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Stock Options versus Stock Warrants – What’s the Difference?

November 2, 2012 By 6 Comments

I frequently hear clients and some of their advisers talk about “stock options” and “stock warrants” and there is often considerable confusion between the two. In this post, I’ll briefly describe the major distinctions between these instruments and how each can be used in a privately held company.

Stock options are issued to key employees, directors and other service providers in exchange for services rendered to the company/employer. Generally, there is a stock option plan under which a set number of options (and often restricted stock) can be issued to one or more key service providers to align their interests with the interests of the employer. The option is a compensatory vehicle that is intended to increase the key service provider’s overall compensation if the company’s stock price increases.

On the other hand, warrants are not compensatory vehicles. Instead, they are issued in connection with the company’s raising of capital, either debt or equity securities, and are used to “sweeten” the deal for the investor. So for example, suppose a technology company is raising capital through a Series A Round and wants to incentivize the first investor who joins the deal by giving it “something extra.” In this case, a stock warrant could be issued to the first investor to purchase X number of shares of the company’s common stock at $Y per share. This stock right is issued in connection with a capital transaction and is designed to increase the overall return on investment to the first investor. This vehicle is properly called a warrant.

Another common example would be a stock warrant issued in connection with a debt transaction. To induce the investor to loan funds to the Company, the company might give the investor a warrant to purchase some number of shares of stock which, from the investor’s standpoint, will hopefully generate a higher total rate of return on the overall transaction.

The tax rules governing options and warrants are completely different. Stock options are compensatory in nature and therefore subject to the rules governing compensatory items. The basic treatment of stock options is as follows (this assumes nonqualified options; special rules apply to “incentive” or qualified options):

  • There is no tax to the employee/service provider on the date of grant of the option and the employee has no tax basis in the option.
  • The exercise price of the option cannot be less than the fair market value of the stock on the date of grant (because of the requirements contained in the Internal Revenue Code section 409A).
  • The employee/service provider is taxed on the spread between the fair market value of the stock on the date of exercise and the exercise price.
  • A subsequent sale of the stock would be a capital transaction taxed at capital gains rates (short-term or long-term depending on the holding period).

For additional information on stock options, see my post on Retaining Key Employees in a Privately Held Company Through Equity Compensation – Part 3: Tax Treatment of Various Plans.

On the other hand, warrants are not compensatory and are generally taxed as follows:

  • A portion of the purchase price associated with the underlying stock or debt deal would be allocated to the warrant so the investor would have tax basis in the warrant (but often a nominal amount).
  • The exercise price of the warrant can be any amount; there is no requirement that it be equal to the fair market value of the underlying stock at date of grant.
  • Upon exercise of the warrant, the investor would pay the purchase price for the shares but, unlike the option, there would be no tax due.
  • Like with an option, a subsequent sale of the stock would be a capital transaction taxed at capital gains rates (short-term or long-term depending on the holding period).

And of course, to state the obvious, you can’t simply change the name of the instrument being issued to change the tax treatment (e.g. calling an instrument issued in connection with services a “warrant” will not change its tax treatment; the “substance over form” rule will require that it be treated as an option and subject to the tax rules for options regardless of its name).

Companies and investors dealing in options and warrants should understand the basic differences and consider the tax consequences when contemplating transactions involving such instruments. And please note that the tax consequences described in these posts are for the most generic instruments and you should consult your own tax adviser in connection with any particular transaction.

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© 2012 Casey W. Riggs — 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.

Filed Under: General Business Law Tagged With: , , , , , , , , ,

Retaining Key Employees in a Privately-Held Company through Equity Compensation – Part 6: Securities Law and Corporate Governance Implications

August 19, 2012 By 1 Comment

This post is the sixth in a series exploring techniques to attract and retain key employee, directors, and other service providers of privately held companies through equity-based compensation arrangements and alternative arrangements that provide cash payments tied to the value of the company’s stock or ownership interests.

In previous posts, Casey Riggs discussed various arrangements available to companies that wish to compensate employees and their service providers with equity, including stock options, restricted stock awards, phantom stock plans, stock appreciation rights, and profits interests in LLCs. When issuing equity compensation, companies should be mindful of the securities law and corporate governance implications of such awards. This post will explore those implications.

