III. Equity Plans.
Equity Plans, by definition, are intended to provide the employees with the opportunity to share in the increased value of the company. These plans provide strong incentives to employees to remain with the company to help achieve that growth. The primary reason for employees to acquire equity in a closely-held company is to allow them to share in a liquidating event, such as the sale of the company or a public offering of the company’s stock. The disadvantage that these plans share is that the employees will have rights as shareholders. We recommend limiting those rights by using only non-voting stock and by requiring the surrender or buy-back of the stock when the employee’s service to the company terminates, regardless of reason. This can be accomplished through an employment contract and/or a stockholder agreement.
Generally, in designing an equity plan, companies need to consider carefully how much stock they are willing to make available, who will receive it and how much employment will grow so that the right number of shares is granted each year. A common error is to grant too many shares or options too soon, leaving no room for additional options for future employees. Questions that are crucial in defining specific plan characteristics include eligibility, allocation, vesting, valuation, holding periods and stock price.
Voting and non-voting stock.
If your company elects to grant stock or options to purchase stock, or the stock is purchased by the employees as part of a stock purchase plan, the stock may be designated by the company as either voting or non-voting. If the stock is voting, upon the grant and the removal of any restrictions, or in the case of the exercise of the option, upon payment of the purchase price, the person holding the stock has the same rights to access information, receive dividend distributions and to vote as any other stockholder. If the stock is non-voting, the shareholder does not have the right to vote unless the right is granted for certain events, but the person holding non-voting stock still has the right to receive information and dividend payments equal to that of voting stockholders.
(a) Stock Grants.
The company may grant stock to employees with or without restrictions. These restrictions will determine when the employee will have to pay income taxes on the value received. Most companies use restricted and non-voting stock. While the fact that such restrictions may limit voting rights or vesting of the stock over time, the advantages are usually considered to outweigh these issues.
If the stock is subject to the possibility of forfeiture or is not completely vested, then the stock is restricted and the tax is deferred until the vesting or forfeiture period ends unless the employee chooses to make an election under Section 83(b) of the Internal Revenue Code (an “83(b)” election). If an 83(b) election is made, the employee pays taxes in the tax year in which he or she receives the stock based on its value in that year. There are some issues with an 83(b) election. If the value of the stock does not increase after the election, taxes will still be payable even if the employee forfeits the stock after making the election. In this case, the employee could deduct any amount actually paid for the stock (subject to capital loss limitations), but he or she would not get a deduction for the compensation income reported when the election was made.
Notwithstanding the potential costs, the 83(b) election may be appropriate if (i) the amount of income reported at the time of the election is small and the potential growth in value of the stock is great, or (ii) the employee expects reasonable growth in the value of the stock and the likelihood of forfeiture is very small. The election form must be completed and filed within 30 days of the grant.
Advantages: Relatively simple and inexpensive to administer; grants are deductible by the company when the restrictions lapse. The employee actually becomes an owner in the company and will receive the benefits and risks of ownership.
Disadvantages: Grants must be treated as ordinary income by the employee or the employee must buy the stock. The employee has rights as a stockholder. These disadvantages can be limited by using non-voting stock and shareholder agreements.
(b) Options to Purchase Stock.
Traditionally, stock option plans have been used as a way for companies to reward top management and “key” employees and link their interests with those of the company and other shareholders. However, if the option plan allows employees to sell their shares within a short period after granting, it may not create long-term ownership vision and attitudes.
A stock option gives an employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years. The price at which the option is provided is called the “grant” or “strike” price and now usually will be the market price at the time the option is granted. There are two principal kinds of stock option programs: incentive stock options (“ISO”s) and non-qualified stock options (“NQO’s ).
ISOs are a form of equity compensation that provides unique tax benefits but also requires meeting certain statutory requirements. There is no deduction for the company or income (other than AMT income) to report by the employee at the time of grant or at the time of exercise (unless the stock is sold within one year of purchase). If the stock is held for one year or longer, any gain from the sale of the stock will be treated as long-term capital gain by the IRS. Grants of ISOs must be made at fair market value (or higher) and the option may be held open only for a limited period of time (10 years). It is very unusual for a closely-held company to grant ISOs rather than NQOs, because normally, neither the employee nor the company wants the employee to exercise the option unless there is a pending sale, thus the employee will not satisfy the holding period needed to obtain the tax benefits. In addition, in most instances, the exercise of an ISO will subject the employee to the Alternative Minimum Tax in the year of exercise.
NQOs have two disadvantages compared to incentive stock options. One is that the person receiving the option has to report taxable income on the difference between the exercise price and the value of the shares at the time the option is exercised, and the other is that the income received when the stock is sold is treated as compensation, which is taxed at higher rates than long-term capital gains.
Advantages: Options allow the employees to participate in the growth of the company and to feel that they have an equity participation without having to pay for that right until it is exercised.
Disadvantages: Once they exercise the option, employees will have rights as stockholder; sometimes complex to administer.
(c) Employee Stock Ownership Plans (ESOP).
In an ESOP, the company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.
Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 years of age must participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within 3 to 6 years, depending on whether vesting is all at once (cliff vesting) or gradual.
When an employee leaves the company, the company must buy back the stock from his or her trust account at its fair market value (unless there is a public market for the shares). This can be a major expense. Private companies must have an annual outside valuation to determine the price of their shares. In private companies, employees must be able to vote their allocated shares on major issues such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the Board of Directors) on other issues. In public companies, employees must be able to vote all issues.
Advantages: Issuance of shares is deductible by the company, creating a non-cash deduction. The owners receive significant tax advantages. Employees do not have any rights as a stockholder while the stock is in Trust.
Disadvantages: The cost of setting up an ESOP is substantial. It is also an ERISA Plan and therefore, much less favorable since you cannot discriminate in favor of key employees. The costs of cashing out retiring employees can be high if the company has been profitable. The plan does not reward performance and the cost may outweigh the values of providing the equity to employees.
(d) Employee Stock Purchase Plans (ESPP).
Under a typical Employee Stock Purchase Plan, employees are given an option to purchase company stock generally at a discounted price at the end of an offering period. Although there are some exceptions, generally all full-time employees over 21 years of age must participate in the plan. Employees who wish to participate indicate the percentage or dollar amount of compensation to be deducted from their payroll throughout the offering period. The percentage or dollar amount employees are allowed to contribute varies by plan; however, the IRS limits the total purchase to $25,000 annually.
Advantages: All employees have full participation in growth of company.
Disadvantages: The biggest disadvantage with this type of plan is the lack of flexibility and the inability to treat certain groups of employees differently. This type of plan is subject to ERISA requirements, therefore, preventing the company from discriminating in favor of key employees. There is no differentiation for performance and rewarding performance. These are complex to establish. The employees have full rights as stockholders.
Paul D. Creme is an attorney with Hamblett & Kerrigan PA. His practice is focused on business and corporate law. Of particular interest are the areas of software and emerging technologies. You can reach Attorney Creme at [email protected].