employee equity compensation: how to incentivize employees without burning through your cash

Employee Equity Compensation:

How to Incentivize Your Employees without Burning Through Cash

August 27, 2014

Tim DuVall – Katz, Sapper & Miller

Erin Eberly – Katz, Sapper & Miller

Kristine Camron – Ice Miller

▪ A tool to attract, retain and motivate key employees with a future interest in the company▫ Typically key employees and executive management, but

can be all employees

▪ Most common types of stock options:▫ Incentive Stock Options(ISO)▫ Non-Qualified Stock Options(NQSO)▫ Restricted Stock ▫ Phantom Stock▫ Profits Interests

What Are Stock Options?

▪ Benefits▫ Preferential tax treatment to option holders▫ Pays only if price increases and a triggering event

▪ Issues▫ Valuation▫ Vesting▫ Pricing▫ Limits on preferential tax treatment per year upon exercise ($100,000)

▪ Taxes▫ Option is not taxed when exercised; could have AMT issues▫ No ordinary income if held for qualifying period, resulting in long term

capital gain▫ The company deducts only ordinary income portion

Incentive Stock Options (ISO)

▪ Benefits▫ Corporate tax deduction▫ Pays only if price increases and triggering event

▪ Issues▫ Valuation▫ Vesting▫ Pricing

▪ Taxes▫ Taxed as ordinary income when exercised▫ The company deducts ordinary income to option holders when

exercised

Non-Qualified Stock Options (NQSO)

▪ Benefits▫ Form of Deferred Compensation and Stock Award▫ Value whether company valuation increases or decreases

▪ Issues▫ Forced income recognition and taxability▫ Section 83b opportunities▫ Vesting

▪ Taxes▫ Taxed as ordinary income when vested unless Section 83b election

made▫ Timing of taxation is fixed based on vesting or Section 83b election

Restricted Stock

▪ Benefits▫ Deferred Compensation Plan▫ Each plan can be unique

▪ Issues▫ Vesting period▫ Triggering Events▫ Timing of Payments▫ Sec 409A

▪ Taxes▫ Taxed as ordinary income by the employee and deductible by the

company

▪ Used by corporations

Phantom Stock

▪ Benefits▫ Entitle the owner both to capital appreciation and future profits▫ Motivates key employees to grow the company while limiting the

downside▫ Not taxed when issued

▪ Issues▫ Valuation▫ Employee could receive taxable income allocation without receiving

distribution to pay the tax

▪ Taxes▫ Can be taxed at long term capital gain rate upon redemption or liquidation▫ Tax is paid on allocated income from K-1

▪ Used by partnerships/LLC’s

Profits Interest

▪ Entity Structure▪ Legal Documents▪ Stock Option Pools▪ Equity Compensation Pools

How to Get Started

▪ Plan Document▫ Eligibility ▫ Stock option pool▫ Terms of grant, including vesting, pricing, timing of payments▫ Valuation method

- Triggered by sale or separate equity raise- Determined by Board

▪ Operating agreement

Legal Documents

▪ A Reserve for future issuances▫ Size is defined by the plan document▫ Authorized vs. Issued▫ New option pools for new financing rounds▫ Diluted ownership

Stock Option Pools

▪ Voting vs. Non-voting Stock▪ Vesting vs. Forfeiture Provisions▪ Company Option/Obligation to Repurchase Upon

Termination Events▪ Acceleration of Vesting on Change of Control

Additional Considerations

▪ Tim DuVall – tduvall@ksmcpa.com

▪ Erin Eberly – eeberly@ksmcpa.com

▪ Kristine Camron – kristine.camron@icemiller.com

Questions?