Recommended
Recommended
More Related Content
What's hot
What's hot (18)
Similar to Equity Compensation for Startups
Similar to Equity Compensation for Startups (20)
More from DrexelELC
More from DrexelELC (9)
Recently uploaded
Recently uploaded (20)
Equity Compensation for Startups
- 1. Equity Compensation for Startups No cash? … No problem Drexel Entrepreneurial Law Clinic Presenters: Robert Bean, Nick Bridge, Michael Delaney, Marco Di Prato Panelists: Chris Miller (Pepper Hamilton), Steven Poulathas (Flaster Greenberg) Clinic Director: Steve Rosard
- 3. Thank You to Our Sponsors
- 4. 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
- 5. Why Grant Equity Compensation? • Align interests • Attract & retain talent • Improve productivity • No cash
- 6. Equity Compensation Types: Corporations and LLCs
- 7. Corporate Equity • Stock Awards • Options – Incentive Stock Options (ISOs) – Non-Qualified Stock Options (NQSOs) • Phantom Stock • Stock Appreciation Rights (SARs)
- 8. 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
- 9. 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
- 10. LLC Equity Alternatives • Capital Interests • Profits Interests • Units Options • Phantom Units
- 11. 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
- 12. 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
- 13. Tax Consequences
- 14. 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
- 15. 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
- 16. 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
- 17. 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 minus any 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
- 18. 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
- 19. 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
- 20. 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
- 21. 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
- 22. §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
- 23. §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
- 24. 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
- 25. 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
- 26. Startup Valuation More An Art Than a Science
- 27. 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
- 28. 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
- 29. 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
- 30. 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
- 31. 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
- 32. Securities Compliance Restricted Securities: Cannot Be Issued, Except When They Can.
- 33. 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 the securities for less than he bought them – Damaging chances of future investment or sale
- 34. 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
- 35. 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
- 37. 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
- 38. 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
- 39. 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
- 40. 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
- 41. 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?
- 42. 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
- 43. 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?
- 44. Any Questions?
- 45. Thank You to Our Sponsors
- 46. Thank You to Our Audience Apply to be a client at www.drexel.edu/law/ELC
Editor's Notes
- Nick will begin the workshop with explaining why startup companies may want to issue equity as compensation Then Nick and I will compare, contrast and summarize equity compensation alternatives for both c-corps and LLCs We will then explain the tax implications for all these alternatives. Mike and Rob will take the latter half of this workshop and discuss how to issue equity and other considerations. Their topics will include: valuation, vesting, administrative issues, securities compliance, how much equity to issue, process of issuing, documents, and transfer restrictions.
- Put this slide 2d
- This should be the third slide and the second to last slide
- Options Entitles the holder to the appreciation in the value of the company’s stock, over the exercise price. Options are also often subject to vesting. The option holder cannot exercise an option until the option has vested. The option holder is not a shareholder until the option is exercised. Thus, not voting rights, dividend rights, or other rights. Disadvantage of Issuing options: Where do you set the exercise price? Need to be able to determine the FMV at the date of grant - to ensure compliance with 409A. Option holder must pay to exercise.
- Section 83 says …
- Only tax at grant if “readily ascertainable” FMV – generally only applies if traded on a market. ISO Spread = FMV at exercise – exercise price Last bullet could be short term or long term.
- Penalty section Options and SAR – exercise price must be equal to or greater than FMV at date of grant – then 409A does not apply NEED 409A VALUATION Phantom – subject to 409A if they are not required to be settled within 2 1/2 months following the end of the year in which they vest.
- What’s a non-deferred compensation plan? Restricted Stock Subject to vesting Why Employees want to know how much their equity is worth List of equity which requires valuation at time of grant Profits interests – IRS does not treat taxable event if done correctly, but if you don’t perform a valuation, they will treat it as a taxable event IRS Revenue Rulings on Profits Interests Focus on the need Employees don’t often care about the value of the equity, or the exercise price Exemptions from 409A How Third party appraisal is too expensive to be reasonable to early stage startups Internal valuation more affordable Needs to be based on something; can’t be arbitrary Optimal Number As low as reasonably possible Low? But I thought it was better to value high? Nope, valuing high leads to trouble; High tax consequences on employees Don’t go too low, though Subsequent IRS audits will put a value on your company If that value is more than the value you put on your company, the IRS will charge your company the taxes owed on the difference, which isn’t too bad However, if your value is significantly lower than the IRS’s value, and you have no way to justify it, the IRS will think you’re willfully evading taxes and will charge you interest on top of the back taxes.
