One of the many challenges facing early stage companies is finding a way to attract and retain employees with the skill sets and motivation to help the company execute its business plan. The solution to this problem almost always includes some form of equity-based compensation. It is important both for employers and potential employees to understand the basic characteristics of the various alternatives to achieve that goal.  The purpose of this Advisory is to provide a non-technical overview of the alternative forms of equity compensation and some of the pros and cons of each.

Outright Grants

Perhaps the simplest method of awarding equity compensation is an outright grant of stock.¹   A stock grant requires very little legal documentation, is easy to understand, and is often the preferred alternative for companies with few assets and little current value.  The problem with an outright grant is that the employee has an immediate tax liability at ordinary income rates measured by the value of the equity granted by the company.  An argument usually exists that the value of the equity is low.  However, if the transaction later comes to the attention of the IRS, they have the benefit of hindsight in considering the valuation issue. More importantly, if they decide on a materially higher valuation, they are presumptively correct and the burden shifts to the company to prove them wrong.

Options

There are two basic types of options that may be awarded to service providers: so-called non-qualified stock options (“NQSOs”) and incentive stock options (“ISOs”) which can only be issued by corporations to W-2 employees.  As long as the exercise price of the option is not less than the value of the underlying stock at the time the option is granted, there is generally no tax consequence to the employee or the company at the time an NQSO granted.  However, upon exercise of the option, the employee will typically have a current income tax liability measured by the difference between the exercise price of the option and the value of the stock subject to the option on the date of exercise.  This will be taxed at ordinary income rates.  However, upon a future sale, the gain or loss will be subject to capital gains treatment.

Stock Appreciation Rights (“SARs”)

As the name implies, the economic benefit to an employee recipient of an SAR is measured by the appreciation in the value of the underlying stock between the date of issuance of the SAR and the date the benefit becomes payable.  If the value stays the same or goes down, the company generally has no obligation to the employee under the terms of the typical SAR.  If the value goes up, the economic return to the employee is capped by the amount of appreciation in the value of the stock.  Nevertheless, SARs granted by early stage companies can still produce a substantial economic benefit to recipients.  Assuming the stock valuation is correct, SARs are not usually taxable to the employee at issuance or vesting.  When the benefit becomes payable the appreciation is taxed at ordinary income rates. Like most forms of equity compensation, SARs are often issued subject to vesting and the employer’s right to “claw-back” outstanding vested SARs if the employee leaves the company.

Phantom Equity

Phantom equity is not real equity; hence the name.  It is an obligation of the company to the employee, measured by the value of the company’s real equity at the time the benefit becomes payable.  For that reason, the terms of a phantom equity plan are very flexible.  Many phantom equity plans also permit the company to pay the employee in either cash or real equity, or some combination of the two, in its sole discretion.

Employee Stock Purchase Plans (“ESPPs”)

ESPPs permit employees to purchase stock of the employer, typically at a discount of 10% to 15% of the value of the stock.  The stock purchase is usually funded via payroll deductions over a stated period after which the employer purchases the stock for the employee.  There are two types of ESPPs – qualified plans and non-qualified plans, which are treated differently for tax purposes. However, ESPPs are not commonly used by early stage companies because stock valuations are difficult to agree upon and are often volatile.

Profits Interests

Profits interests can only be issued by entities treated as partnerships for federal income tax purposes.  However, given the increasing popularity of LLCs, profits interests have become a commonly used structure for employees of limited liability companies that have chosen partnership tax treatment.  Profits interests have a number of advantages but are a bit more complicated to understand.  Our next Client Advisory will be dedicated to a detailed discussion of profits interests.

If we can provide any additional information, please contact Bill Miller at wmiller@bizlaw.group.

¹  The term “stock” as used in this Advisory is intended to include shares of stock of a corporation, equity interests in an LLC, and equity interests in other types of entities.

This memorandum is intended to provide general information of potential interest to clients and others. It does not constitute legal advice. The receipt of this memorandum by any party who is not a current client of the Business Law Group does not create an attorney-client relationship between the recipient and the firm. Under certain circumstances, this memorandum may constitute advertising under the Rules of the Massachusetts Supreme Judicial Court and the bar associations of other states.