an employee chooses to defer receipt of an
  exercised award, taxation can be deferred if
  certain rules are met.
• For time-vested awards, deferral election to a
  specific date must be made in the year prior to
  the year the award vests.
• For performance-vested awards, election can be
  six months before
• For equity awards discussed here, applies only to
  cash-settled SARs and phantom stock and
  discounted stock options.

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Equity Compensation Plans in LLCs

• Limited liability corporations do not have
  stockthey have membership interests.
• There are parallel equity awards available in
  LLCs, but with some wrinkles.
• LLCs are pass-through entities, so there is no
  corporate level tax. Unlike S corporations, they
  can allocate profits and tax obligation as they
  see fit as opposed to pro rata to ownership.

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Profits interests

• Closest parallel to stock options.
• Entitle the owner both to capital appreciation
  and profits of the business.
• Grant no taxable if award held for at least two
  years.
• The LLC and the employee treat the employee as
  the tax owner of the interest from the date of
  its grant and the employee reports his or her
  distributive share of all partnership tax items
  in computing the employee's income tax liability
  for the entire period during which the employee
  has the interest.
• Company does not get a deduction employee gets
  capital gains tax on sale.

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Capital Interests

• Closest parallel to restricted stock
• Right to share in the value of LLC assets through
  the receipt of a share of the proceeds upon sale
  of the LLC assets.
• Fair market value of award taxable in year no
  significant risk of forfeiture (vesting)
• Section 83(b) election can be made (tax treatment
  same as for restricted stock) company gets
  parallel deduction.
• If award is fully vested, owner is treated as a
  member for LLC tax purposes.

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Units and Unit Rights

• Parallel to phantom stock and stock appreciation
  rights.
• With units, employee gets the right to the value
  of membership interests at a specified time
• Unit appreciation rights provide the employee
  with the right to the increase in the value of
  the membership interests
• Awards paid out in cash and taxed the same way as
  a bonus
• Employees not considered LLC members for tax
  purposes
• Simplicity of model often makes it the award of
  choice, but the employee has no opportunity to
  have the gains taxed as capital gains

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Other Forms of Equity Compensation

• 401(k) Plans
• Company matches
• Employee contributions
• Employee Stock Purchase plans
• Employee set aside after tax wages for an
  offering period, usually 6 months to two years
• Can buy stock at lower of 15 off share price at
  beginning or end of offering period
• ESOPs

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Direct Stock Purchases or Awards

• Simplest of plans
• Can be financed as a bonus, with a loan, or with
  employee after-tax money

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Securities Law Issues

• If there is an offer to sell, this triggers
  securities law issues.
• Exercise of an option comes under this
  definition.
• Closely held companies can be exempted from
  registration under federal and most state laws if
  they meet certain rules.
• Anti-fraud disclosure statements are required.

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Percentage of Employees Eligible for Equity
Percentage of Each Group Eligible to Receive Equity Percentage of Each Group Eligible to Receive Equity Percentage of Each Group Eligible to Receive Equity Percentage of Each Group Eligible to Receive Equity Percentage of Each Group Eligible to Receive Equity
eligible to receive equity "C" level executives Other management Supervisory and technical employees Hourly and other non-supervisory, non-technical employees
0 3 21 31 56
130 0 5 13 0
3150 0 0 3 5
5199 0 8 0 0
100 97 67 54 38
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Percentage Actually Receiving Equity
Percentage of Each Group Actually Receiving Equity Percentage of Each Group Actually Receiving Equity Percentage of Each Group Actually Receiving Equity Percentage of Each Group Actually Receiving Equity Percentage of Each Group Actually Receiving Equity
that receives equity "C" level executives Other management Supervisory and technical employees Hourly and other non-supervisory, non-technical employees

0 3 21 31 59
130 0 10 13 0
3150 3 0 8 5
5199 0 15 3 0
100 95 54 46 36
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of Awards Going to Each Group
Percentage of Awards Going to Each Group Percentage of Awards Going to Each Group Percentage of Awards Going to Each Group Percentage of Awards Going to Each Group Percentage of Awards Going to Each Group
of equity granted "C" level executives Other management Supervisory and technical employees Hourly and other non-supervisory, non-technical employees
0 9 29 37 63
130 20 51 54 34
3150 11 11 0 3
5199 40 9 6 0
100 20 0 3 0
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Forms of Equity by Group
Forms of Equity Going to Each Group Forms of Equity Going to Each Group Forms of Equity Going to Each Group Forms of Equity Going to Each Group Forms of Equity Going to Each Group Forms of Equity Going to Each Group
Type of award that grant this type of award "C" level executives Other management Supervisory and technical employees Hourly and other non-supervisory, non-technical employees
Stock options 57 57 50 48 29
Restricted stock 17 17 5 0 2
Restricted stock units 5 5 5 5 2
Performance shares/units 26 21 10 7 5
Stock appreciation rights 10 10 7 7 7
Phantom stock 12 12 5 2 0
Other 24 21 14 14 12
that offer any type of award that offer any type of award 98 79 69 48
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Additional Resources

• The Decision Makers Guide to Equity Compensation
• Equity Compensation for Limited Liability
  Companies
• 2012 Private Company Equity Compensation Survey