Beyond Salary and Bonus: How Private Companies Can Compete with Public Companies for Executive Talent
Stradley Ronon at Work


By Eric D. Schoenborn

Introduction
Private companies often find it difficult to attract and retain key management personnel, who are often lured away by publicly held companies offering better total compensation packages that include long-term equity compensation as a key component. While the equity in a private company is not a marketable security, there are various means by which to provide long-term equity incentives at private companies that may also be liquid investments for employees.

Key concerns for the principal security holder are giving up control and having to account to minority shareholders in connection with managing the business. There are various means by which to provide long-term equity incentives to employees without ceding control to them or interrupting management of the business.

This article summarizes useful ways whereby we have assisted privately held clients in creating long-term equity incentives for upper management while maintaining control over the ownership of the company. It should be noted that there are tax, legal and accounting implications for each of the compensation alternatives described in this article. While we discuss some of these implications below, you should consult with your professional advisers to ensure that you have a properly designed long-term equity compensation program that meets your goals.

Benefits of Equity Compensation
Most publicly held companies have three key elements of compensation: salary, annual bonus and long-term equity compensation (e.g., stock options or restricted stock awards). On the other hand, smaller private companies find it hard to recruit top-level management talent, as they typically do not offer the third element, long-term equity compensation. By offering equity compensation, a private company (i) provides an incentive for employees to perform in the best interest of the company, (ii) preserves capital by paying lower cash compensation, and (iii) can compete for talent with larger companies by holding out the prospect of significant appreciation in the value of the equity.

Types of Long-Term Equity Incentives
There are a variety of long-term compensation tools that can be used to meet the various goals and demands of the security holders of a closely held business. These may include any of the following:

Type of Award	Description	Benefits
Stock Options	Provide employees with the right to purchase equity in the company at a predetermined exercise price during a set time period in the future.	Provide an incentive for employees because options allow them to benefit from the increase in value of the company. Also provide some liquidity to the company upon exercise.
Restricted Stock Awards	A grant of stock, which may be subject to forfeiture if certain future conditions are not met (e.g., continued employment for a period of time or achievement of certain performance goals such as revenue or net income).	Provide an incentive to employees, and serve to retain employees if accompanied by a forfeiture provision.
Equity Bonuses	These are performance bonuses paid in the form of equity instead of cash.	Provide an incentive to employees to meet performance goals, while minimizing cash outlays by the company.
Stock Purchase Plans	Permit employees to purchase equity in the company at a discount to fair market value.	Provide an incentive to employees by allowing them to participate in the growth of the company, while providing the company with some liquidity.
Stock Appreciation Rights (SARs)	Entitle employees to receive cash or stock in an amount equal to the excess of the fair value of the company’s equity on the date of exercise over the exercise price, which is typically equal to the fair value of the company’s equity on the date of grant.	Provide employees with the same financial gain as would a comparable stock option, without requiring a cash outlay upon exercise. Also provide an incentive to employees and serve to retain them. If settled in cash, SARs will not give up any control of the company.
Phantom Stock Units	Entitle employees to receive cash or stock in an amount equal to the value of an equivalent number of shares of stock, or the appreciation in value of an equivalent number of shares of stock since the date the units were awarded, upon the occurrence of one or more predetermined events (e.g., a change in control of the company, retirement at or after age 65, etc.).	Similar to SARs, but realization of value is tied to the occurrence of an event rather than the employee’s unilateral election.

Companies typically alleviate employees’ liquidity concerns by providing that the company or other security holders will repurchase any shares upon certain triggering events, such as demand by employees after a certain time period has elapsed or termination of employment in certain instances. Some of these provisions are described below under “Employer Concerns – Resale Restrictions.”

The long-term incentives described in the above chart can be replicated to varying degrees if the company is a limited liability company or a partnership rather than a corporation.

Employer Concerns
Several practical issues arise in connection with issuing equity to employees, including: (i) diluting current owners, which could reduce their control over management of the company; (ii) ensuring that the equity is not transferred to third parties who are not affiliated with the company or may not share the same views on the direction of the company; (iii) valuing a security that is not publicly traded; and (iv) funding the company’s repurchase of shares. These matters are discussed in more detail below.

