Since its release, this has often been the No. 1 bestseller in its Amazon category. Read on to see why.
Many books discuss the tax, legal, and other aspects of equity compensation, but this book, now updated for the first time in 11 years, is focused on helping you decide what kinds of equity to use, and who should get how much and when. Are options a better fit than restricted stock? What are the pros and cons of phantom stock and stock appreciation rights? Should employees be able to buy stock? If so, how? Who will be eligible and under what rules? How will awards be earned, and how will the company provide liquidity for them?
These and other issues are often either ignored or dealt with by guessing, applying rules of thumb, or using someone’s boilerplate solution. This book is designed to help you make educated, reasoned decisions about the equity compensation strategies you need, not the ones that someone else might want you to use. At the same time, it also covers the general legal, tax, and other rules applicable to each plan type.
In the third edition, every chapter has been reviewed and updated. The accounting chapter was almost completely replaced, for example, and important changes in securities law were incorporated in the relevant chapters. Additionally, every chapter now has a table of contents. (See our detailed table of contents for the entire book.)
Table of Contents
Introduction: Creating an Equity Compensation Plan That Works for Your Closely Held Company
1. Stock Options
2. Unrestricted Stock Grants and Stock Purchase Plans
3. Restricted Stock Awards and Restricted Stock Units
4. Phantom Stock and Stock Appreciation Rights
5. Performance Award Plans
6. ESOPs, Profit Sharing, and 401(k) Plans
7. Equity Interests in Limited Liability Companies
8. Deferred Compensation Issues
9. Accounting for Equity Compensation
10. Securities Law Considerations
11. Special Considerations for Public Companies
12. Designing an Equity Incentive Plan
13. Deciding on Executive Equity
About the Authors
About the NCEO
From "Introduction: Creating an Equity Compensation Plan That Works for Your Closely Held Company"
Research on equity compensation plans indicates ownership can be a powerful tool in this effort. Turnover rates at companies with broad-based ownership plans are significantly lower than at companies without these plans. Research by the NCEO has shown that the more stock employees get in employee stock ownership plans (ESOPs), the less likely they are to leave. Turnover rates in 100% ESOP-owned companies, in fact, are about half of that in comparable non-employee-owned companies. Employees also consistently report that, other things being equal, the more equity they have, the more they like their jobs regardless of whether the equity is in the form of options or in an ESOP.
There are many ways to share ownership with employees. These include stock options, restricted stock, restricted stock units (RSUs), and stock purchase plans, all of which provide employees with direct share ownership rights. Phantom stock is designed to give employees the equivalent value of ownership, but not actual shares. Stock appreciation rights (SARs) can be designed to pay out in either shares or cash. Employee stock purchase plans (ESPPs) and direct share purchase plans allow employees to purchase shares directly, often at a discount. And an ESOP, which is a type of retirement plan, is funded by the company and provides ownership to most or all employees through a trust. How do you decide which vehicle or combination of vehicles makes sense?
From Chapter 2, "Unrestricted Stock Grants and Stock Purchase Plans"
If the company is not publicly traded or is so thinly traded that reselling shares is difficult, it must consider what the market for shares will be. Will employees sell shares to the company? Will employees be expected to hold the shares for an anticipated initial public offering (IPO) or an acquisition by another company? In any case, the company must decide how the employees will end up getting income from the shares they receive.
If the company remains private, there are several alternatives. In a private company, each alternative raises the valuation issues mentioned below.
- The company can buy back the shares.
- The company could create a formal or informal internal market for shares. This can become quite expensive and is discussed in chapter 12.
- An ESOP can serve as the market (or one of the markets) for shares that employees have received from other plans. People often think of an ESOP as a means for a sole or main shareholder to sell a large block of stock, but there are no restrictions on the number of shareholders the ESOP can buy from. Thus, if the company has an ESOP, the ESOP can buy shares that were granted or sold to employees. And whereas the company would generally not receive a tax deduction for redeeming stock from employees, its contributions to an ESOP (to enable the ESOP to buy the shares from employees) are tax-deductible.
If the company is to repurchase the shares from employees, it must consider potential cash flow issues that might arise. Say, for example, that a stock grant agreement provides that employees can sell their shares to the company within 30 days of termination of employment and receive immediate payment at the then-current fair market value of the shares. (Indeed, the company might require employees to sell their shares back to the company after termination, as noted above.) Suppose that employees with grants representing a large number of shares leave precisely when the company has cash-flow problems; in such a situation, the company may be hard-pressed to satisfy its obligations. (Closely held companies that sponsor ESOPs are familiar with planning for the repurchase obligation that the ESOP creates, as discussed in the chapter of this book that covers ESOPs.) Similarly, cash-flow problems could arise if employees can sell back their shares at any time, even while still employed, and a surge in the value of the company (and thus the price they will receive) prompts a large number of them to sell their shares back. Even if the ESOP or internal market solutions mentioned above are used, a sudden flood of stock for sale could create a strain on the company.
