Giving Employees a Piece of the Company Equity Pie

Private companies typically compensate their employees primarily with salary, bonuses and employee benefits such as retirement plans and health insurance. Many early-stage, venture capital-backed companies seek to manage these costs by giving their employees some “skin in the game” through awards of Restricted Stock or Stock Options. Even more mature private companies occasionally supplement the compensation of higher-level executives and, in some cases, lower-level employees with corporate stock or option grants, or LLC equity or option grants. And LLCs have one additional employee equity incentive tool in their kit – Profits Interests.

The tax laws governing employee equity incentives are frustratingly complex. Over the years, we have seen what works well and what’s not worth the effort when it comes to setting up equity incentive plans. Following is an overview of some of the things we’ve learned along the way.

Equity Incentive Alternatives for Corporations

The most common types of equity incentives for corporations are:

1. Restricted Stock – an actual grant of shares of corporation stock which may or may not be subject to “vesting” restrictions that create an incentive for the employee to stay with the company and may be repurchased by the company upon termination of employment.
2. Stock Options – the right to purchase shares of corporation stock at a specified time at a specified “exercise” or “strike” price, and which may be “incentive stock options” or “non-qualified stock options”.
3. Restricted Stock Units (“RSUs” or “phantom stock”) – the right to receive shares or the cash value of the shares after the RSUs vest, which may or may not be “deferred” RSUs or “DSUs” which can provide better tax treatment to the employee.
4. Stock Appreciation Rights (“SARs”) – the right to receive the appreciation in value of shares rather than the full value of the shares when the SARs vest, either through the issuance of a portion of the underlying shares or, more commonly, a cash payment.

Choosing the “Best” Corporation Alternative

The selection of any type of equity incentive will be made on the basis of both the company’s business objectives and tax considerations. Restricted Stock and RSUs give the employee the full value of the shares, whereas Stock Options and SARs only entitle the employee to the increase in value of the shares. Restricted Stock and Stock Options enable the employee to own “real” stock (and are easier to understand), whereas RSUs and SARs are typically paid out in cash.

In our experience, the perceived tax advantages of “incentive” or “statutory” Stock Options or “ISOs” are usually not actually realized, so we see more “non-qualified” Stock Options being issued today than was the case several decades ago. We often advise companies to grant Restricted Stock (or, for LLCs, Profits Interests) or RSUs to key management employees and Stock Options or SARs to lower-level personnel. RSUs and SARs that are paid in cash don’t dilute the stock percentages of the company’s shareholders. The “vesting” of each type of equity incentive determines when the employee becomes entitled to receive shares or cash, and can be time-based or triggered upon the achievement of specified “performance” events.

Restricted Stock is usually taxable as compensation based on the fair market value of the shares when the shares are received (either because they are not subject to vesting or are subject to vesting and the employee makes a so-called “83(b)” election to avoid future taxation on the value appreciation in the shares). Restricted Stock that is purchased for cash or a recourse promissory note should not be taxable to the employee if the cash or principal amount of the note equals the fair market value of the shares. A later sale of Restricted Stock or shares received upon the exercise of Stock Options results in capital gain to the employee on the difference between the original value of the shares and the sale price.

Stock Options issued with an exercise price equal to the fair market value of the shares are not taxable upon grant, but upon exercise the difference between the exercise price and the fair value upon exercise is taxable as compensation income. RSUs and SARs are usually taxable as compensation income upon the employee’s receipt of shares or cash. Whenever an employee recognizes compensation income related to an equity incentive award, the company is entitled to a tax deduction. Because of this, some companies are willing to assist their employees with bonuses to help them pay the taxes on the income triggered by Restricted Stock grants or Stock Option exercises.

Section “409A” of the tax code makes it important to set the exercise price of Stock Options or SARs at the fair market value of the shares upon grant. However, Stock Options that are not exercisable until the earlier of termination of employment or a company sale may have an exercise price below fair market value (but we typically advise that the strike price be equal to at least 20% of the share value). And RSUs need to be carefully designed to avoid similar adverse tax consequences under 409A. Many companies obtain independent valuations for purposes of complying with 409A but some value their shares based upon some reasonable methodology. A 409A “foot fault” can have bad consequences for the employee, including acceleration of taxation and a 20% penalty tax back to the year of the grant. Depending on the company’s objectives for certain employees and the timing of awards, we have helped clients design options, SARs and RSUs both to comply with 409A and to avoid it altogether.

LLC Alternatives – Similar, But with One Unique Alternative

Like corporations, limited liability companies (“LLCs”) taxed as partnerships can grant equity incentives similar to Restricted Stock, options, RSUs and SARs. The business and tax planning considerations are similar to those for corporations. However, LLC restricted equity or equity acquired via options can have a significant go-forward impact on the employee’s taxation (in particular, because the employee may be treated as a “partner” receiving “K-1s” rather than a “W-2” employee for various tax and benefits purposes).

The most significant equity incentive alternative which is only available to LLCs (and not corporations) are Profits Interests. Profits Interest are actual LLC shares or equity, but if properly designed, can be received without current income taxation to the employee and a future sale of the Profits Interest shares will be taxable as capital gains. This is accomplished by structuring the Profits Interest in a manner that is economically similar to Stock Options and SARs, so that the employee is only entitled to benefit from the increase in value of the Profits Interest shares following the date they are received. However, we often design Profits Interests which allow the employee to be “caught up” if future company profits or sale gain are sufficient to provide the employee with the full value of the shares.

Profits Interest can and are usually subject to vesting conditions similar to Restricted Stock and Stock Options. It is common for vesting Profits Interest recipients to make the 83(b) election mentioned above to provide additional protection from future taxation if the company’s value was inaccurately determined at the time of grant or the Profits Interest shares are sold within 2 years of grant. The award of LLC shares or units which do not qualify as Profits Interest will generally be subject to the same tax rules applicable to Restricted Stock. Profits Interests are a great equity incentive alternative in the right circumstances, and have become especially popular with private equity-backed companies structured as LLCs.

Take Aways

Employee equity incentives are a powerful tool in providing employees with an additional incentive to work for a company’s success and eventual sale. They can be particularly valuable for a business that is planning to sell in a few years after the employee team has helped the company achieve strong growth and a high valuation. In deciding whether, how, and when to grant equity incentives, a company’s management should work with their accountants and attorneys to determine which types of equity incentives will best achieve their business goals and provide a fair tax result as between the employees and the company.

Upfront tax planning and well-drafted legal documents (including an equity incentive plan and individual agreements for Restricted Stock, Stock Options, RSUs, SARs or Profits Interests) are critical to achieving the intended business and tax results and protecting the company and its principal owners. The legal documents should give the company maximum flexibility regarding the vesting, payment, transfer, forfeiture, and repurchase of the equity incentives upon the death, disability or termination of the employee or a company sale.