This book describes the full spectrum of equity compensation plans (such as stock options, stock purchase plans, stock grants, restricted stock, phantom stock, and stock appreciation rights) available to private and public companies as well as LLCs. Unlike most books on equity compensation, it focuses on helping decision-makers decide what kinds of equity to choose, and who should get how much and when. In the second edition, every existing chapter has been revised and updated, and new chapters on performance awards and limited liability companies have been added.
Table of Contents
Introduction: Creating an Equity Compensation Plan That Works for Your 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 Company"
Companies can offer employees a variety of kinds of equity in their plans, with some restrictions. ESOPs, for instance, must own stock with the highest combination of voting and dividend rights (typically Class A common) or stock that is convertible into that class of stock. Profit sharing and 401(k) plans cannot own options or other forms of equity rights. The necessity that the ESOP get shares that carry voting rights (or shares convertible into such shares) is, as we will see later, not really a problem and should not be a factor in choosing or not choosing an ESOP as it does not mean that owners who want to maintain control of the company must cede that control to workers.
There is no such voting rights requirement for stock option, restricted stock, performance share, or stock purchase plans. Although they all typically provide the right to buy or own common stock, they could just as well offer preferred shares or some other variety of common stock. (Preferred and super common stock typically have higher dividend and/or liquidation rights; in a few cases, special classes of common stock with special voting rights have been created.) The shares may or may not have voting rights, although the existence or lack of these rights may affect how the shares are valued. A company that does not have stock because it is an LLC or a partnership, for example, can offer ownership by granting partnership rights or units instead of stock.
The issue of whether unvested or unexercised equity awards can pay dividends is specific to each type of vehicle and thus is discussed in the individual chapters. In some cases, dividends paid on such awards lead to steep taxes for the award recipient under the tax rules governing deferred compensation.
From Chapter 2, "Unrestricted Stock Grants and Stock Purchase Plans"
Direct stock grants are straightforward and, unlike stock plans that are tax-qualified under the Internal Revenue Code (the Code), such as Section 423 ESPPs, discussed later in this chapter, or employee stock ownership plans (ESOPs), discussed later in this book, they have no particular legal requirements or restrictions on their use. The company can give them to a single person, to a group or groups, or to all employees. Direct stock grants can be used in a variety of ways as the company pleases. For example, a grant can be given as a bonus, as an adjunct to other stock arrangements (such as giving employees a free share of stock for every share they buy through a stock purchase program), or even as part of the salary at a cash-starved startup company.
The shares that are granted may be "restricted" in the sense of transferability restrictions, such as that the shares can be resold only to the company, that they must be resold to the company when employment terminates, or that the company has a right of first refusal when the shares are sold. This allows a private company to keep stock "in the family" (literally or figuratively) and avoid ex-employees or unwanted outsiders gaining ownership and perhaps some degree of control.
Since a direct stock grant makes the employee a shareholder, that person now will have the same voting rights and other privileges as do other shareholders of that class of securities. For a given employee, employee group, or everyone receiving stock grants, the company may wish to use shares with certain voting attributes or even create a new class of shares with the desired attributes. Even in S corporations, which are limited to one class of stock, it is permissible to have "differences in voting rights among the shares of common stock." Typically, a company would limit the voting rights granted to employees because it was sensitive to control issues. However, the experience of many employee ownership companies, such as ESOP companies (which must pass through at least a minimum subset of voting rights to ESOP participants), is that this is not a big issue. Employees generally have no desire to use their voting rights to turn the company upside down and, in any event, would typically not own enough stock to do so. Also, excessively limiting voting rights may send the wrong message to employees: "We want you to think and work like an owner, but we don't trust you."
From Chapter 5, "Performance Award Plans"
The first step in proper alignment is to clearly define the purpose of the plan. Compensation programs are intended to attract, motivate, and retain staff members. It can be difficult to design a single program that equally meets all three of these objectives. Most often performance plans are designed to first motivate staff and then to retain them. At present, these programs are seldom used to attract new staff. Once you have defined your programs' high-level objectives, you must then clarify the specifics of what you are trying to motivate and who you are trying to retain. You must also define how you will link these individuals to the intended objectives of the plan.
Companies with successful performance equity plans have thoroughly analyzed the elements that relate directly to their performance. 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.
From Chapter 7, "Equity Interests in Limited Liability Companies"
An LLC employee who receives a capital interest without a substantial risk of forfeiture (that is, a vested capital interest) in exchange for services rendered recognizes compensation income in the year of the grant 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.