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EQUITY INCENTIVES IN EMERGING GROWTH COMPANIES. Amit Singh, Esq. Tech Coast Angels. Copyright 2010 Benchmark Law Group PC

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EQUITY INCENTIVES IN EMERGING GROWTH COMPANIES

B By Amit Singh, Esq.

Presented to

Presented to

Tech Coast Angels

(2)

Options Stock

(3)

RATIONALE FOR EQUITY RATIONALE FOR EQUITY

INCENTIVES INCENTIVES INCENTIVES INCENTIVES

••

Align the interests of Employees with Align the interests of Employees with

••

Align the interests of Employees with Align the interests of Employees with Investors to work toward the common Investors to work toward the common goal of increasing the value of the

goal of increasing the value of the goal of increasing the value of the goal of increasing the value of the enterprise

enterprise

Goals:

Goals:

••

Goals: Goals:

•• Maximum incentive for EmployeeMaximum incentive for Employee

•• Minimize tax to EmployeeMinimize tax to EmployeeMinimize tax to EmployeeMinimize tax to Employee

•• Maximize deduction for CompanyMaximize deduction for Company

Only covering private companies, not public

Only covering private companies, not public y y g p g p p p , , p p

(4)

Stock Option Plans Stock Option Plans Stock Option Plans Stock Option Plans

Option Option -- the right to buy a fixed number the right to buy a fixed number

Option Option the right to buy a fixed number the right to buy a fixed number of shares at a fixed price for a fixed

of shares at a fixed price for a fixed period of time Usually subject to

period of time Usually subject to period of time. Usually subject to period of time. Usually subject to vesting

vesting

2 Types:

2 Types:

••

2 Types: 2 Types:

•• NonNon--Qualified Stock Options (“NSOs”)Qualified Stock Options (“NSOs”)

•• Incentive Stock Options (“ISOs”)Incentive Stock Options (“ISOs”)Incentive Stock Options ( ISOs )Incentive Stock Options ( ISOs )

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NSOS AND ISOS NSOS AND ISOS

GENERALLY GENERALLY GENERALLY GENERALLY

Both ISOs and NSOs must have an Both ISOs and NSOs must have an

Both ISOs and NSOs must have an Both ISOs and NSOs must have an

exercise price at least equal to the fair exercise price at least equal to the fair market value (“FMV”) of the underlying market value (“FMV”) of the underlying market value ( FMV ) of the underlying market value ( FMV ) of the underlying shares, otherwise subject to 409A

shares, otherwise subject to 409A penalties (to be discussed)

penalties (to be discussed) penalties (to be discussed) penalties (to be discussed)

No tax at grant No tax at grant

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NON

NON--QUALIFIED STOCK QUALIFIED STOCK OPTIONS

OPTIONS OPTIONS OPTIONS

On Exercise On Exercise

On Exercise On Exercise

•• Ordinary income on spread between FMV of the Ordinary income on spread between FMV of the shares and the exercise price

shares and the exercise price

•• Withholding and Employment taxes on such Withholding and Employment taxes on such spread

spread

C d d ti i

C d d ti i

•• Company deduction on exerciseCompany deduction on exercise

When stock sold When stock sold

•• Gain/loss is capital gain/loss on change in value Gain/loss is capital gain/loss on change in value after exercise

after exercise

•• If sale occurs more than 12 months after exerciseIf sale occurs more than 12 months after exerciseIf sale occurs more than 12 months after exercise, If sale occurs more than 12 months after exercise, long

long--term capital gain/loss, otherwise, shortterm capital gain/loss, otherwise, short--termterm

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INCENTIVE STOCK OPTIONS INCENTIVE STOCK OPTIONS INCENTIVE STOCK OPTIONS INCENTIVE STOCK OPTIONS

Major Requirements Major Requirements

Major Requirements Major Requirements

•• Optionee must be an employee Optionee must be an employee

•• Must be held at least 2 years from date of grant Must be held at least 2 years from date of grant yy gg and 1 year from date of exercise

and 1 year from date of exercise

•• Optionee must exercise option within 3 months Optionee must exercise option within 3 months after ceases to be an employee or within 12

after ceases to be an employee or within 12 after ceases to be an employee or within 12 after ceases to be an employee or within 12 months after service terminates because of months after service terminates because of disability

disability

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INCENTIVE STOCK OPTIONS INCENTIVE STOCK OPTIONS

(CONT’D) (CONT’D) (CONT’D) (CONT’D)