Securities Law Implications

Equity compensation arrangements are subject to both federal and state securities laws. This means that a company cannot utilize equity compensation without either registering the securities that are issued to service providers or finding an exemption from registration. Many startups frequently overlook this, resulting in problems for them down the road. The seminal case, SEC v. Ralston Purina Co. involved a company that sold its stock to its own employees. The court found that this was an unlawful issuance of unregistered securities (without an exemption), notwithstanding the fact that the securities in question were only offered to the company’s own employees.

Fortunately, since then, the SEC has created an exemption from federal securities registration through a regulation known as Rule 701, which allows companies to compensate service providers with the company’s own securities (or that of an affiliate) without registering with the SEC. The rule is relatively straightforward to use, compared to some of the other federal securities exemptions. For instance, no filing is required with the SEC to take advantage of it (in contrast to Regulation D, which requires the filing of Form D). In addition, offers and sales under Rule 701 will not be “integrated” with other securities offerings, which means, for instance, that a company can simultaneously compensate employees with stock under Rule 701 while also conducting a Reg. D offering. The class of potential recipients is quite broad, including directors, employees, officers, their families, and even outside consultants or advisers (as long as those consultants or advisers are not assisting the company in its capital raising). Securities sold under Rule 701 are “restricted securities,” which means that they are issued with significant restrictions on resale. Finally, while the terms of the offering must be disclosed, there are no other specific disclosure requirements (as long as the total value of securities issued under Rule 701 in any 12-month period is under $5 Million).[1]

There are some downsides to Rule 701. It is subject to a numerical value cap over any 12-month period of time, which is always at least $1 Million, but can be higher in the case of companies with significant assets.[2] In addition, unlike Rule 506 of Regulation D, there is no preemption of state registration requirements, which means that the issuer will need to find a state exemption for each state in which recipients reside. States are actually quite varied in their approach to offerings of securities to service providers. Some states have an exemption which is identical or similar to Rule 701, but require that the issuer make a notice filing with the state securities division, while other states do not require a filing. Still other states have exemptions that are quite different from Rule 701, resulting in the company being required to comply with both the federal and state securities regulations.

Corporate Governance Implications

One issue that founders of startups do not always think about when granting stock to employees is that once these employees have stock in the company, they will be entitled to all of the privileges of stockholders, including voting rights and records inspection rights. In addition, management will have a fiduciary duty to these stockholder-employees, which they did not have prior to granting the equity compensation.

It is possible to mitigate some of these effects. For instance, when dealing with the issue of voting rights, if the equity compensation is in the form of restricted stock, the company could issue that stock as non-voting stock. If the company is a Delaware LLC, the issue of fiduciary duty can be mostly eliminated by including a provision within the company’s governing documents which has the equity compensation recipients waive management’s fiduciary duties to them.[3] Ultimately, however, if a company wants to avoid these issues altogether, it should not use actual equity in its incentive compensation plan, but rather should use stock appreciation rights or a phantom stock plan.

Equity compensation arrangements can be a great way of aligning the interests of a company with its employees and other service providers. However, properly utilizing them is also quite complex and will introduce new legal and accounting issues for the company. Therefore the decision to issue equity to any service provider should not be taken lightly.

Footnotes

[1] While there are no specific disclosure requirements, issuers remain subject to the anti-fraud provisions of securities laws, which means that any statements made to recipients can’t be untruthful or misleading.

[2] The aggregate sales price of securities sold under Rule 701 in any consecutive 12-month period cannot exceed the greatest of: (a) $1 Million, (b) 15% of the total assets of the issuer, or (c) 15% of the outstanding amount of the class of securities being offered under Rule 701.

[3] This would not be effective for a Delaware corporation or an entity organized in most other states.

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© 2012 Alexander J. Davie — 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.

Filed Under: Startups and Venture Capital Tagged With: , , , , , , , , , , ,

Retaining Key Employees in a Privately-Held Company through Equity Compensation – Part 5: Accounting Implications

July 28, 2012 By Leave a Comment

This post is the fifth in a series exploring techniques to attract and retain key employees, directors, and other service providers of privately held companies through equity-based compensation arrangements and alternative arrangements that provide cash payments tied to the value of the company’s stock or ownership interests.

Previously, I provided an overview and discussed the tax treatment of various equity compensation arrangements typically used by corporations, such as stock options, restricted stock, phantom stock, and stock appreciation rights and the tax treatment of profits interests in entities taxed as partnerships (like LLCs). In this post, we’ll briefly discuss the accounting treatment for some of these vehicles (and in particular, the effects on the company’s P&L). While the details of accounting for stock-based compensation and deferred compensation plans are complex and certainly beyond the scope of this blog post, the basic concepts are important and should be considered before such awards are made. In particular, companies considering awards will want to have an understanding of the potential expenses that will be recognized on the company’s P&L in connection with an award and how those expenses might affect financial statements and agreements with third parties (e.g. financial covenants in a loan agreement).