• Control – Since the company will likely be providing a minority interest, the probability that this will take away control is minimal. Nevertheless, minority security holders can create disturbances from time and time and can be a distraction. Accordingly, resale provisions should be put in place that would be triggered upon departure of an employee (see below). Also, a nonvoting equity interest, such as a Class B nonvoting interest can be issued. Alternatively, stock appreciation rights that are settled in cash can be awarded, which provide no rights to management but merely the right to cash, based on the appreciation in the value of the company.

• Resale Restrictions – The company will not want employees to transfer their equity to third parties. Accordingly, each employee must enter into certain agreements with buy-sell provisions that will require him to sell his equity back to the company under certain circumstances. These circumstances include termination of employment, sale of the company by the majority security holder (i.e., drag-along rights), insolvency of the employee, etc. These transfer restrictions are also important to ensure compliance with securities laws.

• Valuation of Equity – A company also needs to determine its fair market value in order to issue equity and/or make repurchases. There are various means of doing this, including periodic (e.g., annual) determination by a valuation expert, book value, and a formula based on a multiple of revenues or net income. The method chosen will depend upon the industry, the preferences of the security holders, and the amount of time and money they wish to spend.

• Funding Repurchases – Certain smaller companies may not have sufficient cash flow to fund repurchases by the company. This can be handled in numerous ways, including making payments over time above certain dollar amounts, using certain insurance vehicles if the repurchase occurs in connection with the death or disability of the security holder, or placing contractual limits on the dollar amount of repurchases that can be made in any year (absolute amount or percentage of annual revenues or net income). The company may also consider a line of credit to assist during seasonal periods when working capital may be low.

Legal, Tax and Accounting Issues
The type of equity incentive, the type of payments and the persons who are offered these incentives will be influenced by various legal, tax and accounting laws. An overview of some of the more common issues is included below, but by no means is this an all-inclusive description of all matters that can affect this decision. Once you have narrowed down your choice of incentives to a few, you should consult your legal, tax and accounting professionals to ensure that laws are complied with and a tax-efficient award is chosen for the benefit of the company and its employees.

Legal
• Corporate Laws – Several corporate law issues need to be considered in connection with the issuance of equity interests. For instance, proper consideration must be received by the company for issuance of equity under the law of the state of formation, including the form of consideration and the amount. By way of example, certain states do not permit the issuance of securities for future consideration and other states prohibit loans to officers (which may impact how a purchase by an officer is financed). Fiduciary duties must also be considered to avoid waste of company assets and conflicts of interest. In addition, corporate laws may disallow an absolute restriction on transfers of equity by a security holder, which would necessitate the creation of reasonable buy-sell provisions, such as a right of first refusal upon a holder’s receipt of a bona fide third-party offer for his or her equity interest. 

• Securities Laws – Companies will need to comply with federal and state securities laws that govern the sale of securities, including dealing with the threshold question of whether the grant of an equity award will require registration under the Securities Act of 1933 (Securities Act) or is exempt. Many companies fall into the trap of assuming that only public companies need to comply with securities laws; however, even private companies granting equity awards will need to register their offering of securities to employees or find an exemption from registration.¹ If structured properly, these offerings to employees can fit within an exemption that will not require registration of the securities with federal or state regulators. Set forth below are a few of the federal exemptions we use for clients: 

1. No “Sale” – Registration is not required when there is no “sale” of a security as defined under the Securities Act. This exemption may be used for a properly structured equity bonus and the grant of options to acquire an equity interest in the company where the employee is not required to make a payment to receive the award. 

2. Section 4(2) or Regulation D – If awards are made to a limited number of employees who are knowledgeable about the company and have a high level of investment sophistication to be able to fend for themselves, then an exemption under Section 4(2) of the Securities Act may be available. Section 4(2) exempts “transactions by an issuer not involving any public offering.” However, “public offering” is not defined under the federal securities laws, which creates ambiguity in certain offerings. For more certainty, companies may rely on the safe harbor exemptions provided by Regulation D, adopted pursuant to the Securities Act, which provides an exemption for limited offerings based on the number of persons, the offering amount and purchaser qualifications.

3. Rule 701 – Rule 701 exempts equity awards to employees of nonpublic companies pursuant to a compensatory employee benefit plan. The maximum amount or sales price of equity securities that can be sold in any consecutive 12-month period is the greatest of the following: 

a. $1 million;
b. 15% of the total assets of the company; or
c. 15% of the outstanding amount of the class of securities of the company being offered pursuant to the Rule 701 exemption.