Other Requirements Other Requirements

Other Requirements Other Requirements

•• Shareholders must approve plan within 12 months Shareholders must approve plan within 12 months before or after employer adopts plan

before or after employer adopts plan

•• Options must be granted within 10 years of plan Options must be granted within 10 years of plan adoption/approval

adoption/approval

•• The term of the option cannot exceed 10 yearsThe term of the option cannot exceed 10 years

•• The term of the option cannot exceed 10 yearsThe term of the option cannot exceed 10 years

•• FMV (at time of grant) of underlying stock with FMV (at time of grant) of underlying stock with

respect to which ISOs vest for the first time in any respect to which ISOs vest for the first time in any pp yy calendar year may not exceed $100,000 for any calendar year may not exceed $100,000 for any employee

employee

Not transferable except as death Not transferable except as death

•• Not transferable except as deathNot transferable except as death

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INCENTIVE STOCK OPTIONS INCENTIVE STOCK OPTIONS

(CONT’D) (CONT’D) (CONT’D) (CONT’D)

No Tax on Exercise but difference No Tax on Exercise but difference

No Tax on Exercise, but difference No Tax on Exercise, but difference

between FMV of underlying shares and between FMV of underlying shares and exercise price included in AMT

exercise price included in AMT exercise price included in AMT exercise price included in AMT calculation

calculation Long

Long term capital gain on difference term capital gain on difference

Long Long--term capital gain on difference term capital gain on difference

between FMV of underlying shares and between FMV of underlying shares and sale price

sale price

sale price

sale price

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ISOS VS NSOS ISOS VS NSOS ISOS VS. NSOS ISOS VS. NSOS

Company Prefers NSOs Company Prefers NSOs

Company Prefers NSOs Company Prefers NSOs

More flexible More flexible

Company deduction on exercise Company deduction on exercise

Company deduction on exercise Company deduction on exercise

Employee Prefers ISOs Employee Prefers ISOs

•• Defer tax until stock soldDefer tax until stock sold

•• Defer tax until stock soldDefer tax until stock sold

•• If holding requirements met, long term capital gain If holding requirements met, long term capital gain on appreciation of stock after grant

on appreciation of stock after grantpppp gg

•• However, employees may be indifferent because However, employees may be indifferent because may sell shares less than 1 year after exercise, so may sell shares less than 1 year after exercise, so would receive NSO treatment (e g exercise upon would receive NSO treatment (e g exercise upon would receive NSO treatment (e.g., exercise upon would receive NSO treatment (e.g., exercise upon acquisition)

acquisition)

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409A 409A 409A 409A

Options Must Have Exercise Price of At Options Must Have Exercise Price of At

Options Must Have Exercise Price of At Options Must Have Exercise Price of At Least FMV of the Underlying Stock,

Least FMV of the Underlying Stock, Otherwise Constitutes a Deferred

Otherwise Constitutes a Deferred Otherwise Constitutes a Deferred Otherwise Constitutes a Deferred

Compensation Arrangement Subject to:

Compensation Arrangement Subject to:

Ordinary income tax on spread between Ordinary income tax on spread between

Ordinary income tax on spread between Ordinary income tax on spread between exercise price and FMV at vesting, plus exercise price and FMV at vesting, plus

•• 20% federal excise tax (plus 20% CA state20% federal excise tax (plus 20% CA state20% federal excise tax (plus 20% CA state 20% federal excise tax (plus 20% CA state penalty)

penalty)

Company must withhold income and Company must withhold income and

employment taxes on spread at vesting

employment taxes on spread at vesting

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409A (CONT’D) 409A (CONT’D) 409A (CONT D) 409A (CONT D)

Company’s valuation is presumed Company’s valuation is presumed

Company s valuation is presumed Company s valuation is presumed reasonable if:

reasonable if:

Independent appraisal made within 12 Independent appraisal made within 12

Independent appraisal made within 12 Independent appraisal made within 12 months; or

months; or

Illiquid Start Illiquid Start--Up Presumption Up Presumption

Illiquid Start Illiquid Start Up Presumption Up Presumption

•• Valuation is of “illiquid stock of a startValuation is of “illiquid stock of a start--up up corporation”

corporation” -- no publicly traded shares and has no publicly traded shares and has conducted business for less than 10 years

conducted business for less than 10 years

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409A

409A – – ILLIQUID START ILLIQUID START--UP UP PRESUMPTION (CONT’D) PRESUMPTION (CONT’D) PRESUMPTION (CONT’D) PRESUMPTION (CONT’D)