Thank you to Keith Johnson and Tammy Joscelyn, CPAs with Byrd, Proctor & Mills for providing the accounting expertise to write this post.

Stock Options and Restricted Stock

Within the last decade, the rules for governing the accounting treatment for stock based compensation have changed significantly and now most companies (public and private) are required to recognize an expense associated with stock options and restricted stock. This was not the case prior to some of the corporate scandals that took place in the last decade which created a growing perception that financial statements were not accurately reflecting stock based compensation. Warren Buffet stated in a 2002 New York Times article that there existed a “crisis in confidence” regarding the earnings number reported by most corporations, and he attributed much of the problem to stock option accounting and pension fund returns. In fact, he stated in the article that “the aggregate misrepresentation in these two areas dwarfs the lies of Enron and WorldCom.”[1]

As a result of this growing concern, under 2004 Financial Accounting Standards Board Statement 123(R) (now incorporated into FASB Accounting Standards Codification Topic 718, Compensation-Stock Compensation), companies are required to recognize an expense for stock based compensation.

Without going into too much detail, the basic concepts are as follows:

For restricted stock, the value of the award at the date of grant will be recognized over the vesting period. So for example, if the company awards shares of stock worth $10,000 and the award vests over 5 years, then the company would recognize an expense of $2,000 per year. In addition, because the company gets a tax deduction when the amount is included in the income of the service provider, there is a partial offset to the expense for the value of the future tax deduction. So assuming the company is in the 35% tax bracket, it will have recognized an after-tax expense equal to $6,500 ($10,000 expense – $3,500 tax savings) when the award is fully accounted for (assuming it fully vests). Subsequent changes in the price after the date of grant do not affect the expense; however, for purposes of comparison to an example below, let’s assume the stock price doubles resulting in the service provider owning stock worth $20,000 when the award is fully vested.

Stock options are a little bit more complex and generally require the application of an option pricing model to determine the fair value of the option. Such models include “closed end” or “lattice” models, which take into account factors such as volatility of the stock, the time value of money, the option’s strike price and the dividend yield. The resulting value of the option is expensed over the vesting period and, as with restricted stock, there is a tax deduction for the amount included in the income of the service provider (for nonqualified options only; ISOs do not result in a tax deduction). Also, stock price changes after the date of grant do not affect the expense.

So for example, assume the company grants an option to purchase the same shares worth $10,000 as in the prior example. However, in this case, it’s an option (and not an outright grant of stock), so the service provider can purchase the shares for an exercise price of $10,000. In this case, there is no intrinsic value at the date of grant because the purchase price equals the value of the stock. But the option does have some value because of the chance that it could increase in value in the future. So the fact that they have value and consequently cost the company something seems intuitive, but what’s less intuitive (or perhaps not intuitive at all) is how to determine the expense.

Under current rules, the company would determine the fair value of the option (not the stock) by inputting several variables into an option model which is used to value the option based on the probability that it will be “in the money”, will vest, and will be exercised. So let’s assume the company runs this model and it tells us the option value is worth $9,000 at the date of grant. In that case, the company will recognize an expense in this amount over the vesting period (if any). Now let’s assume the stock price increases to $20,000, as in the prior restricted stock example, and is exercised at that time. In this case, the company will have recognized an expense of $9,000 and will benefit from a tax deduction of $10,000 ($20,000 value over $10,000 exercise price; and if the tax bracket is 35%, a tax savings of $3,500). So the after tax cost recognized will be $9,000 – $3,500 = $5,500 and the recipient will have received value of $10,000 ($20,000 value received less $10,000 exercise price).[2]

Phantom Stock and Stock Appreciation Rights

Phantom Stock and Stock Appreciation Rights (SAR) (those settled in cash) are in essence deferred compensation plans and as such are subject to liability accounting (as opposed to equity accounting). As with stock based compensation, the company recognizes a P&L expense for the current value of the award at date of grant which is fully taken into account over the vesting period and which is reduced by the future tax deduction. However, unlike stock based compensation, the expense is subsequently adjusted for both vesting events and stock price changes.

