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Types of Equity Compensation
Presented by
Daniel N. JanichJanich Law Group
222 N. LaSalle Street, Suite 2500Chicago, IL 60601
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The Popularity of Equity Compensation
• NCEO Estimates Up to 25% of Employees Own Corporate Equity in U.S.
• Primary Reason for Popularity of Equity Ownership:– Its Favorable Impact Upon Corporate Performance
• Coopers & Lybrand Survey: 39% higher revenue growth rate in companies with employee equity sharing programs
• Other Reasons Equity Sharing is Important to Closely Held Companies:
– Tool to Promote Employee Loyalty & Long Term Retention
– Shift to Entrepreneurially-Oriented Pay Systems More Closely Linking Pay to Performance
– Helps Motivate and Retain Employees– The Expectations of Employees in Pre-IPO Companies
• Equity Ownership a Prerequisite for Attracting and Retaining Quality Personnel
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Disadvantages of Equity Sharing
• For All Employers:– Dilution of Equity Interests Held by Current
Shareholders– Securities Law Compliance Issues
• Additional Considerations for Closely Held Companies:– Marketability of Shares– Perceived Loss of Control/Corporate
Governance Issues
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Which Equity/Equity Like PlansBest Fit Your Company?
• Does company want to share economic value of equity but not equity itself?
• Are there corporate restrictions?– Types of Legal Entities– Existing Contractual Obligations
• Does company already offer an ownership plan to its employees?
• Which Plan(s) Best Fit(s) Your Company’s Culture?
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The Equity Dilemma of Closely Held Companies
• Goal– Maximize Equity Advantages and Minimize
Equity Disadvantages
• Equity Plans Not Adopted by Closely Held Companies:– Option Plans (except pre-IPO)– Employee Stock Purchase Plans (only post-
IPO)
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Sharing Equity Growth/Sharing Equity
• Equity/Equity Like Plans Most Commonly Used By Closely-Held Companies:– Phantom Stock – Stock Appreciation Rights (SARs)
• Stock Settled SARs
– Restricted Stock/Restricted Stock Units– Direct Stock Purchase Plan– Performance Awards
• Performance Units
• Performance Shares
– Employee Stock Ownership Plan (ESOP)
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Common Plan Design Issues
• Most of these plans are flexible in design• Common design features:
– Plan eligibility criteria– Amount of awards– Holding Periods; Forfeitures; Vesting Rules– Liquidity Concerns– Right to Earnings; Voting Privileges– Applicability of Section 409A
• 3 Basic Issues:– Award payable in stock or cash?– Employee to receive value of shares, share
appreciation only, or something else?– Employee required to make payment for receipt
of award?
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Phantom Stock Plan – Equity Like Plan
• Employees Awarded Units of “Phantom Stock”
• Each Unit Equals One Share of Common Stock
• After Specified Number of Years of Employment, Employee Receives Value of Phantom Stock in Cash + Dividends Credited to Phantom Stock
• Units of Phantom Stock Are Book Entry; Award Does Not Entitle Employee to Rights of Stock Ownership
• State Securities Laws Inapplicable
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How Phantom Stock Plan Works
• Company awards employee with 1,000 shares of phantom stock valued at $10 per share.
• Award is subject to vesting schedule – may be fixed time period or performance-based
• Company schedules a company valuation at future date or spell out a formula that will determine the stock's value at future date
• Value of company’s stock at $30 per share on valuation date
• Company issues employee $30,000 check• Company payment qualifies for $30,000 tax
deduction. Employee award subject to income tax on $30,000 worth of ordinary income
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Stock Appreciation Rights (SARs) – Equity Like Plan
• Similar to Phantom Stock except SARs entitle employee to receive only the value in cash of appreciation in designated number of company shares; no dividend rights
• Appreciation is measured from date SAR is awarded until specific time in future
• Requires continued employment until SARs vest
• Allow the participant to realize the appreciation without having to first front the money
• Spread is paid in cash or stock—possible cash flow drain
• Most frequently used below the executive level
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How Stock Appreciation Rights Work
• Company awards employee with rights with respect to 1,000 shares of common stock with base price per right of $10.
• Award is subject to vesting schedule – may be fixed time period or performance-based
• The right is exercised by employee after vesting
• Value of company’s stock at $30 per share at time right is exercised
• Company issues employee $20,000 check or settles payment in company stock worth $20,000
• Company payment qualifies for $20,000 tax deduction. Employee award subject to income tax on $20,000 worth of ordinary income
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Phantom Stock Plan & SARs– Equity Like Plan
• Advantages– Effective means of sharing equity value without sharing
equity• Some closely held companies do not want
employees to own company shares—perceived loss of control
• Particularly useful to limited liability companies, partnerships, and sole proprietorships—all of which do not have stock
– Avoid issue of no marketability of shares– Simpler to give employees cash rather than buy back
shares– Avoid securities law and corporate law compliance
issues
• Disadvantages– No significant tax benefits to employers or employees,
such as ESOP, 401(k) plan, ISOs– Challenge of communicating value to employees who
may be skeptical whether company will furnish a fair value determination of company’s worth
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Stock-Settled Stock Appreciation Rights (SS-SARs)
• Stock-Settled SARs is an appreciation right satisfied solely with stock
• The economic benefit of the award is the same as nonqualified stock options
• Stock-Settled SARs are less dilutive than stock options because company issues only enough shares to equal difference between price of stock at award date and price at vesting
• Employees receive actual shares upon vesting
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Restricted Stock – Equity Sharing Plan
• Restricted stock refers to shares whose sale or acquisition is subject to restrictions until vesting schedule is satisfied
• Restricted shares are awarded conditionally, subject to satisfaction of vesting which may be based upon employment term or attainment of performance goals
• Restricted Shares may be eligible for dividends and voting rights; subject to forfeiture if conditions are unsatisfied
• Section 83(b) Election Available
• “Freebie factor”—restricted stock provides value even in declining stock market, thus fewer are issued than options
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How Restricted Stock Works
• CEO is granted 10,000 shares of restricted stock.
