Based on an interview with Joe Wallin
In 2001, a Silicon Valley startup started awarding employees stock options under a stock option plan. But for all of its good intentions to share the equity with its workers, the company violated the securities laws. The company? Google. The penalty? Offering to buy back up to $25.9 million worth of common stock and unexercised options. It was very likely the case that very few employees accepted the rescission offer — given the company's upcoming IPO. However, for an ordinary company, this could have been fatal.
Companies today are struggling to attract and retain the employees they need to sustain growth, and small business owners are feeling the pressure most acutely. One study found that 33% of small business owners expect talent retention to be their biggest challenge in 2019, followed closely by offering a competitive compensation and benefits package. A well-thought-out stock option program can help you solve both of these challenges.
Motivating employees through shared equity
Long considered a hallmark of the technology industry, equity compensation benefits (such as stock options) are now a standard feature in most benefits packages. And benefits such as these are especially enticing for private companies because they can help attract employees without requiring cash outflows, and they give employees and other service providers a stake in the potential upside of the business.
Done right, sharing equity with service providers can help transform your business by changing the way your workers think about their work and your company. Would Amazon be the company it is today if cash compensation wasn't capped at $160,000 a year, with the rest of the compensation in equity?
For private companies, there are two primary equity compensation instruments to choose from:
- Restricted stock awards (RSAs): A restricted stock award is an actual issuance of shares to the service provider, with the shares subject to vesting over what is usually a time-based service vesting requirement. Meaning, if you quit before the shares are vested, the company can repurchase them from you at a nominal cost. Because they’re being given actual shares of stock, recipients of RSAs must pay taxes. Recipients will probably want to file an 83(b) election to elect to be taxed on receipt of the shares and at the value at that time rather than being taxed when the shares vest when their value might be higher (which would then cause more taxes to be owed).
- Stock options: A stock option gives the holder of the option the opportunity to purchase shares in the company at a fixed price. The advantage for of optionees to service providers is that as long as the option is priced at not less than fair market value, no taxes are due until the option is exercised, and only then if there if the value of the shares has increased. That’s why stock options are the equity compensation benefit of choice for private companies.
But if employees are never given the chance to exercise their options, morale – and your company’s image – could take a hit. With this in mind, some companies extend the ability to exercise stock options well past an employee’s termination date. For example, after leaving Pinterest, its employees have seven years to exercise their options.
Avoiding legal penalties and pitfalls
For all the potential of equity compensation plans, there’s a significant downside when executed incorrectly – Google being a prime example. Federal requirements under Rule 701 of the Securities and Exchange Commission stipulate that companies granting restricted stock or stock options must:
- Issue any awards pursuant to a written compensatory benefit plan or agreement.
- Issue the awards to an individual not an entity (you can't under Rule 701 issue an award to an LLC, for example).
- The award must be for incentive purposes, rather than raising capital.
- Companies can only grant a certain amount of equity to service providers each year. You can't run over this hard cap. If you do, you won't be able to rely on Rule 701 for the awards beyond the cap, you and you will need to find a different exemption to rely upon.
- If you give out more than $10,000,000 in awards in any 12-month period, you also have to provide a prospectus with a variety of disclosures to the awards recipients.
In addition to federal law, each state has its own list of securities requirements, which runs the gamut. Some states have a fairly short and straightforward list of filing requirements. Other states, such as California, have a list that’s quite extensive.
Establishing fair market value
Over the years many people have gamed the system by timing deferred compensation to reduce their tax burden, or prematurely cashing-in stock before it loses value (the Enron scandal of 2001 being one of the biggest and most recent examples). In response, the IRS passed Section 409A of the federal tax code, which requires private companies to issue stock options at a price at or above fair market value (FMV). If you issue stock options at a price below FMV, then horrible tax consequences ensue for the worker.
To minimize the risk of undervaluing an option, you can hire an independent appraiser to establish the FMV, otherwise known as a 409A evaluation. This assessment is based on your particular industry, the stock price of comparable, publicly traded companies, your company’s financial statements, business plan, and many other factors.
A 409A assessment is good for no more than 12 months, after which it must be updated. If a “material” event occurs before the 12 months expires (such as securing a new round of funding or shifting your business plan), you must update your assessment. In addition, you’ll need approval from the board and a signed agreement by the recipient of the option.
Seeking legal guidance to stay on course
Stock options and RSAs could be the perfect addition to your benefits package, but don’t enter into these arrangements without thinking it through and getting some advice first. The legal implications of an employee stock option program are multi-faceted, covering securities, corporate and tax law. Online resources, such as the Holloway Guide, can provide additional guidance on equity compensation, but you would be wise to consult with experts in each of these areas. Doing so will help to avoid any legal entanglements and ensure that your equity compensation plan delivers the desired result: a team of skilled employees who feel rewarded and remain loyal to your company.
