This article is sponsored by Parsons Behle & Latimer.

A company’s management may decide to offer equity awards as a retention tool to incentivize employees and to better align interests of the company and such employees. In designing any equity incentive plan, management must consider various factors.

First, management must first consider the company’s tax status. If a company is taxed as a partnership, including a limited liability company taxed as a partnership, then the most common incentive is a “profits interest.” A profits interest allows a recipient to participate in future profits, but not the partnership’s then existing value. A partnership may also use ‘phantom equity’ tied to increases in enterprise value–essentially a cash award. Other types of awards are not available to partnerships or may be complicated to implement. The following information about equity incentives applies particularly to C corporations, although incentives are available for other types of business structures as well.

Second, management must consider a company’s goals and objectives in implementing an equity incentive plan and then tailor the plan to those goals. One goal might be to provide participants with a sense of ownership and rights to participate in developing company strategy. Or the goal may be to offer dividends and distributions as compensation based on company performance and cash flow. Alternatively, management may want to implement incentives that will only be paid on an exit transaction to participants who are still employed at the time of the exit.

Management must also consider certain tax provisions:

  • Section 83 of the Internal Revenue Code provides that a person who receives property (i.e., stock) in connection with services will have compensation income based on the property’s value on grant (i.e., the value of the shares). However, if property is subject to forfeiture (i.e., vesting), income will be realized later as vesting occurs based on the then (hopefully) appreciated value. A recipient may file a Section 83(b) election with the IRS to be taxed at the grant date and value.
  • Section 409A addresses deferred compensation rules and must be considered in any equity incentive plan. If an award is only paid out on a future event, it is important to ensure that the requirements of Section 409A are considered in defining a payout event.
  • Section 422 establishes requirements and limitations applicable to stock options, specifically options that are intended to be incentive stock options entitled to special tax treatment.
  • The nature and timing of any award will affect whether applicable income is taxed as ordinary income or at capital gains rates.

Also, various types of awards may be granted by a corporation as follow:

  • Stock Awards—a stock award is an outright issuance of stock. The recipient becomes a shareholder of the company entitled to all the rights of a shareholder. A stock award may be subject to time-based or performance-based vesting, or a combination. Vesting is sometimes accelerated on a change in control event so that the recipient may benefit from the exit transaction. A stock award may have additional forfeiture conditions, including on a termination for “cause.”
  • Stock options—a stock option is the right to buy shares in the future at a fixed price. The exercise price is usually equal to the fair market value of the stock on the date of grant. In fact, this is mandated for an incentive stock option. In order for a nonqualified stock option to avoid Section 409A, the exercise price must be equal to the date of grant. An option is usually subject to vesting based on continued employment or performance metrics.
  • Restricted Stock Units (RSUs)—an RSU is a commitment by the company to grant shares or pay cash in the future if vesting requirements are met. RSU implementation must address both Section 83 and Section 409A.
  • Stock Appreciation Rights (SARs) or Phantom Stock Plans—are a right that allows a recipient to benefit from increases in company value. Those rights may be settled in cash or in stock, depending on the type of award.

While stock awards may be preferred in startups where the stock has a lower fair market value, options may be more advantageous in other situations. RSUs are used by companies when the fair market value has grown and would result in an exorbitant exercise price. A company must evaluate the appropriate award type based on the company’s stage in its growth cycle; standards in the company’s marketplace and industry; and the specific tax impacts on the company and on participants.

Individual award terms may vary. A company may tailor grants to individuals to consider a variety of factors including (1) time-based vesting; (2) performance-vesting; (3) acceleration on a change of control; (4) termination or repurchase if the individual leaves employment, including for cause or voluntary termination; (5) voting rights; (6) transferability; (7) early exercise features for options; (8) gross up payments to assist in tax obligations; and (8) various other factors and limitations.

Implementing an equity incentive plan is a complicated process that should be approached thoughtfully. All plans and awards should be in writing, and the various rights and obligations of an employee should be clearly spelled out so there is agreement between the employee and the company.

Shane is a deal attorney with more than 30 years’ experience. He effectively and efficiently advises and guides clients to support their business objectives, providing valuable knowledge and insights at all stages. Shane regularly assists clients with formation and organizational matters, corporate governance, debt and equity financings, securities matters, mergers and acquisitions, technology transactions and other matters. To discuss this or related matters with Shane, call (801) 532.1234 or send an email to shanna@parsonsbehle.com.