Contributors: Jamey Seely | Tricia Elias | Melanie Margolin
Equity compensation has become important to many companies’ employee recruiting, retention, and engagement strategies. Both private and public companies increasingly compensate at least senior executives (and, in many cases, all leaders or, in rare cases, all employees) with forms of equity, including incentive stock options (ISOs), restricted stock units (RSUs), performance stock units (PSUs), and performance stock awards (PSAs).
Grant programs must be structured carefully for incentive equity compensation to achieve their goals. This is a team effort in which the legal team must collaborate with the finance, human resources, corporate development, and capital markets teams.
In the GC AdvantageSM webinar, “The In-House Counsel’s Guide to Equity Compensation from Private Startups to Public Companies,” we discussed equity compensation at both private and public companies. This article summarizes our conversation.
Restricted Stock Units vs. Incentive Stock Options
Pros and Cons of ISOs for Employee Compensation
Many companies start their equity grant journey by offering stock options to employees. The benefits of incentive stock options, or ISOs, include the fact that employees can easily understand the ISOs and how to calculate or increase their value, and there are no immediate tax consequences upon grant.
As a company grows, exercising ISOs may become more prohibitively expensive for many employees working in privately held companies without a liquid market for shares. This is mainly a concern if employees want to exercise their options and keep them for at least a year to pay the lower long-term capital gains rate when selling shares.
When to Consider RSUs
This is one reason many companies transition to granting restricted stock units, or RSUs, as companies grow and scale. These direct stock grants typically are subject to a vesting schedule. While RSUs don’t introduce the same exercise-affordability concerns as ISOs, they usually have immediate tax consequences upon vesting—something that employees may not fully appreciate.
At any company, employee morale can take a significant hit if the value of the company’s stock price falls and the exercise price of employees’ options is higher than or close to the stock price. A decline in value similarly affects the price of an RSU because an RSU still has some value, and employee morale suffers less than when a stock option is underwater.
Transitioning from Options to Stock
For companies considering a transition from ISOs to RSUs, advanced planning with finance, human resources, and the legal team is crucial. A change management plan and a communication timeline are critical to a smooth transition.
A successful transition from granting ISOs to RSUs depends heavily on educating employees about the tax implications, the value of the stock units they will receive, and ways to manage or afford the tax consequences effectively. Importantly, any education sessions should clearly outline the levers that affect the company’s valuation or stock price—directly motivating the behaviors that lead to value creation.
Managing Tax Implications for Employees and the Company
Equity grant programs must be structured to limit situations where employees experience a taxable event without commensurate liquidity to pay those taxes—sometimes called a “dry tax.” If employees must pay taxes with no gains or income to show for the taxes, morale can quickly nosedive.
Smart Structures for RSUs
GCs, the Chief Financial Officer, human resources leadership, and outside experts can devise creative ways for the company to ensure its employees feel valued, understand their equity and worth, and avoid tax surprises. One way to do this is by structuring RSUs so they do not fully vest until a liquidity trigger event, thereby delaying tax liability until liquidity. The downside to this structure is that employees who exit before the liquidity event will lose equity that, under a normal vesting scheme, may have been vested but for the unique liquidity-event vesting construct.
Another option may be for the company to pay the employees’ taxes by purchasing RSUs at the company’s 409A valuation. This share buyback requires that the company commit to spending the capital for such a move, which may not be the right strategy for a growing company with scarce cash resources.
Peer Group Pressure
The choice of peer group is particularly important when preparing for an initial public offering. The board and investors expect performance and compensation to be on par with or better than peer companies. Founders may resist categorizing their company this way, but it is required and should be carefully considered within the regulated framework since it will enhance or limit it after selection.
Peer group analysis and benchmarking also help companies understand how much equity compensation to offer potential new employees, how to structure performance-based compensation, and whether grant equity exists across the organization. Public company shareholders may not approve equity-based compensation plans that are more generous than peer companies’. Unfortunately, for private companies, benchmarking equity grants, in terms of the amount granted and levels of employees receiving equity grants, is difficult due to a lack of available data.