From Chapter 5, "Performance Award Plans"
Companies with successful performance equity plans have completed a thorough analysis and evaluation of the elements that relate directly to performance at their company. Unlike many other types of equity plans, it is very difficult to determine the proper metrics to use based on a simple review of competitive market data. With the exception of total shareholder return (TSR), the specific metrics used in these plans are usually as unique as each individual company. A thorough analysis requires a review of financial, operational, and human resources metrics and objectives from the past. This analysis must then show a link between those metrics and objectives and their impact on both corporate performance and (hopefully) the stock price.
As discussed above, most plans allow for a range of potential payouts. The lowest amount of equity that can be earned is based on a threshold or minimum goal. The base amount of the award is expressed as the target, and the highest number of shares is based on a maximum goal. The target of the award is usually expressed as the 100% goal. This is the number of shares or units that is communicated to the participant as their award amount. If performance is somewhere between the target and the threshold, the participant receives less than 100%. If performance is above the target, the payout is above 100%. Many plans have a minimum threshold that pays out regardless of performance. This allows for the company to have a guaranteed retentive value for the award. Payouts between each defined level can be calculated linearly or in predefined steps. Because we are discussing only equity-based awards, the maximum amount refers only to the number of shares, units, or options and not the cash value.
Goal-setting rule of thumb: The target level of achievement should stretch the performance, but not require an extraordinary level of achievement. A good place to start is setting the target to something you believe is achievable with 65%–70% probability.
From Chapter 7, "Equity Interests in Limited Liability Companies" (footnote omitted)
An employee who receives a capital interest in an LLC in exchange for services recognizes compensation income in the year of grant that is equal to the fair market value of the interest. The market value of this interest, for purposes of computing the employee’s income and the LLC’s deduction, may be determined in one of several ways: by reference to the value of the services rendered to the LLC’s assets; by determining the value of the capital that was shifted from existing LLC members to the new grantee; by determining the value according to what a willing buyer and willing seller would agree upon as a purchase price in an arm’s-length sale (i.e., the willing buyer/willing seller test); or by determining the amount the employee would receive upon a liquidation of the LLC at the time the interest is issued (i.e., the liquidation value). Regardless of the method used to determine fair market value, income and employment tax withholding will be required.
If the interest is subject to a substantial risk of forfeiture and is nontransferable, then the taxable event can be delayed until the restriction lapses unless the employee makes a Section 83(b) election within 30 days of the grant date. The election states that the employee agrees to be taxed immediately upon receipt of the capital interest at ordinary income rates, with any subsequent appreciation in the interest taxed at capital gains rates upon disposition. An employee who receives a restricted capital interest will not be treated as a member for tax purposes until the restriction lapses unless the Section 83(b) election is made.
From Chapter 10, "Securities Law Considerations" (footnotes omitted)
A consideration of all recipients of equity compensation is how and when they can resell their company securities. Shares that are not registered under the 1933 Act, such as shares acquired under one of the private company exemptions described above, are referred to as “restricted securities.” (If the company goes public, it often will register restricted securities previously issued under employee stock plans.) A restriction may also be imposed by contract. Restricted securities will have a legend stamped on the certificate that indicates the securities may not be resold unless they are registered with the SEC or are exempt from the registration requirements.
Restricted securities of a nonreporting company may be sold only (1) under Rule 144 of the Securities Act, discussed in further detail below, which provides that resales are subject to conditions such as a minimum holding period and, in some cases, the availability of current public information about the issuer; or (2) in a private resale transaction exempt from registration under “Section 4(1½)” or the resale safe harbor under Rule 144A of the Securities Act.
The term “restricted securities” generally describes shares issued by a company before its IPO. Until 90 days after a company’s IPO, resales of restricted securities are limited to persons who are not or have not been affiliates of the company for at least three months before the sale. There is one important exception: 90 days after the shares become subject to the reporting requirements of the Exchange Act, if the stock was granted under Rule 701, option shares issued to nonaffiliates can be sold without regard to Rule 144 (except for the manner-of-sale provisions), and affiliates can sell their shares pursuant to Rule 144 (see below), but without regard to the holding period. So as not to adversely affect the value of recently issued public shares, it is quite common for companies that issue equity grants in connection with their IPOs to “lock up” or restrict key employees (generally, “affiliates”) from selling their shares well beyond the 90-day period. A related issue concerns the value of securities that are issued before an IPO. The existence of “cheap stock” is also briefly addressed below.
State securities laws also may restrict resales of securities issued in a compensatory award. Unlike Securities Act restrictions on resales of restricted securities that continue to apply after a company goes public, state securities laws restrictions generally relate to the period that the company remains private, and generally no longer apply after the company goes public because NSMIA preempts states from requiring state registration and qualification or notice filings and fees regarding resale transactions in securities that are listed on certain stock exchanges.