Assume, for example, a phantom stock plan that provides the service provider with phantom stock award, to be settled in cash, equal to 1,000 shares of stock valued at $10 per share on the date of grant. In addition, the award vests 20% per year over five years.

In this example, the company would recognize a compensation expense in the first year equal to $2,000 if the stock price remained constant. However, unlike with stock based compensation, the company would subsequently re-value the expense based on the change in the stock price. So, in our example, if the stock price increased to $20 per share at the end of our five-year vesting period, then the company would have recognized a compensation expense equal to $20,000. In addition, when the award is paid out the company will recognize a tax deduction resulting in tax savings of $7,000 (again, assuming a 35% tax bracket (35% of $20,000)). So the after-tax expense is $13,000.

It’s interesting to note that the company comes up with very different accounting expenses based on the type of award. Notice the following based on the simple examples:

Pre-tax Value to Recipient

After-tax Cost Accounting Expenses to Service Provider

Restricted Stock Example

$20,000

$6,500

Stock Option Example

$10,000

$5,500

Phantom Stock Example

$20,000

$13,000

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Accounting for stock based compensation and deferred compensation plans is complex, but should be taken into account by companies considering such awards. In particular, the P&L expenses that will potentially be recognized over the lifetime of the award can vary significantly based on the type of award and should be factored into the equation. A good CPA can provide this expertise.

Footnotes

[1] Buffett, Warren E. (July 24, 2002). “Warren E. Buffett, ”Who Really Cooks the Books?”, The New York Times, July 24, 2002″.

[2] Note that $10,000 is the pre-tax value to the service provider who would recognize $10,000 in income in this example. This example is simplified to illustrate the basic concepts. The actual accounting entries would result in a tax savings of $3,150 ($9,000 book expense x 35%) and a balance sheet entry to additional paid in capital for $350 (the excess of the amount deductible for tax purposes ($10,000) over the book expense ($9,000) multiplied by the tax rate).

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© 2012 Casey W. Riggs — 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.

Filed Under: Startups and Venture Capital Tagged With: , , , , , , , , ,

Retaining Key Employees in a Privately-Held Company through Equity Compensation – Part 3: Tax Treatment of Various Plans

June 17, 2012 By Leave a Comment

This post is the third in a series exploring ways to attract and retain key employees, directors, and other service providers of privately held companies (herein “service providers”) through equity-based compensation arrangements and alternative arrangements that provide cash payments tied to the value of the company’s stock.

Previously, in the first and second posts of this series, I provided a general overview of four alternatives available to private companies to provide equity-based compensation to key employees and other service providers and some of the factors used to select among these alternatives. In this post, I’ll describe the federal income tax treatment of stock options, restricted stock, phantom stock, and stock appreciation rights, both from the employer and employee perspective.

Stock Options

There are two types of stock options for tax purposes, nonqualified options (“NQSOs”) and incentive stock options (“ISOs”) (also sometimes referred to as statutory stock options).

From the service provider side, NQSOs usually result in (i) no tax consequences at the date of grant of the option and (ii) compensation income (i.e. income tax at “ordinary income” rates and FICA taxes) to the service provider on the “spread” at the date of exercise of the option. The “spread” is the value of the share of stock at the date of exercise over the exercise price. This tax treatment (i.e. taxed at date of exercise and not date of grant) is applicable in most cases except in the rare event that the options in the privately held company have a readily ascertainable fair market value at the date of grant. On a subsequent sale of the stock, the service provider may get long-term capital gain treatment, taxed at 15% (at least until January 1, 2013)

From the employer side, NQSOs result in (i) no tax consequence at the date of grant and (ii) a tax deduction on the amount treated as compensation income to the service provider at the date of exercise (again, except in the rare case of stock that has a readily ascertainable market value at date of grant). On a subsequent sale of the stock by the service provider, there is no tax consequence to the employer.

On the other hand, incentive stock options are given special tax treatment under Internal Revenue Code Sections 421 and 422. Specifically, there is no tax at date of grant or at date of exercise and the employee (only employees may receive ISOs) may receive long-term capital gain treatment on a subsequent sale of the stock if the stock received upon exercise of the ISO is held at least a year after exercise and at least two years from the original date of grant of the option.[1] In addition, FICA taxes do not apply to ISOs. From the employer side, however, the tax treatment is less favorable; there is no tax deduction at date of grant, exercise or on a subsequent sale.