Private companies must also comply with state securities laws (aka “blue sky” laws) requiring the registration of securities or find exemptions therefrom. This analysis is usually performed once the state of residence is determined for each employee expected to be offered securities. While many states have an employee benefit plan exemption, if company employees reside in a large number of states, a company may wish to rely on the Rule 506 exemption under Regulation D, as this generally provides an exemption from the registration provisions of state blue sky laws per the Securities Act. Regardless of the exemption, a filing with the state securities regulators may be required (e.g., some states require a short “notice” filing if the company is relying on Rule 506).

Tax
The tax treatment of the various awards can vary widely for both the employee and the company and, in some circumstances, will depend on actions or elections taken by the employee. Set forth below are some of the potential tax issues: 

1. Ordinary Income vs. Capital Gains: Under current law, the federal income tax rate on ordinary compensation income and short-term capital gains can be as high as 35%, whereas the tax rate on long-term capital gains is generally 15%. When an employee exercises an option to acquire an equity interest in the company (other than an incentive stock option as described below), the excess of the fair market value of the equity at the time of exercise over the exercise price of the option is taxed at ordinary tax rates. Similarly, the gain realized upon the exercise of a SAR, the value of an equity interest received as a bonus or the realization of value from a phantom equity award is taxed at ordinary tax rates. On the other hand, future appreciation in value of equity after an option has been exercised, or after receipt of an equity bonus award, will be taxed at lower long-term capital gains rates when the equity is sold, if it is held for at least one year after exercise or receipt before being sold. Depending upon the circumstances, an important consideration in designing a long-term incentive program for employees may be to give employees as much opportunity as possible to have at least some portion of the value of their equity taxed at lower long-term capital gains rates. 

2. Incentive Stock Options: The most common concern is whether a stock option should be structured as an incentive stock option (ISO) or not (e.g., a nonqualified stock option). An ISO provides certain tax benefits to the employee upon exercise and sale of the underlying stock if provisions of the Internal Revenue Code (IRC) are met. However, if ISO treatment is obtained, the company will not be able to claim deductions attributable to these awards. 

3. Alternative Minimum Tax: In general, an employee does not have a taxable event upon exercising an ISO. However, the excess of the value of ISO stock over the exercise price of the ISO will be included as ordinary income for purposes of determining whether the employee is subject to the federal alternative minimum tax (AMT) for the year in which the exercise occurred. This is a very complicated subject, but as many readers likely know, many more taxpayers are currently subject to the AMT than Congress ever envisioned. 

4. Section 83 Elections: Section 83 of the IRC governs the taxation of property received as compensation for services. If the property in an employee’s hands is subject to a substantial risk of forfeiture (e.g., due to vesting requirements), Section 83 allows the employee to either (i) defer recognition of tax on the value of the property until the risk of forfeiture lapses or (ii) elect immediate taxation, which converts potential future appreciation to capital gains. 

5. Section 1202 Preferential Tax Treatment for “Qualified Small Businesses”: As an incentive to invest in small businesses, under certain circumstances only 50% of the gain realized upon the sale of stock of certain types of small business corporations held for at least five years will be subject to federal income tax. This opportunity is available to employees who receive stock in a qualifying corporation as part of their compensation. Therefore, the requirements and benefits of Section 1202 of the IRC should be considered when designing any long-term incentive program. 

As noted above, an employee will realize taxable compensation income upon exercising an option to acquire stock or other equity (other than an ISO) or a SAR, upon receiving a stock or other equity bonus, or when the risks of forfeiture of any previously received stock or other equity lapse. However, even though the employee may not receive any cash, the company would be required to withhold federal income tax and FICA tax, as well as any applicable state and local taxes, on the amount of that compensation. When designing any long-term incentive program, the company must develop a mechanism to enable it to comply with its tax withholding obligations under the law.²

Accounting
Details on the accounting treatment of various equity awards is beyond the scope of this article. It should be noted, however, that the granting of awards will be treated as an expense in the company’s income statement and will reduce earnings. Financial Accounting Standards Board Statement No. 123(R), Share-Base Payment, requires this expense. Companies should consult with their accountants before implementing any equity award program, to ensure that they understand the accounting implications, which could have an adverse impact on their ability to meet certain financial covenants in outstanding loan agreements.