The RSU Valuation “Black Box” in Private Companies
Valuing private-company RSUs is an art. The most common method is the 409A valuation, which is the fair market value of the company’s stock, as determined by an outside advisor. However, the 409A valuation often doesn’t accurately represent the company’s health or growth trajectory. Many companies prefer to look at how investors in the most recent fundraising round valued the company’s shares. Some companies use both numbers, others use neither, and many add in other factors.
Given the black-box nature of private-company RSU valuation, it’s particularly important to educate employees about what the 409A valuation represents, what fundraising valuations indicate, and how they should understand the value of their RSUs.
Sharing valuation information with employees should be carefully considered—both in terms of the frequency of updating and the potential consequences for engagement should the valuation be lower than, for example, a company’s growth trajectory or future prospects would suggest.
Calculating Total Compensation
Given the black-box nature of private company valuation, how can an employee with equity options or shares calculate total compensation? After all, an employee must understand the potential compensation ramifications of a job move.
The best way to create a total compensation number is to consider the company’s trajectory. Employees must be educated to consider the current value of the shares, their growth rate, and whether a new opportunity will have the same growth rate. For example, shares in the new company might be worth more to start, but it might be a low-growth company.
Generally, when calculating the value of options or stock to evaluate whether to move and compare other jobs, it’s best to use the per-share valuation indicated by the last fundraising round.
Melanie shared the process she used to negotiate equity compensation when moving from a private company close to an IPO to a public one. She provided the new employer with a range of what she believed her existing equity was worth based on the company’s value at its last funding round. She also shared the funding round information and valuation with her potential employer and the 409A to demonstrate how the “current equity replacement value” was calculated. The transparency and flexibility ultimately made both parties feel the final compensation package was fair and competitive.
Performance-Based Equity Compensation
Many companies have incorporated performance-based equity compensation, or performance shares, into their compensation plans. Individual or company metrics or a combination may measure performance.
Although performance shares can motivate employees, they also come with risks. If performance benchmarks aren’t reached, employees receive less compensation, morale may fall, and high-level executives may leave. This can be a significant risk for newly public companies that attempt to establish multi-year performance targets with no baseline.
Despite its human-capital risks, proxy advisory firms Glass Lewis and Institutional Shareholder Services (ISS) favor performance shares. They may recommend that shareholders vote against compensation plans that don’t include them. However, companies should decide about equity compensation based on the company’s best interests.
Stakeholder Engagement is Critical
Even if major shareholders don’t have to approve any compensation plan that could dilute the value of their shares, it’s critical to consistently and proactively engage with them around any new equity compensation plans or potentially controversial plan amendments. Key executives should communicate with shareholders throughout the year, especially when the company is contemplating plan structure or changes, rather than waiting to engage when a significant equity compensation or other equity-related matter is on the ballot.
Companies proposing new equity compensation plans or significant amendments should also include investor relations in the early conversations. IR can research whether shareholders have voted on similar plans before and examine comparable companies’ performance. They may also be best positioned to take the pulse of private equity investors, institutional shareholders, and board members.
Managing Private Company Liquidity
Private company employees with options or shares cannot reap the rewards of their equity without a liquidity event, such as an IPO, acquisition, merger, tender offer, or secondary sale.
Companies without a natural liquidity event on the horizon are often better off undertaking tender offers and secondary sales to boost employee morale and retention. Cross-function collaboration and early involvement of the audit firm are critical and can avoid complex audit issues arising post-closing.
Take Advantage of Expert Advice
While structuring equity compensation to benefit the company and employees can be challenging, GCs have many resources they can tap into. BarkerGilmore’s 2024 In-House Counsel Compensation Report can help shed light on the overall compensation picture for in-house counsel, and our legal and compliance department consulting services can connect you with more specialized legal expertise.
Jamey Seely and our team of professionals are happy to help accelerate the initiatives that you’re already pursuing or to supplement your current strategic thinking to help you realize your vision. Please reach out if you or your organization may benefit from our recruiting, leadership development and coaching, or legal and compliance department consulting services. Let BarkerGilmore help you build and optimize your legal and compliance departments.
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