To achieve ISO status, there are several requirements which must be met. Briefly, these requirements include, but are not limited to:

  • Only employees may receive ISOs
  • The plan must be approved by the stockholders
  • The plan must set forth a maximum number of shares and the employees or class of employees eligible to receive options
  • Options cannot have a term exceeding ten years (five years for 10%+ shareholders)
  • The exercise price is not less than fair market value at date of grant (110% of fair market value for 10%+ shareholders)

In addition to the general tax treatment for options, Code Section 409A is critically important. Without delving too deep into the details, issuers of stock options need to know that they must issue the stock option with an exercise equal to or exceeding fair market value on the date of grant. If stock options are issued with an exercise price below fair market value, then the option would be subject to Code section 409A, and in almost all cases would not comply. The result would be significant taxes and penalties assessed against the service provider.

The most problematic part of Code section 409A for privately held companies is determining the fair market value of a share of stock at date of grant. Many privately held companies, particularly those in a growth phase, are short on cash flow and don’t want to pay for an appraisal. Fortunately, Treasury regulations provide that a company may use a number of methods to determine fair market value, including “a reasonable application of a reasonable method”. The most important point is that the board of directors needs to take into account all relevant information, including third-party offers for purchases of stock, and apply a reasoned approach to determine value. And perhaps most importantly, the methodology and the price need to be well documented in the issuer’s board minutes.

Restricted Stock

Restricted stock is taxed under Code Section 83 governing transfers of property. If the stock granted is non-transferable and subject to a substantial risk of forfeiture, which will exist when (i) the service provider must continue performing substantial services for some period of time for the stock to vest and/or (ii) there are certain performance based conditions, then the restricted stock is not taxed at grant.[2] Instead, the stock will be taxed when it is vested as compensation income (at ordinary income rates and FICA). In addition, any income to the service provider before the stock is vested, such as dividends, will be treated as compensation income to the service provider. On the employer side, it will receive a tax deduction equal to the amount included in the income of the service provider at the time the stock is included in the service provider’s income.

However, there is an election available under Code section 83(b) which allows the service provider to elect to take the stock into account for tax purposes at date of grant. Although deferral of income is normally the goal, with restricted stock it may (and often does) make sense to make the 83(b) election if the stock is expected to increase in value after date of grant. The result of the 83(b) election for stock increasing in value is that the recipient pays tax on a low value at date of grant and achieves capital gain treatment for a subsequent sale of the stock at a higher value. The 83(b) election must be made within 30 days of the date of grant.

Restricted stock is generally not subject to Code section 409A.

Phantom Stock and Stock Appreciation Rights

Phantom stock (also sometime structured as restricted stock units) and stock appreciation rights (SARs) generally result in compensation income to the service provider upon the date of payment and the employer gets a deduction for the amount taxed to the service provider.

However, for FICA tax purposes, there is a special timing rule for phantom stock plans which provides that the income is taxed at the later to occur of the time when the services are performed or when there is no substantial risk of forfeiture. FICA taxes on SARs are generally applied on vesting.

Both phantom stock plans and SAR plans are usually structured to avoid the necessity of complying with Code section 409A. This is done by having the award paid out under the short-term deferral exception (payment to the service provider within 2½ months after the end of the taxable year in which the award vests). However, if the short-term deferral exception is not used, then plan will be subject to Code section 409A and its many requirements

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As this brief post illustrates, taxation of stock and stock based awards is complex, to say the least. Companies exploring equity based compensation arrangements should be sure to understand the tax treatment of any award they propose to issue. Competent tax counsel or a good CPA who is knowledgeable in this area can help.

Footnotes

[1] Incentive stock options may result in payment of alternative minimum tax.

[2] A substantial risk of forfeiture may also exist if there is one or more conditions to vesting related to the purpose of the transfer (such as company performance measures). On May 29, 2012, the proposed regulations under Code Section 83 were published discussing and clarifying certain circumstances in which such conditions may or may not result in a substantial risk of forfeiture.

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© 2012 Casey W. Riggs — 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.

Filed Under: Startups and Venture Capital Tagged With: , , , , , , , , ,

Retaining Key Employees in a Privately-Held Company through Equity Compensation – Part 2: Basics of Stock Options, Restricted Stock, Phantom Stock, and Stock Appreciation Rights

June 3, 2012 By Leave a Comment

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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© 2012 Casey W. Riggs — 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.

Filed Under: Startups and Venture Capital Tagged With: , , , , , , ,