• At share price of $10, grant is worth $100,000.
• Stock vests over 5-year period, with 20% annual vesting on anniversary date of grant.
• If CEO leaves, there is a forfeiture of unvested shares.
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Performance Accelerated Restricted Stock
• Similar to restricted stock except vesting may be accelerated based on company or individual performance
• Performance period and performance goals specified in advance
• Performance measured by stock price, revenue growth, or other factors
• Value based on share price, but timing of vesting dependent on meeting stock price or financial performance hurdles
• Normal vesting does not occur for extended period of time
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How Performance AcceleratedRestricted Stock Works
• Similar to restricted stock except for vesting—
• Full vesting occurs at end of 8-year period• Shares will vest earlier if performance
targets met– 50% of shares vest when XYZ Company
achieves 50% growth in net income– 75% of shares vest when XYZ Company
achieves 80% growth in net income– 100% of shares vest when XYZ
Company achieves 90% growth in net income.
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Restricted Stock – Equity Sharing Plan
• Advantages– Employees must achieve service or performance target
before receiving shares; company performance targets help foster “team” mentality among employees
– Dividend and voting rights may be available– Shares always have some value in downturn market (unlike
options or SARs)– Employees receive capital gains treatment on all or part of
gain on shares if 83(b) election made
• Disadvantages– Requires “delayed satisfaction” in a world of “immediate
gratification.” Employee who makes purchase must wait until restrictions lapse before receipt of shares
– Company must ensure that shares have a market for employees to value their receipt. Without a market for shares, restricted stock meaningless to employees
– No company tax deduction for value of gain accrued after 83(b) election
– More complicated vehicle than others; may be more financially risky for employees who make 83(b) election
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Restricted Stock Units – Delayed Award
• Restricted Stock Units (RSUs) similar to phantom stock plan paid out in shares
• An award of restricted stock units means the employee is given restricted right to receive shares at some future date or subject to some performance condition
– No shareholder rights or privileges until shares are actually issued
– No Section 83(b) Election
• Accounting, Tax and Securities Law Ramifications are same as Stock-Settled Phantom Stock
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Performance Award Plan
• Rewards employee participants for individual or company achievement of specified performance targets, such as improvement in EBITDA, sales, quality, or any other measure
• Employee receives conditional grant of performance units that are paid if performance targets satisfied during award period
• Award units are not equity based:– “performance unit plans” use a fixed value
(specific dollar amount) – “performance share plans” uses value of
employer’s stock• Earnings under performance unit plans are paid in
cash equal to number of shares earned times current share price
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How Performance Award Plans Work
• CEO receives target grant of 10,000 shares• If XYZ Company meets performance target of 15%
annual earnings per share growth over 4 year period, CEO receives 10,000 shares
• If XYZ Company does not achieve threshold of 10% annual earnings per share growth over 4 year period, CEO receives no shares
• If XYZ Company achieves 20% annual earnings per share growth over 4 year period, CEO receives 15,000 shares
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Performance Award Plan
• Advantages– Settled in cash or stock – Directly linked to performance targets– Flexible in design– Cash settlements can more closely link
individual performance with reward
• Disadvantages– Cash settlements provide no ownership stake– Challenges exist in determining acceptable
measures of performance as measure for awards
– Narrowly focused performance goals may overlook other legitimate company objectives
– Individual awards may discourage teamwork
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Direct Stock Purchase Plans – Equity Sharing Plan
• Employees able to purchase company shares with own funds, at market price or discount
• Employers may provide below-market or non-recourse loans to employees to help finance the stock purchase
• Upon purchase, employees become shareholders with same rights as other shareholders of same class of securities
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Direct Stock Purchase Plans – Equity Sharing Plan
• Advantages– Purchase results in sense of “ownership”
stake in company’s welfare– Purchase evidence commitment to company– Purchase infuses company with new capital– Purchase evidences individual’s willingness to
make financial sacrifice
• Disadvantages
– Purchase requirement limits employee participation to higher paid; ownership culture will not be widespread
– Offer of purchase = Demand to Purchase; Political Pressure to Make the “Buy-In”
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Direct Stock Purchase Plans – Equity Sharing Plan
• Disadvantages– Legal/Practical Restrictions on Transferability;
If no market exists for shares, will employees be willing to make purchase?