- What’s a non-deferred compensation plan? Restricted Stock Subject to vesting Why Employees want to know how much their equity is worth List of equity which requires valuation at time of grant Profits interests – IRS does not treat taxable event if done correctly, but if you don’t perform a valuation, they will treat it as a taxable event IRS Revenue Rulings on Profits Interests Focus on the need Employees don’t often care about the value of the equity, or the exercise price Exemptions from 409A How Third party appraisal is too expensive to be reasonable to early stage startups Internal valuation more affordable Needs to be based on something; can’t be arbitrary Optimal Number As low as reasonably possible Low? But I thought it was better to value high? Nope, valuing high leads to trouble; High tax consequences on employees Don’t go too low, though Subsequent IRS audits will put a value on your company If that value is more than the value you put on your company, the IRS will charge your company the taxes owed on the difference, which isn’t too bad However, if your value is significantly lower than the IRS’s value, and you have no way to justify it, the IRS will think you’re willfully evading taxes and will charge you interest on top of the back taxes.
- What is a Nonqualified Deferred Compensation Plan? Discounted Stock Options Option to purchase stock at a later date Exercise price is below fair market value at the date of grant Phantom Stock Phantom Units Stock Appreciation Rights Have to make the payout in the same year that they vest to comply with 409A
- With few exceptions, every offer or sale of a security must, before it is offered or sold in a state, be registered or exempt from registration under Federal securities laws, and the laws of the state(s) in which the security is offered and sold. Rescission of the employment contract entails termination of the contract and return of all consideration that the recipient gave the company in exchange for the non-compliant security; in the case of employees, this consideration entails the fair market value of all the work done by the employee up until the lawsuit
- What is Vesting Vesting should always be included in every equity grant When somebody leaves, you don’t want them to keep their equity, because then they’re free-riding May need their equity to offer to a replacement Want to incentivize them to stay with the company Contractual Device Common Forms Time-Based Performance Based Why do I want it? Time-based vesting incentivizes the employee to stay with the company Performance-based vesting incentivizes the employee to meet goals or help the company meet goals
- Acceleration is Double trigger acceleration Single trigger – company sold Should there be acceleration on a sale? Should it be single trigger or double trigger?
- ROFR A standard clause in many stockholders agreements which requires a stockholder who has received an offer to purchase all or any portion of its shares in a company from a third party to first offer those shares to the other stockholders. A right of first refusal provides that a stockholder cannot sell its shares to a third party without first giving the other stockholders the right to buy, in proportion to their ownership interest in the company, those shares on the same terms and conditions as the third party offer. One of the basic principles of corporate law is the free transferability of shares and a prohibition against restraints on the alienation of property. As a result, absolute transfer restrictions are not generally enforceable. However, provisions limiting transfers to affiliates and certain permitted transferees, or preventing transfers for a certain period of time after acquiring the shares (typically two to five years), are generally acceptable and are often included in stockholders agreements. Why have it? Unlike public companies whose ownership is diffuse and whose stockholders' principal contribution is monetary, Member, at least at the early stage of a startup, tend to be a small group who require each other's assistance and expertise to manage the company. A Member is not therefore interchangeable with any other person. Want to limit the people who you deal with Unless the consideration offered by the third party is cash it may difficult and time consuming to establish the fair market value of the in-kind consideration. As a result, many stockholders agreements provide that a stockholder can only consider third party offers where the third party is offering cash. Process: Upon receipt of a Bona Fide Offer must submit Offer Notice to the Company and the other Stockholders stating that it has received a bona fide offer from an Independent Third Party and specifying: (w) the number of Offered Shares to be sold by the Offering Stockholder; (x) the name of the person or entity who has offered to purchase such Offered Shares; (y) the per share purchase price and the other material terms and conditions of the Transfer, including a description of any non-cash consideration in sufficient detail to permit the valuation thereof; and (z) the proposed date, time and location of the closing of the Transfer May also require proposed purchaser to put a certain percentage of equity in escrow
- call right gives the company or a majority stockholder the right, but not the obligation, to buy the equity interests of another stockholder in certain specified circumstances. Upon a termination for cause – Company generally has option to buy that Member’s membership interest at discounted rate Discount may range from exercise price to 20% of current value Seen as punitive measure Reasoning: Don’t want Employee whose actions were harmful to the company to be able to benefit from the gain in value
- This should be the third slide and the second to last slide
- This should be the last slide