Valuation must be performed by a person Valuation must be performed by a person

Valuation must be performed by a person Valuation must be performed by a person with significant knowledge and experience with significant knowledge and experience or training in performing similar valuations or training in performing similar valuations or training in performing similar valuations or training in performing similar valuations

At least 5 years relevant experience in At least 5 years relevant experience in business valuation or appraisal financial business valuation or appraisal financial business valuation or appraisal, financial business valuation or appraisal, financial accounting, investment banking, private accounting, investment banking, private

equity, secured lending, or other comparable equity, secured lending, or other comparable experience in the line of business or industry experience in the line of business or industry of the Company

of the Company

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409A

409A – – ILLIQUID START ILLIQUID START--UP UP PRESUMPTION (CONT’D) PRESUMPTION (CONT’D) PRESUMPTION (CONT’D) PRESUMPTION (CONT’D)

Made reasonably in good faith evidenced Made reasonably in good faith evidenced

Made reasonably, in good faith, evidenced Made reasonably, in good faith, evidenced by a written report an takes into the

by a written report an takes into the following general valuation factors:

following general valuation factors:

following general valuation factors:

following general valuation factors:

the value of tangible and intangible assets of the value of tangible and intangible assets of the company

the company the company the company

the present value of future cash flows the present value of future cash flows

the public trading price or private sale price of the public trading price or private sale price of

the public trading price or private sale price of the public trading price or private sale price of comparable companies

comparable companies

other relevant factors such as control other relevant factors such as control

other relevant factors such as control other relevant factors such as control

premiums and discounts for lack of

premiums and discounts for lack of

(15)

409A

409A – – ILLIQUID START ILLIQUID START--UP UP PRESUMPTION (CONT’D) PRESUMPTION (CONT’D) PRESUMPTION (CONT’D) PRESUMPTION (CONT’D)

Not considered reasonable if it is more than Not considered reasonable if it is more than

Not considered reasonable if it is more than Not considered reasonable if it is more than 12 months old

12 months old

If significant events occur before the 12 If significant events occur before the 12-- g g month anniversary, the valuation must be month anniversary, the valuation must be updated (e.g., possibility of sale of the

updated (e.g., possibility of sale of the

company, resolution of material litigation, or company, resolution of material litigation, or the issuance of a patent)

the issuance of a patent)

IRS b i if i h

IRS b i if i h

IRS can rebut presumption if it can prove the IRS can rebut presumption if it can prove the method or application of the method was

method or application of the method was unreasonable

unreasonable

unreasonable

unreasonable

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LIMITING OPTION LIMITING OPTION

EXERCISABILITY TO AVOID 409A EXERCISABILITY TO AVOID 409A EXERCISABILITY TO AVOID 409A EXERCISABILITY TO AVOID 409A

Option Cannot be Exercised Until Earlier Option Cannot be Exercised Until Earlier

Option Cannot be Exercised Until Earlier Option Cannot be Exercised Until Earlier of:

of:

Final Year of Option; Final Year of Option;

Final Year of Option; Final Year of Option;

Closing of Change of Control; and Closing of Change of Control; and

Date Relationship With Company Terminates Date Relationship With Company Terminates

Date Relationship With Company Terminates Date Relationship With Company Terminates

Also, Cannot be Exercised Later than Also, Cannot be Exercised Later than

12/31 f Y O ti ’ R l ti hi ith 12/31 f Y O ti ’ R l ti hi ith 12/31 of Year Optionee’s Relationship with 12/31 of Year Optionee’s Relationship with Company Terminates

Company Terminates

(17)

RESTRICTED STOCK RESTRICTED STOCK RESTRICTED STOCK RESTRICTED STOCK

Shares Subject to Vesting Conditions Shares Subject to Vesting Conditions

Shares Subject to Vesting Conditions Shares Subject to Vesting Conditions

Unvested Stock Subject to Repurchase Unvested Stock Subject to Repurchase Right at Price Paid for Stock

Right at Price Paid for Stock Right at Price Paid for Stock Right at Price Paid for Stock

409A Does Not Apply 409A Does Not Apply

Have all Rights as a Shareholder Have all Rights as a Shareholder

Voting Voting

Dividends Dividends

(18)

RESTRICTED STOCK RESTRICTED STOCK

TAX IMPLICATIONS TAX IMPLICATIONS TAX IMPLICATIONS TAX IMPLICATIONS

Difference between price paid and FMV at Difference between price paid and FMV at