– Cost of Stock Registration Requirements and State Corporate Law Requirements vs. Likelihood of Significant Employee Investment in Company Stock
– Purchase Requires Use of After-Tax Dollars by Employee; Is Company Loan Available to Make Purchase?
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Employee Stock Ownership Plan (ESOP)
• ESOP is tax qualified employee retirement plan:– Subject to Tax Qualification Rules Re.
Nondiscrimination– Subject to Extra Tax Rules Complicating
Costs of Administration– Subject to ERISA: reporting and disclosure
• Common ESOP Applications– Business Succession Strategy: Buy Shares of
Departing Owner of Closely Held Company– Finance Company Growth or Acquisitions:
Buy Newly Issued Shares in Company with Borrowed Funds Used to Buy New Capital
• Leveraged vs. Non-Leveraged ESOP: Both Effectively tie Employee with Corporate Interests
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How Leveraged ESOP Works
• Basic Steps:– Company Sets Up Trust– Trust Borrows Money from Lender/Company Borrows
Money from Lender and Reloans Proceeds to ESOP– Trust Uses Loan Proceeds to Purchase Stock in
Company– Acquired Stock is Placed in Trust’s Suspense Account
for Later Allocation to Employee Accounts as Loan is Repaid
– Company Repays Loan Through Tax-Deductible Contributions to Trust
– Trust Gives Repayment Contributions Received from Company to Lender
– Company Buys Back Shares of Terminated Employees
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How Leveraged ESOP Works
• Company Tax Benefits:– Deduct Entire Loan Contribution Made to
ESOP (interest & principal)– Deduct Dividends Paid on Shares Acquired
with Loan Proceeds if Used to Repay Loan Itself
– Deduct Dividends Passed Through to Employee Participants
– S Corp earnings attributable to ESOP not subject to corporate income tax
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Non-Leveraged ESOP
• Refers to Manner in Which ESOP is Funded:– Company May Contribute New Shares of
Stock to ESOP– Company May Contribute Cash to Buy
Existing Shares• In Either Case, Company Contributions are Tax-
Deductible Up to 25% of Payment
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A Word About Section 401(k) Plans
• Allows Employee to Defer Portion of Wages on Pre-Tax Basis into Investment Fund Held by Trust
• Tax Qualified Retirement Plan: Subject to Nondiscrimination Rules
• Company Matching Contribution Invested in Company Stock
• 401(k) Plan Less Attractive to Closely Held Companies – Securities Law Issues– Matching Contribution Entails Dilution of
Ownership or Reacquisition of Existing Shares• No Rollover Tax Benefit (of ESOP)
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Are 401(k) Plans/SIMPLE Plans Ever Attractive to Closely Held Companies?
• Yes, when Company desires employee ownership without stock purchases or ESOP borrowing
• Combination of 401(k) Plan and ESOP—– ESOP contribution used as 401(k) Matching
Contribution• Alternative to 401(k) Plan for Small Employers:
– SIMPLE Plan Used by Employers with under 100 Employees
• Similar to 401(k) Plan• Rules Stricter than 401(k) Plan• Easier Administration
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Summary of Tax and Accounting Issues
*Subject to section 162(m) or applicable qualification rules, as the case may be.
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Additional Resources
• Beyond Stock Options: Phantom Stock, Restricted Stock, Stock Appreciation Rights and Other Equity Alternatives (NCEO, 4th Ed.).
• A Tiered Approach to Equity Design with Multiple Equity Compensation Vehicles. (2006). An update of an earlier article which takes into account recent developments, including the adoption of FAS 123(R). Available for download at http://www.janichlawgroup.com/articles2. (Chapter 8 in Beyond Stock Options, 4th ed.)
• If Not Stock Options, Then What? Equity Compensation in Today’s Economy. (2003). A discussion of how companies are adapting to the current economic climate by reassessing their equity compensation practices. This article, which appeared in the September, 2003 issue of Workspan, is available for purchase through http://www.WorldatWork.org.
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Daniel N. Janich - Biography
• Daniel N. Janich is a member of Janich Law Group. In his practice he designs employment and severance agreements, incentive arrangements, stock compensation plans and deferred compensation plans for executives of private and public companies. He also counsels companies on employee benefit plan matters, including issues relating to corporate transactions. Mr. Janich is an experienced litigator, having represented individual and corporate clients in numerous employee benefit and executive compensation disputes in state and federal courts.
• He is current co-chair of the ABA Labor Section’s Employee Benefits Committee, Reporting & Disclosure Subcommittee; and former Chair of the Chicago Bar Association Employee Benefits Committee. Mr. Janich is also Associate Senior Editor of Employee Benefits Law, a legal treatise. His frequent speaking engagements at professional and trade group conferences include presentations on equity compensation issues before the National Center of Employee Ownership.
• He received his B.A. cum laude from Marian College, his J.D. from John Marshall Law School, and his LL.M. in taxation from DePaul University, Chicago.
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Questions ?
Daniel JanichJanich Law Group
222 N. LaSalle Street, Suite 2500Chicago, IL 60601
