Corey Rosen National Center for Employee Ownership nceo

1. Sharing Equity With Employees: Options, Restricted Stock, Phantom Stock, and Stock Appreciation Rights Corey Rosen National Center for Employee Ownership www.nceo.org

2. Key Decisions in Equity Sharing • Deciding how much equity to share • Deciding who will get how much with what terms • Allocation • Vesting • Sale of stock rules • Deciding how to make shares liquid • Choosing a form or forms of equity

3. Approaches Fixed percentage of the company (such as 10%) Individual percentage of the company based on surveys Dynamic model based on sharing a percentage of growth targets Pros and Cons Simple and intuitive 10% of one company is not 10% of another Doesn’t accommodate growth easily May be what people expect Seems market based Doesn’t accommodate growth easily Hard to equate value across companies Less certain about how much will be shared Focuses on sharing value, not percentages Changes entitlements to incentives Models for Deciding How Much Equity to Share

4. Approaches Using surveys Percentage of compensation Merit assessment Egalitarian Pros and Cons Market-based (in theory) Hard to find truly comparable companies Your other compensation and your corporate philosophy may be very different Consistent with your assessment of employee’s overall contribution May seem more equitable to broad employee population Doesn’t recognize special roles or abilities Based on actual contributions Can be difficult and controversial to implement “All in this together” Top performers may see it as unfair Deciding Who Gets How Much

5. Vesting, Exercise, and Share Sale Rules • Vesting can be gradual, “cliff,” or only on a liquidity event • If only at a liquidity event, will employees over-discount the value of the reward? • Will employees be able to exercise before a liquidity event? • If they can, and have to pay taxes, will they resent this? • Can employees sell the shares to anyone or will the company have a right of first refusal?

6. Liquidity • Value for the shares must be established. If the company is public, a rule must be set as to what price (such as average price for the day) governs. If private, some form of reasonable valuation method must be employed. • Company can be sold or go public, but this may be impractical or too far off in the future. Company can also buy back shares and/or arrange informal markets between employees.

7. Choosing an Instrument • Stock options • Restricted stock • Phantom stock • Stock appreciation rights • Other approaches

8. Stock Options • Rapid growth of plans giving stock to most or all employees from 1 million employees in 1992 to 12 million in 2001. This number has now dropped to about 9 million due to accounting rules changes and shareholder pressure for reduced dilution. • Most common in technology companies, but most people getting them actually work for non-technology companies. • Most common in pre-IPO, pre-sale, and public companies or as a tool to compensate key employees

9. What is a Stock Option? • Right to buy shares at a price fixed today for a defined number of years into the future • Can be granted on a discretionary basis • Different kinds of options have different kinds of tax treatment

10. ISOs and NSOs • Spread on nonqualified options (NSOs) is taxed at exercise as ordinary income and is deductible to the employee. • Employee who gets an incentive option (ISO) is not taxed on exercise, but rather at sale, and then the spread is taxed as a capital gain. • ISO must be held one year from exercise and two years from grant. Spread is not deductible to company.

11. More ISO Rules • Grant at fair market value; 10% shareholders must receive grant at 110% of FMV • Not more than $100,000 can first become exercisable in any one year • Not more than 10-year term • Only employees can hold ISOs (automatically convert to nonqualified options if not exercised within 90 days of termination)

12. The Dreaded AMT • The spread on the exercise of an incentive stock option is subject to Alternative Minimum Tax. • Many, if not most, ISO recipients will be subject to the AMT, meaning they will have to pay tax in the spread with their next return even though they have not sold their shares.

13. Nonqualified Options Rules • Can be granted to anyone • Can have any terms the company chooses • Can be transferred, but the tax obligation rests with optionee

14. Restricted Stock • Right to buy or be granted stock • Stock only transfers when restrictions lapse, such as meeting performance or vesting targets. • Taxed as ordinary income when restrictions lapse unless 83(b) election made

15. 83(b) election • Election to be taxed on value of benefit at time of grant (may be zero if stock purchased for FMV) • If stock never transferred, taxes cannot be recovered. • If stock is transferred, gain from FMV at time of grant to FMV at time of sale is taxed as capital gain. • When employee realizes ordinary income, employer gets a corresponding tax deduction.