Conclusion
Equity-based compensation is typically used by publicly traded companies as the long-term component of a total compensation program but is often ignored by private companies. Nevertheless, successful private companies are competing with public companies for the same management talent. Accordingly, private companies seeking to grow their business should also consider equity-based compensation for their employees, and can employ some of the protective measures described in this article to retain control of the company and minimize potential problems associated with having minority shareholders.

¹ By way of example, the initial public offering (IPO) of Google, Inc. was delayed following an investigation and charges filed by the Securities and Exchange Commission and the California Department of Corporations related to Google's failure to register or find an exemption for more than $80 million in stock options issued to employees in the two years preceding the IPO.

² For example, in the case of a stock option, the company could impose a condition that the option may not be exercised unless the employee delivers to the company an amount of cash that is sufficient to both pay the option exercise price and cover the company’s tax withholding obligation in connection with the exercise.

Stradley Ronon at Work

Steve Scolari, Business Department partner and chair of the Closely Held/Family Owned Business Practice Group, was recently selected as the recipient of The Main Line Chamber of Commerce 2008 Chairman’s Award. The award was given out at the chamber’s 2008 Red Carpet Dinner, and it recognizes a chamber board member who has exhibited outstanding work and service to the organization.

We recently assisted the shareholders of a closely held corporate client in structuring and implementing a succession plan that, upon death, will shift value from the company to the shareholders’ respective families in a way that shields the transferred value from federal estate tax. The company’s existing shareholders agreement used a valuation formula that was admittedly on the high side (the formula having been set several years ago in more bullish economic times) and, given the company’s growth, the stock value was not fully funded at death with insurance. In order to protect the overall value that the shareholders expected for their stock at death, we: (i) established irrevocable life insurance trusts (ILITs) for each shareholder; (ii) had the company and each ILIT buy life insurance on the affected shareholder in a total amount equal to such expected value (splitting the insurance between the company and the ILIT), and (iii) amended the shareholders agreement to bring the valuation down to a more reasonable level, including by taking advantage of appropriate valuation discounts. Consequently, upon a shareholder’s death, (a) the life insurance maintained by the company will now fully fund the buyout of the shareholder’s stock, and (b) the value of the life insurance proceeds in each ILIT will be excluded from the shareholder's estate and, therefore, not subject to federal estate tax.

We represented a manufacturing company in connection with the transfer of stock from the majority shareholder to his children pursuant to a stock redemption. The transaction involved complicated tax issues, a restructuring of the board of directors, a revision of bylaws, a bank loan to fund the transaction and a new shareholders agreement. We also redeemed the stock of one of the other children, who elected not to continue in the business.

We represented a bank in connection with a $16 million credit facility to a company that provides security personnel to third parties. The transaction included various guarantees, pledges of stock, subordination agreements and a mortgage on certain real property.

We represented a commercial finance company in connection with a $22 million restructuring of its existing credit facility with a refrigerant services company and its affiliates. The transaction involved a co-lender arrangement and the granting of stock purchase warrants to the lenders.

We represented a commercial finance company in connection with a $3 million credit facility to a company that manufactures braiding equipment. The transaction proceeds were used to partially repay the existing lender, and required negotiation of the existing lender’s loan documents and an intercreditor agreement.

We represented a commercial finance company in connection with a $5 million credit facility to a cosmetics distributor and several of its affiliates. The transaction involved a complex financial structure with various layers of preferred stock and mezzanine financing.

We represented a publicly-held investment management company in connection with the sale of a portion of its fixed income invest management services to a start-up entity. The purchase price was approximately $60 million subject to various adjustments. Of significance was a guaranty from the entity that initially funded the start-up. 

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In these times of economic uncertainty, it is generally not the time to be thinking of selling your business. However, if your timeframe for a sale is over the next 3-5 years, it is not too early to be thinking about positioning the business properly. One key point of focus should be on retaining your key talent. This is even more important if you had started down the sale path and the transaction never materialized because of current economic conditions. If your key people were aware of this process, they may be more willing to consider leaving the company (when times improve) for what might be perceived as a more stable employment situation. We have helped one client design and implement contracts for 5 key people which provides significant financial incentives in terms of a percentage of sales proceeds, if the employees stay through a sale of the business. The contracts have been very well-received by the key employees.