Alert April 07, 2011

Equity Compensation for Private Equity Investors and Entrepreneurs – Ten Current Topics

Equity compensation is a subject that captures the attention of private equity investors and company management teams alike. Historically, the rules and standard techniques used to grant equity compensation were relatively static. In recent years, however, changes in the tax, accounting and securities laws and development of new techniques have led to new approaches and the revival of old approaches. Some of the changes, such as Internal Revenue Code Section 409A (which was adopted in 2004), have been well publicized. Other changes are less obvious and present both opportunities and pitfalls for the unwary.

The discussion that follows highlights recent trends and developments in the area of equity compensation, focusing primarily on private equity portfolio companies and private equity financings, while also drawing upon similar (and/or divergent) trends and developments as they relate to public, venture-backed and other emerging growth companies.

1.  Profits Interests. As private equity investors seek to provide management with equity-based incentives taxable at capital gains rates, particularly in both growth equity financings and larger private equity sponsored buyouts, the use of so-called “profits interests” as a means of incentivizing management teams remains widespread. A profits interest is an interest in an LLC that only has residual equity value if there is an increase in the equity value of the LLC, much like a stock option. If structured properly, any gain above the “strike price” of the profits interest can be capital in nature, as opposed to a stock option, where gain on exercise/cash-out will generally be taxed at ordinary income rates, and restricted stock, which generally requires risk of capital and may require the grantee to incur some ordinary income tax in order to begin a capital gains holding period. Profits interests are also a particularly useful way to structure incentive and performance compensation arrangements. Profits interests may be granted by an existing LLC and/or an LLC holding company formed to hold the equity of an acquired company.

Management holders of profits interests will be treated as members of the LLC and will receive K-1s. As a result, if they are also employees of the LLC they will be subject to self-employment taxes and their participation in the company’s benefit plans will need to be self-funded. They also may be required to file multiple state income tax returns if the LLC does business in more than one state. Therefore, the company and management must consider whether the benefits of granting profits interests outweigh these burdens. To ameliorate some of these concerns, companies sometimes have employees employed by a different entity than the issuer of the equity, such as arrangements under which profits interests are granted to a separate LLC owned directly by the management team.

2.  Options vs. Restricted Stock vs. RSUs. Despite the widespread use of profits interests by private equity-backed companies, more traditional types of equity incentives, including options and restricted stock, remain popular. A third type, restricted stock units (“RSUs”), is also being used with increased frequency, especially by publicly traded companies.

The type and form of equity-based compensation a company selects may have different tax consequences for management and the company, as well as different accounting consequences. While not taxable at grant or at vesting, the exercise or cash-out of unexercised options at the time of a sale event results in ordinary income to the optionholder. Awards of restricted stock, on the other hand, generally permit the grantee to receive capital gains treatment, provided the recipient has made a timely 83(b) election. Restricted stock may, however, require the grantee to incur some ordinary income to begin this capital gains holding period. In certain circumstances, companies may provide the grantee a cash bonus or a loan to mitigate some or all of this tax liability. Management often will purchase the stock (and file a timely 83(b) election) with the proceeds from a loan from the company evidenced by a full (or in some cases partial) recourse promissory note bearing a market interest rate. However, this approach will require repayment of the note and, if the note is forgiven, will result in debt forgiveness income to the holder. Some companies, particularly venture-backed companies, combine the features of options and restricted stock and grant employees options that are immediately exercisable for shares of restricted stock.

RSUs are essentially the same as restricted stock from an economic perspective, except that the grantee will not actually own shares of the company’s stock until the RSU is settled. RSUs therefore, have become increasingly popular with public companies because shares subject to the RSUs are not outstanding until they are actually settled. RSUs, however, are taxed as ordinary income when settled, and thus do not provide for the same capital gain treatment that restricted stock or profits interests generally provide.

Restricted stock granted for no purchase price and RSUs have greater value than fair market value (“FMV”) options on the same number of shares of stock, with both upside potential and downside protection. Accordingly, many public and private companies grant fewer shares of restricted stock or RSUs relative to a comparable option grant, resulting in lower dilution.

From an accounting perspective, under ASC 718 (formerly FAS 123R), the company will generally take a fixed earnings charge over the vesting period for each type of equity incentive. Consequently, accounting considerations are not given as much weight as they were in the past when a company decides which type of equity incentive to utilize.

3.  Section 409A. Section 409A, which levies an additional 20% penalty tax on certain non‑compliant arrangements, continues to creep into many aspects of equity compensation arrangements, sometimes unexpectedly. Compliance with Section 409A for equity compensation arrangements requires more than merely insuring that stock options are granted with an exercise price at least equal to FMV. While restricted stock is generally exempt from Section 409A, companies must consider many issues with respect to stock options in light of Section 409A, including:

  • How to determine FMV (independent third-party valuations may take time, but can provide worthwhile protection)
  • Whether the stock can be considered “service recipient stock” under Section 409A (common stock will generally qualify, but preferred stock and LLC interests pose greater challenges)
  • Whether any features of the option will cause the option to be non-compliant (such as features truing-up the number of shares subject to an option or providing for repurchase at a price other than cost or FMV)
  • Whether the structure of payments following a sale event can unintentionally cause Section 409A issues for option holders (such as certain delayed transaction payments)

Section 409A is a growing area of intense scrutiny for buyers (especially strategic buyers) during the due diligence process. Buyers are more frequently demanding strict compliance and special, often long-lasting, indemnification provisions for Section 409A issues, placing greater focus on the value of implementing appropriate compliance measures at the time of grant.

4.  Fair Market Value Issues. In addition to gaining Section 409A comfort, obtaining adequate support for FMV determinations is particularly critical for companies contemplating an initial public offering. During the IPO registration process, underwriters and the SEC routinely scrutinize a company’s stock grant history to determine whether the company should have recorded a greater compensation expense for options. When support for FMV determinations is lacking, delays in obtaining SEC clearance and thus accessing the market can result.

