This post is the second in a series exploring ways to attract and retain key employees, directors, and other service providers of privately held companies through equity-based compensation arrangements.
Previously, in the first post of this series, I provided a general overview of the options available to private companies to provide equity-based compensation to key employees and other service providers. In this post, I’ll describe in further detail four of those options: stock options, restricted stock, phantom stock, and stock appreciation rights.
Stock Options and Restricted Stock
Stock options and restricted stock are often made available under a single plan. And companies new to the world of equity compensation often ask what the difference is. Broadly speaking, the biggest difference between the two is that restricted stock gives the employee or service provider the right to earn a share of stock over some period of time through continued service or the accomplishment of certain goals, whereas a stock option gives the service provider the right to purchase a share of stock.[1]
A simple example illustrates the distinction.
Example 1: 1,000 shares of restricted stock are granted to a key employee. A share of the company’s common stock is worth $10 on date of grant. Therefore, the key employee has received stock worth $10,000 on the date of grant. If the stock value increases to $20 per share, then the key employee has received $20,000 in value. If the stock decreases to a value of $5 per share, then the key employee has received value of $5,000.
Example 2: Options to purchase 1,000 shares of common stock are issued to a key employee at an exercise price of $10 per share, which represents the fair market value of one share of the company’s stock on the date of grant. At date of grant, the award to the key employee has no intrinsic value because it would cost the key Employee $10,000 to buy stock worth $10,000. However, if the stock doubles in value to $20 per share, then the key employee could purchase $20,000 of common stock for $10,000, giving him a $10,000 profit. If the stock decreases to a value of $5 per share, then the key employee has received no value.
As the examples illustrates, the stock option benefits the service provider only to the extent of growth in value of the company’s stock while restricted stock allows the service provider to benefit from the entire value of a share of stock. The employer needs to consider this important difference and give some thought to which type of award best suits any particular service provider and will best align the service provider’s interests with those of the company. For higher level employees who are in a position to influence the company’s value and consequently its stock price, stock options may be a good choice. The stock option will, hopefully, incentivize the key employee to use his best efforts to lead the company in a positive direction and ultimately increase the company’s stock price. On the other hand, for a mid-level employee, a stock option may not be as meaningful because the employee may have little ability to influence the company in a way that will impact its stock price. In that case, a restricted stock grant may be a good idea to help retain the employee.
Basic terms to be considered for a stock option and restricted stock plan include the following:
· Number of shares available for issuance under the plan
· Any shares specifically reserved for restricted stock
· Vesting schedules
· Type of options available for issuance under the plan (non-statutory options and/or incentive stock options)
· Eligibility to receive awards – key employees, directors, consultants.
· Setting the exercise price for options
· Payment of the exercise price for options (cash, check, cancellation of indebtedness, exchange of other stock, cashless exercise, etc.)
· Termination of employment or other relationship and impact in exercisability of options and/or vesting or lapse of shares of restricted stock
· Adjustments and other terms upon changes in capitalization, merger or other transactions affecting the company
Phantom Stock and Stock Appreciation Rights
Although the names are not always determinative, phantom stock (sometimes called a “restricted stock unit”) is often structured to provide a cash payment to the service provider based on the value of a share of stock whereas a stock appreciation rights (“SAR”) award is usually structured to provide a cash payment to the service provider for growth in value of a share of stock. So in this respect, the phantom stock award resembles an award of restricted stock whereas the SAR award resembles a stock option.
The biggest difference between stock options and restricted stock on the one hand and phantom stock and SARs on the other is that the service provider never becomes a stockholder with phantom stock and SARs. Instead, phantom stock or SARs are simply cash bonus or deferred compensation arrangements, with the payout amount being tied to the value of the stock.[2] However, they can be great tools because they provide an economic incentive to the service provider if the company’s stock performs well without giving the service provider all the rights of a stockholder (and consequently creating the same fiduciary duties as are owed to stockholders). A downside may be the company’s requirement to make cash payments at some time in the future.
Basic terms to be considered for a phantom stock and/or SAR Plan include the following:
· Eligibility to receive awards – key employees, directors, consultants
· Method for determining the value of a share of common stock (i.e. formula versus appraisal)
· If a formula is used, then what formula is appropriate for the particular company (e.g. 5 x EBITDA) and what items should be deducted or added back (e.g. non-recurring income or expenses)
· Vesting schedules
· When will the award be paid (termination of employment, fixed date, etc.)
· Plan must generally be limited to a select group of management or key employees to comply with ERISA “top hat” rules
· Adjustments and other terms upon changes in capitalization, merger or other transactions affecting the company
In future posts, we’ll discuss the tax treatment (from the employer and the service provider side), accounting treatment, fiduciary and corporate governance issues, and securities laws considerations.
Footnotes
[1] The purchase or exercise price is usually fixed at the date of grant. Under Internal Revenue Code section 409A, the exercise price must not be less than the fair market value of a share of stock on the date of grant (to be discussed more in a future post).
[2] Phantom stock plans and stock appreciation rights plans can be settled in stock, but this post assumes cash payments, which is more common for private companies in my experience.
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This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