Difference between price paid and FMV at Difference between price paid and FMV at time of grant is ordinary income at time stock time of grant is ordinary income at time stock vests

vests

83(b) Election 83(b) Election -- Can report such difference as Can report such difference as ordinary income even for unvested shares at ordinary income even for unvested shares at time of grant

time of grant

•• Must file within 30 days of grantMust file within 30 days of grant

Ri k th t t k l d f f it t k

Ri k th t t k l d f f it t k

•• Risk that stock value goes down or forfeits stockRisk that stock value goes down or forfeits stock

•• 83(b) Election not needed for Employee’s grant of 83(b) Election not needed for Employee’s grant of repurchase right on vested stock because no

repurchase right on vested stock because no repurchase right on vested stock because no repurchase right on vested stock because no transfer occurs for Section 83 purposes

transfer occurs for Section 83 purposes

(19)

RESTRICTED STOCK RESTRICTED STOCK

ADVANTAGES ADVANTAGES ADVANTAGES ADVANTAGES

If FMV of Stock is Low, Better than Options If FMV of Stock is Low, Better than Options

If FMV of Stock is Low, Better than Options If FMV of Stock is Low, Better than Options

•• If acquisition occurs and hold stock more than 1 If acquisition occurs and hold stock more than 1 year, long term capital gains

year, long term capital gains

•• C.f. options, if acquisition occurs, exercise option C.f. options, if acquisition occurs, exercise option and sell stock, ordinary income on spread between and sell stock, ordinary income on spread between FMV of shares and exercise price for NSO (if ISO FMV of shares and exercise price for NSO (if ISO FMV of shares and exercise price for NSO (if ISO, FMV of shares and exercise price for NSO (if ISO, would be disqualifying disposition and treated as would be disqualifying disposition and treated as NSO because not held at least 1 year from

NSO because not held at least 1 year from i )

i ) exercise) exercise)

Company gets a deduction for ordinary Company gets a deduction for ordinary income reported by employee

income reported by employee

income reported by employee

income reported by employee

(20)

PAYMENT FOR STOCK VIA PAYMENT FOR STOCK VIA

PROMISSORY NOTE PROMISSORY NOTE PROMISSORY NOTE PROMISSORY NOTE

Promissory Note Used to Purchase Restricted Promissory Note Used to Purchase Restricted

Promissory Note Used to Purchase Restricted Promissory Note Used to Purchase Restricted Stock or Exercise an Option Must be Full

Stock or Exercise an Option Must be Full-- Recourse to:

Recourse to:

•• Start capital gains holding periodStart capital gains holding period

•• Enable employee to file 83(b) ElectionEnable employee to file 83(b) Election

Full Full--Recourse Promissory Note Creates a Recourse Promissory Note Creates a Personal Obligation for Employee to Repay Personal Obligation for Employee to Repay N t (I l di I t t) E if St k V l N t (I l di I t t) E if St k V l

Note (Including Interest) Even if Stock Value Note (Including Interest) Even if Stock Value Decreases

Decreases

•• In Bankruptcy Trustee may seek to collectIn Bankruptcy Trustee may seek to collect

•• In Bankruptcy, Trustee may seek to collectIn Bankruptcy, Trustee may seek to collect

Debt Debt--Forgiveness Income if Debt Forgiven Forgiveness Income if Debt Forgiven

(21)

VESTING VESTING VESTING VESTING

Typical Vesting Typical Vesting -- 25% after 1 year 1/48 25% after 1 year 1/48

thth

Typical Vesting Typical Vesting 25% after 1 year, 1/48 25% after 1 year, 1/48 monthly thereafter

monthly thereafter

Vesting before VC Financing? Vesting before VC Financing?

Vesting before VC Financing? Vesting before VC Financing?

Yes, if reasonable, may be accepted Yes, if reasonable, may be accepted

If F d l d h i f

If F d l d h i f

If a Founder leaves, need mechanism for If a Founder leaves, need mechanism for taking back shares to give to others

taking back shares to give to others

(22)

ACCELERATED VESTING ACCELERATED VESTING

(CONT’D) (CONT’D) (CONT’D) (CONT’D)

Single Trigger Single Trigger – – Change of Control or Change of Control or

Single Trigger Single Trigger Change of Control or Change of Control or

Termination without Cause or Constructive Termination without Cause or Constructive Termination

Termination Termination Termination

Double Trigger Double Trigger – – Change of Control and Change of Control and Termination without Cause or Constructive Termination without Cause or Constructive Termination without Cause or Constructive Termination without Cause or Constructive Termination within 12 to 18 months