16. Phantom Stock and SARs • Phantom stock is the right to the value of a set number of shares, subject to some restriction lapsing (vesting, performance, etc.) Usually paid in cash, not shares. • Stock appreciation rights (SARs) are the right to the increase in the value of a number of shares. • Both are taxed as ordinary income when paid.

17. Stock Settled SARs • Essentially the same as a stock option, except that, typically, when they vest the employee would exercise the SAR rather than wait for some additional term • Less dilutive than options

18. Accounting Issues • Companies must record the estimated present value of all equity awards at the time of grant. • Formula considers volatility, dividends, risk- free interest rates, exercise and current price, and expected life of award • Amounts can be adjusted to forfeitures.

19. Deferred Compensation Rules • If an employee chooses to defer receipt of an exercised award, taxation can be deferred if certain rules are met. • For time-vested awards, deferral election to a specific date must be made in the year prior to the year the award vests. • For performance-vested awards, election can be six months before • For equity awards discussed here, applies only to cash-settled SARs and phantom stock and discounted stock options.

20. Equity Compensation Plans in LLCs • Limited liability corporations do not have stock—they have membership interests. • There are parallel equity awards available in LLC’s, but with some wrinkles. • LLCs are pass-through entities, so there is no corporate level tax. Unlike S corporations, they can allocate profits and tax obligation as they see fit as opposed to pro rata to ownership.

21. Profits interests • Closest parallel to stock options. • Entitle the owner both to capital appreciation and profits of the business. • Grant no taxable if award held for at least two years. • The LLC and the employee treat the employee as the tax owner of the interest from the date of its grant and the employee reports his or her distributive share of all partnership tax items in computing the employee's income tax liability for the entire period during which the employee has the interest. • Company does not get a deduction; employee gets capital gains tax on sale.

22. Capital Interests • Closest parallel to restricted stock • Right to share in the value of LLC assets through the receipt of a share of the proceeds upon sale of the LLC assets. • Fair market value of award taxable in year no significant risk of forfeiture (vesting) • Section 83(b) election can be made (tax treatment same as for restricted stock); company gets parallel deduction. • If award is fully vested, owner is treated as a member for LLC tax purposes.

23. Units and Unit Rights • Parallel to phantom stock and stock appreciation rights. • With units, employee gets the right to the value of membership interests at a specified time • Unit appreciation rights provide the employee with the right to the increase in the value of the membership interests • Awards paid out in cash and taxed the same way as a bonus • Employees not considered LLC members for tax purposes • Simplicity of model often makes it the award of choice, but the employee has no opportunity to have the gains taxed as capital gains

24. Other Forms of Equity Compensation • 401(k) Plans • Company matches • Employee contributions • Employee Stock Purchase plans • Employee set aside after tax wages for an offering period, usually 6 months to two years • Can buy stock at lower of 15% off share price at beginning or end of offering period • ESOPs

25. Direct Stock Purchases or Awards • Simplest of plans • Can be financed as a bonus, with a loan, or with employee after-tax money

26. Securities Law Issues • If there is an offer to sell, this triggers securities law issues. • Exercise of an option comes under this definition. • Closely held companies can be exempted from registration under federal and most state laws if they meet certain rules. • Anti-fraud disclosure statements are required.

27. Percentage of Employees Eligible for Equity

28. Percentage Actually Receiving Equity

29. % of Awards Going to Each Group

30. Forms of Equity by Group

31. Additional Resources • The Decision Makers Guide to Equity Compensation • Equity Compensation for Limited Liability Companies • 2012 Private Company Equity Compensation Survey