In this series of posts, we’ll explore ways to attract and retain key employees, directors and other service providers (all of which I’ll refer to throughout this post simply as “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. Clients considering such plans often think of stock first, but there are several arrangements that can accomplish various goals and objectives of the organization and which should be considered. To the typical client question: “which is best”, comes the typical attorney response: “it depends”, so in this series of posts we’ll attempt to explain some of these arrangements and provide some suggestions for companies considering an equity or similar compensation plan.
First, here’s a list and generic description of plans or arrangements that are often used to retain and reward key service providers:
- Stock Options – a stock option gives the service provider the right to purchase a share of the company’s stock at a set exercise price
- Restricted Stock – a grant of stock to the service provider which vests over some period of time or upon attainment of certain goals
- Phantom Stock – a deferred compensation arrangement that provides a payout (usually in cash) based upon the value of the Company’s stock
- Stock Appreciation Rights – the right to a payment (usually in cash) based on the appreciation in the value of the Company’s stock
- Profits interests (for entities taxed as partnerships) – gives the employee or service provider a share of future profits in the Company but no ownership in the current capital of the company
One point of clarification that I’m often asked about involves the distinction between stock warrants and stock options. Stock warrants differ from stock options in that they are typically granted in an investment transaction whereas stock options are granted in connection with the performance of services. Therefore, if as a company you are granting a right to purchase stock to an employee or other service provider in exchange for services, then you are providing an option and not a warrant. This distinction has important consequences for tax purposes, which we’ll discuss in a later post.
Where to Start
So where does one start when considering a plan to retain or reward key service providers? It seems to us that a good decision is best made by starting by clearly defining and articulating the purpose of the plan in the context of the specific employer. Questions to consider include:
- What is the legal structure of the company (corporation (taxed under subchapter C or S?), partnership, limited liability company, etc.)?
- What does the Company produce or what service does it provide?
- Where is the company in its life cycle (start-up, growth company, established company, etc.)?
- What critical goals must the company meet in the next 12, 24, 36 months, etc.?
- How many service providers does the company have?
- Who is the plan for? It is for one key service provider? Or all service providers?
- What is the purpose of the plan specifically? Is it to incentive the key service providers generally by aligning their interests with those of the employer? Or is it to motivate one or more service providers to help the Company achieve a specific goal?
With some of these questions answered, it will be easier to narrow the choices. However, there are many additional considerations that need to be explored. In future posts, we’ll describe the basic features of the various alternatives in more detail, their tax treatment (from the employer and the service provider side), accounting treatment, fiduciary and corporate governance issues, and securities laws considerations.
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.