5.  Premiums for Founders’ Stock. Sometimes founders sell some of their shares to private equity investors at a premium over the FMV of the common stock (e.g., at the price paid by the investor for preferred stock). In these cases, the founders, the company and the purchaser must determine how to measure this premium and whether all or part of the premium may be compensation income to the founders. Although a higher premium results in more taxes owed by the founder, it also puts less pressure on the company’s FMV determination when granting stock options for a lower price around the time of the founder’s sale. Also, investors are more frequently structuring investments (or a portion of investments) as a purchase of stock directly from employees of private companies (e.g., in the case of Facebook). In these contexts, similar questions may arise when the purchase price paid to the employees represents (or may represent) a premium over the FMV of the common stock.

6.  Estate and Gift Tax Opportunities. Tax law changes in late 2010 created significant estate planning opportunities through the end of 2012. Through 2012, individuals may generally transfer up to $5 million and married couples may generally transfer up to $10 million, in each case reduced by prior gifts, without incurring gift tax. Individuals who have already used the previous $1 million gift tax exemption will have an additional $4 million in exemption (or more for married couples) that can be applied to lifetime gifts. As a result, many executives may want to consider transferring their vested equity awards to trusts for the benefit of family members to take advantage of this limited opportunity. After the gift of equity is completed, future appreciation will not be subject to gift tax, providing the potential to transfer significant value to the recipient. Transfers, however, may be prohibited or restricted by the applicable equity plan and may require board approval.

7.  Performance-Based Vesting. Historically, companies have viewed performance-based vesting favorably due to its ability to align executive and corporate goals. However, adverse accounting treatment from the mid-90s to mid-00s practically eliminated performance-based vesting. In recent years, companies, investors and management teams are once again emphasizing broader use of performance-based vesting. Increasingly, in addition to specific company performance vesting conditions, private equity-backed companies are setting performance-vesting conditions based on the return to the investors (or a class of investors) at exit (e.g., at 2X, Y shares will vest/share in sale proceeds, and at 3X, Z shares will vest/share in sale proceeds), creating an alignment between the stockholders’ goals and management’s incentives. Defining the relevant vesting levels and conditions has grown progressively more complex:  companies must consider at the time the arrangements are established which payments/expenses will be included/excluded from the relevant return calculations (such as amounts held in escrow, deferred payments subject to “earn-outs” or achievement of performance milestones, prior distributions made to the stockholders, transaction costs, etc.), as well as the treatment and valuation of any non-cash deal consideration.

8.  Change-in-Control. It continues to be true that no “market” standard exists for treatment for accelerated vesting of equity, if any, upon a change-in-control. For public companies, full acceleration was historically common, but is now disfavored by institutional stockholder groups (except where awards are not assumed or substituted in the transaction) and has become somewhat less widespread, particularly in new arrangements. Many newer public companies and private companies are implementing so-called “double trigger” vesting arrangements. Under these arrangements, options, restricted stock and RSUs assumed in a change-in-control vest if the optionee is terminated without cause (or resigns for good reason) within a specified time after the change-in-control. Increasingly, when buyers do not want to assume existing awards, buyers substitute the unvested awards with a right to receive cash payments (determined based on the transaction price) over the award’s original vesting schedule. Moreover, many private equity portfolio companies are linking vesting on a change-in-control to the investors’ return, as discussed above.

The cash-out of options or other equity grants at the time of a sale produces a tax deduction for the company equal to the amount taxable as compensation. Sellers continue to negotiate for some or all of this benefit. In a contested auction process, a buyer’s willingness to share these benefits with the seller can sometimes help win the deal. Conversely, a seller’s willingness to forego any portion of this deduction can translate to a higher per-share purchase price to the stockholders by conferring more value to the buyer.

9.  Pool Size and Pool Allocation. Companies generally appear to be establishing pools of shares in the 5% to 10% of outstanding stock range for more established companies and later stage buyouts/recaps, and in the 15% to 20% range for technology, life sciences and early-stage companies that tend to deliver a higher percentage of overall compensation to employees in the form of equity. In any case, companies need to be sure that equity grants do not exceed applicable SEC (i.e., Rule 701) and state “blue sky” limits. Further, companies should be sure to have stockholders approve a sufficient equity pool (perhaps with an evergreen) prior to going public, as stock exchanges generally require that all equity awards be made from stockholder-approved plans and adding shares to the pool results in significant costs and challenges for public companies. Private companies must also be mindful of the number of stockholders and the number of option holders, in each case to ensure the number stays below 500. With increased frequency, companies are permitting employees to sell their stock directly to private investors as they approach 500 stockholders and/or option holders.

10.  Buy-Backs. While there is no “market” standard for treatment of vested equity awards when an employee departs, many private equity-backed companies typically include in award agreements a right to buy back vested shares. The repurchase price for vested equity is usually FMV, determined by the board or by an appraisal, or, in many cases, the lower of cost or FMV if the termination is for cause. These arrangements sometimes include a non-compete claw-back, under which shares are forfeited if a non-competition provision is breached, although some state laws may restrict the ability to implement this non-compete claw-back.

Buy-back rights are waived in many cases and usually disappear upon an IPO. For a closely held company, however, the right to buy back shares from an employee who leaves on bad terms can avoid future conflicts and permits recycling of the equity to other employees who will build the company’s future value. Buy-back rights also provide companies with a useful tool to control the number of stockholders and avoid the need to track down former stockholders at the time of a sale. It is important to remember that all stockholders, including disgruntled former employees, have broad inspection rights and are owed fiduciary duties under state corporate laws.