Termination within 12 to 18 months

V i f 6 th dditi l ti t

V i f 6 th dditi l ti t

Varies from 6 months additional vesting to Varies from 6 months additional vesting to 100%

100%

(23)

ACCELERATED VESTING ACCELERATED VESTING

DISADVANTAGES DISADVANTAGES DISADVANTAGES DISADVANTAGES

Acceleration on Termination without Acceleration on Termination without

Acceleration on Termination without Acceleration on Termination without Cause or Constructive Termination or Cause or Constructive Termination or Double Trigger Acceleration OK for high Double Trigger Acceleration OK for high Double Trigger Acceleration OK for high Double Trigger Acceleration OK for high level executives

level executives

Avoid Single Trigger Acceleration on Avoid Single Trigger Acceleration on

Avoid Single Trigger Acceleration on Avoid Single Trigger Acceleration on Change of Control

Change of Control

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VESTING ON CHANGE OF VESTING ON CHANGE OF

CONTROL CONTROL CONTROL CONTROL

•• No incentive to work for acquirer, so acquirer will No incentive to work for acquirer, so acquirer will qq ,, qq reallocate portion of purchase price to key

reallocate portion of purchase price to key employees, reducing payment to other

employees, reducing payment to other shareholders

shareholders shareholders shareholders

•• Parachute Payment Parachute Payment -- If aggregate payments If aggregate payments

exceed 3 times average compensation for last 5 exceed 3 times average compensation for last 5 years

years

NonNon--deductible to Company deductible to Company –– affects purchase priceaffects purchase price

20% Excise tax on recipient20% Excise tax on recipient

20% Excise tax on recipient20% Excise tax on recipient

Payment of compensation to a disqualified individual Payment of compensation to a disqualified individual (officers, 1% shareholders, top 1% earners)

(officers, 1% shareholders, top 1% earners)

E t if ¾ f Sh h ld t

E t if ¾ f Sh h ld t

•• Exempt if ¾ of Shareholders approve payment Exempt if ¾ of Shareholders approve payment immediately before Change of Control

immediately before Change of Control

(25)

SERIES FF STOCK SERIES FF STOCK SERIES FF STOCK SERIES FF STOCK

•• Same as Common Stock, But, Convertible at Same as Common Stock, But, Convertible at ,, ,, Buyer’s Option Into Class of Preferred Stock Buyer’s Option Into Class of Preferred Stock

Issued if Buyer Purchased it in Connection with the Issued if Buyer Purchased it in Connection with the Round of Financing

Round of Financing Round of Financing Round of Financing

•• Can Only Be Converted to Preferred if Buyer Paid Can Only Be Converted to Preferred if Buyer Paid Same Price as Price Paid in the Financing

Same Price as Price Paid in the Financing

•• Board Must Approve ConversionBoard Must Approve Conversion

•• Convertible Into Common at Holder’s Option at Convertible Into Common at Holder’s Option at A Ti

A Ti Any Time Any Time

•• Automatically Converts to Common on a qualified Automatically Converts to Common on a qualified IPO or with consent of a majority of Series FF

IPO or with consent of a majority of Series FF IPO or with consent of a majority of Series FF IPO or with consent of a majority of Series FF

(26)

SERIES FF STOCK (CONT’D) SERIES FF STOCK (CONT’D) SERIES FF STOCK (CONT D) SERIES FF STOCK (CONT D)

•• Should be issued at incorporation, otherwise Should be issued at incorporation, otherwise pp ,,

should be issued for more than Common given the should be issued for more than Common given the extra rights

extra rights

C j tif l i th P f d b

C j tif l i th P f d b

•• Can justify lower price than Preferred because Can justify lower price than Preferred because consent of Board is required to convert

consent of Board is required to convert

•• Investors don’t like to see Founders cashing out,Investors don’t like to see Founders cashing out,Investors don t like to see Founders cashing out, Investors don t like to see Founders cashing out, but may allow for a small portion of shares as extra but may allow for a small portion of shares as extra compensation, plus can help Founders achieve

compensation, plus can help Founders achieve some liquidity so not incentivized to sell company some liquidity so not incentivized to sell company some liquidity so not incentivized to sell company some liquidity so not incentivized to sell company too early

too early

•• If Founders’ common shares were purchased by a If Founders’ common shares were purchased by a pp yy VC fund to allow liquidity, would likely affect stock VC fund to allow liquidity, would likely affect stock option pricing

option pricing

(27)

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