What Do Private Companies Need to Know About Equity Compensation?
January 2011
When non-public client companies come to us for help in developing employee equity plans, it’s typically for one of two reasons: (1) Rapid growth has a young company’s owner(s) now concerned about maintaining morale and motivating key employees, who have started to wonder about the company’s end-game and want to share in its success, or (2) the owner of an established company is seeking a creative way to retain key executives over the long term, with a minimal outlay of cash up front. In both cases, equity compensation seems like a good possible solution, but the first question we’re asked is whether or not a private company can make that solution work without a public market for its shares.
The answer is yes. In fact, designing and implementing such a plan is not as complicated as one might think. And far from being available to only public companies, equity compensation is a retention and motivational tool that can be used by S-Corps or C-Corps and even by partnerships and sole proprietorships.
After learning that equity compensation is a viable option, most clients then want answers to the following key questions:
Do we need to register an equity offering with the SEC or State? Generally, no. Under "Rule 701" of the Securities Act of 1933, securities used for employee compensation purposes are broadly exempted from registration requirements at the federal level, and most states (including Georgia) have conforming exemptions. Large offerings—such as transfers of more than 15% ownership in a single year, which most private companies will not exceed—are not exempt. And offerings of more than $5 million will require disclosure of company finances and risks.
Should we use actual common stock or phantom (notional) shares? Employees can be granted the same financial benefits of ownership through either issuance of common stock or a share in the equity value and dividends. Real shares must be used when designing a plan that avoids some of the tax complexities of being a "deferred compensation plan" under IRC Section 409A (see below). And some employees may simply consider real shares more attractive. Ownership of real shares, however, gives them voting rights and, depending on the state of incorporation, may also include minority shareholder rights to attend annual meetings, review financial statements, and sell shares to any buyer under the same terms as those of majority holders.
Note: Partnerships and sole proprietorships have no common stock but can still share "equity" with non-partners using notional shares.
How do we value the shares (whether real or notional)? Shares can be valued using any reasonable and consistent method: for example, periodic assessments of market value, net-book-value appreciation, or via a formula. To avoid some of the complexities of having what is defined as a "deferred compensation" plan under IRC Section 409A, the use of a market-value approach is generally advisable, although not a requirement.
Do we have liquidity obligations? Because private companies have no external liquid market for their shares, they have to make sure they will have the cash on hand to repurchase any equity compensation awards. This can be accomplished by restricting the timing of liquidation, forecasting and modeling various distribution scenarios, and/or, most commonly, by ensuring a strong correlation between share value and the cash available in the business.
What are the tax issues associated with an equity grant? IRC Sections 83 and 409A are the key sections dealing with the taxation of most equity offerings. Generally, employees can be taxed (and employers become eligible for deductions) when their right to property or cash is no longer subject to a significant risk of forfeiture. The determination of when this occurs varies, depending on (a) whether the award settlement is in the form of cash or real equity, (b) when an employee is vested, and (c) whether or not the equity plan is defined as a "deferred compensation" plan under 409A. For example, employees who exercise options granted by a stock-option plan that is not defined as "deferred compensation" will be subject to taxation at exercise, assuming they have vested rights to option gains at the exercise date.
How many shares should we give out? Reasonably well-established private companies most often give out +-10% of their equity value. But we have seen numbers ranging from 5% to 25%, depending on the owner's comfort with giving away ownership as compensation and, most importantly, on the value employees place on share ownership. An owner may think he has the greatest company in the world and a solid balance sheet, but unless his employees believe strongly in him and in the company’s future prospects, offering them equity—whatever the percentage—is not going to accomplish much in terms of engagement or retention.
Can I require employees to forfeit their shares if they leave the company before a specified retirement age? Yes. But consider this: The purpose of giving out equity is to encourage retention and motivate performance. If employees understand that shares given can just as readily be taken away at owner discretion—by firing or forcing the employee to resign, for example—those shares will hold no real value for them. A better solution is to require some years of service, or even company performance level, to become "vested" in the share value.
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Granting equity to employees is the most effective way to motivate them, retain them over the long term, and align their pay with company performance. While equity grants such as stock options, performance shares, and restricted shares are most often used by public companies, there is no reason why they cannot be used just as effectively by private companies.
