U.S. Equity Compensation

1
U.S. Equity Compensation

• Atlas Venture European Employee
• Incentives Conference 2001
• Amy N. Moore
• Covington Burling
• 6 February 2001

2
U.S. Employment Basics

• In US, unlike much of Europe, only key employees
  typically have employment contracts
• Employment for rank-and-file employees is at
  willemployer can terminate at any time, without
  cause
• Employer may not discriminate on the basis of
  race, gender, age, etc.
• Government provides basic retirement and medical
  benefits at age 62-65no significant benefits
  (except unemployment insurance) for younger
  workers
• Emerging company compensation package generally
  includes
• Salary (relatively low)
• Stock options
• Health insurance (usually at least partly
  employer-paid)
• Life and disability insurance (often entirely
  employee-paid)
• Cafeteria plan offering a choice between cash
  and tax-free benefits
• Elective (401(k)) retirement plan, often with
  discretionary employer matching contributions

3
Why Use Equity Compensation?

• Stock is plentiful cash is scarce
• Necessary to attract and retain employees
• Gives employees a stake in the success of the
  business
• Aligns employee and shareholder interests
• Favorable accounting treatment
• Favorable tax treatment
• Flexible timing
• Lower tax rates

4
U.S. Compensation Taxes

• Federal income tax (39.6 maximum)
• Federal alternative minimum tax (28 maximum)
• Federal employment tax (employer and employee)
• 7.65 up to wage base (80,400 in 2001)
• 1.45 above wage base
• Income tax withholding (28 flat rate)
• State and local income tax
• E.g., New York, NY 11.31
• Employer tax deduction (against 35 max. rate)

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Equity Compensation Menu
6
U.S. Option Basics

• Employer can limit eligibility to key employees
• Employee receives the right to buy a fixed number
  of shares at a fixed price during a specified
  period
• The option price is usually the fair market value
  of the stock when the option is granted
• Options often vest over time
• For example, an option covering 1,000 shares
  might become exercisable in installments of 200
  shares over 5 years
• Option usually expires if employee terminates

7
Incentive Stock Option (ISO)

• No tax at grant
• No ordinary income tax at exercise
• Might be subject to alternative minimum tax
• No employment tax
• No withholding
• Lower capital gain tax at sale of stock
• 20 if held more than 1 year, 18 if held more
  than 5 years
• Ordinary income rates (max. 39.6) if held less
  than 1 year

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ISO Restrictions

• Vesting limited to 100,000 per year
• No discount permitted on exercise price
• 10 shareholders pay 110 of market value
• Must hold stock 2 years from grant, 1 year from
  exercise
• Shareholders must approve plan
• Employer gets no deduction
• Employee might owe alternative minimum tax
• Available only to employees (not consultants or
  directors)
• Must exercise within 90 days after termination

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Nonqualified Stock Option

• No grant limits or holding periods
• May be granted at a discount
• May be granted to consultants, directors, etc.
• No tax at grant no alternative minimum tax
• Compared with incentive stock option, generally
  taxed earlier and at a higher rate
• Income and employment tax at exercise
• Capital gain tax at sale of stock (applies to
  appreciation from exercise to sale)

10
Stock Appreciation Right (SAR)

• Employee has the right to receive in cash or
  (sometimes) in stock any appreciation in the
  value of a set number of shares over a specified
  period
• Employee chooses when to exercise the right
• Similar to an option, except that employee does
  not have to put up cash to pay the option price,
  and he receives only the appreciation, not the
  original shares
• When employee exercises the right, he pays
  ordinary income tax and employment tax on the
  amount he receives
• Seldom used by public companies because of
  unfavorable accounting treatment

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Employee Stock Purchase Plan

• Stock is offered for sale at a fixed price for a
  specified period (e.g., 24 months)
• Offering price is generally discounted 15
• Employees elect to have wages withheld to
  purchase stock
• No more than 25,000 worth of stock may be sold
  to an employee for each year of the offering
• All employees of an adopting employer (with
  limited exceptions for part-time employees, new
  employees, etc.) must be eligible to participate
• Very favorable tax treatment (similar to ISO)

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Restricted Stock

• Employee receives shares (usually free or for a
  nominal price)
• Employee must work for a fixed period (e.g., 5
  years) in order to keep the shares
• Some grants vest in installments (e.g., 20 per
  year)
• Vesting is sometimes contingent on reaching
  performance targets
• Employee forfeits non-vested shares when his
  employment terminates
• Value of shares is subject to ordinary income tax
  at vesting (or, at employees election, when
  granted)

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Employers Objectives

• Retain and motivate key employees with
• Options that expire at termination of employment
• Options or restricted stock that vests after a
  fixed period of service
• Options or restricted stock that vests when
  performance targets are reached
• Reduce compensation expense by providing
  tax-efficient compensation
• Obtain favorable accounting treatment (more
  important to public companies than private)

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Other Considerations

• Stock must be registered under US securities laws
  or exempt from registration
• Private offering exemption
• Rule 701 exemption
• Program must comply with or be exempt from
  Investment Company Act
• Offering must comply with state blue-sky laws
• Some types of equity compensation receive more
  favorable accounting treatment than others
• Providing equity compensation is more difficult
  for non-stock entities (partnerships, LLCs, etc.)

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Frequent Issues

• Employee does not have enough cash to exercise
  option
• Stock appreciation rights
• Stock-for-stock exercise
• Cashless exercise
• Employee incurs tax liability but cannot sell
  stock
• ISOs
• Immediate exercise
• Elect immediate taxation for restricted stock
• When stock price falls, employees leave
• Repricing
• Cash bonuses
• Valuation issues for non-public companies