DAVIS POLK & WARDWELL

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1 EQUITY COMPENSATION AWARD DESIGNS 1 General Description Right to purchase stock from the company at a fixed price May be exercised at any time (after becoming exercisable) at the election of the holder or exercise can be prohibited until a liquidity event Right to purchase stock from the company at a fixed price Complies with requirements of Section 422 of the IRC May be exercised at any time (after becoming exercisable) at the election of the holder or exercise can be prohibited until a liquidity event Right to receive the excess of the FMV at time of exercise over the exercise price (exercise price must be equal to or greater than FMV as of SAR grant date) Value may be paid in cash or stock, but historically has usually been paid in cash May be exercised at any time (after becoming exercisable) at the election of the holder Stock of the company that is issued and outstanding, but subject to forfeiture (or repurchase) unless specified conditions relating to continued employment and/or company performance are satisfied A contractual right to receive the value of a share of stock May be payable in cash or stock Conditions to payment generally relate to continued employment and/or company performance Award must specify payment date (cannot be exercised at the election of the holder) Also called performance shares, restricted share units, phantom units, etc. Sometimes (imprecisely) called restricted stock Can replicate synthetically all attributes of stock ownership (e.g., dividend equivalents) except voting and tax advantage for dividends on vested shares 1 This table does not include a summary of profits interests. As discussed in our newsletter, profits interests are highly customized to the particular transaction. A-1

2 Mandatory Requirements Exercise price must be equal to or greater than FMV on date of grant to avoid being subject to Section 409A of the IRC (Section 409A governs nonqualified deferred compensation) Standard practice closely resembles ISO rules May be granted to any service provider, including directors, consultants and advisors Exercise price must be equal to or greater than FMV on date of grant (110% of FMV for 10% stockholder) Term not longer than 10 years (five years for 10% shareholders) Plan must be approved by shareholders Must be granted within 10 years of plan adoption and shareholder approval Exercise price must equal FMV on date of grant to avoid being subject to IRC Section 409A Stock is outstanding stock for all corporate purposes Subject to IRC Section 409A, so must have permitted settlement dates Depending on terms of the preferred stock, cannot be granted on the preferred stock without becoming subject to IRC Section 409A Nontransferable Holder must be employee Operational Requirements Accounting and tax constraints will limit flexibility to amend Stock acquired upon exercise cannot be sold until at least one year has elapsed since the date of exercise and two years have elapsed since the date of grant, in order to maintain tax treatment for employees Accounting and tax (IRC Section 409A) constraints will limit flexibility to amend Stock is outstanding for all corporate purposes IRC Section 409A will limit flexibility to amend, particularly settlement provisions Must be exercised while employed or within 90 days after terminating employment (one year if terminated on account of A-2

3 death or disability) Accounting and tax (Sections 409A and 422 of the IRC) constraints will limit flexibility to amend If mandatory or operational requirements are violated, ISO will be taxed as if it were nonqualified Quantity Limits None (subject to Value of underlying stock at time of grant cannot exceed an exercisability rate of $100,000 per year None (subject to None (subject to None (subject to Limit is filled in order of year granted Options granted in excess of the quantity limit will be treated as nonqualified U.S. Tax Treatment No tax and no IRC Section 83(b) election upon grant. is possible at the time of exercise if the option is stock (see Restricted Stock). Options shares are more common in venture capital companies, but less common in established private equity portfolio companies. No tax and no IRC Section 83(b) election upon grant. is possible for AMT purposes (see below) at the time of exercise if the option is exercisable for unvested stock (see ). Options shares are more common in venture capital companies, but less common in established private equity No tax and no IRC Section 83(b) election upon grant. is possible at the time of exercise if the SAR is stock (see ) No tax upon vesting No tax upon amendment or adjustment Amount of cash or stock received upon payment is A-3 Governed by IRC Section 83 (IRC Section 83 governs taxation of property transferred in connection with performance of services) Not subject to Section 409A of the IRC Taxed at vesting, assuming no IRC Section 83(b) election (see below). Income realized is excess No tax upon grant Subject to compliance with IRC Section 409A, no tax upon vesting if payment/ settlement is scheduled for a future date following the vesting date, (but, Social Security and Medicare tax will apply upon vesting) No tax at amendment or adjustment Amount of cash or stock

4 No tax upon vesting Subject to compliance with IRC Section 409A, no tax upon amendment or adjustment At exercise, holder taxed on excess of FMV of shares acquired at time of exercise over exercise price. Ordinary income rate applies (subject to withholding and payroll taxes). deduction in tax year in which exercise occurs portfolio companies. No tax upon vesting No tax upon amendment or adjustment (but improper amendment or adjustment can cause loss of ISO status) No tax at exercise (but spread value at exercise is an item of adjustment for AMT purposes) Upon sale of underlying shares, holder taxed on excess of sale proceeds over exercise price. Capital gain rate applies. Holding period begins at exercise. Upon sale prior to required holding date, spread at exercise will be taxed at ordinary income rates and any remaining proceeds will be capital gain If and to the extent that holder gets capital gain treatment, corporation gets no deduction ordinary income deduction If unvested property (e.g. stock) is received as payment, will be taxed at ordinary income rates when vested, under IRC Section 83 (see ) A-4 of FMV at vesting over amount paid, if any Ordinary income rates apply (subject to withholding and payroll taxes) If dividends are paid on unvested shares of restricted stock, ordinary income rates apply on the dividends Capital gain holding period begins at vesting deduction In the alternative, holder may elect (per IRC Section 83(b) election) to be taxed at receipt, based on value at receipt at ordinary rates. Future appreciation is taxed at capital gains rates. May not deduct loss if forfeiture subsequently occurs. Holding period begins at grant date if IRC Section 83(b) election is made. In addition, if IRC Section 83(b) election is made and dividends are paid on unvested shares of restricted stock, dividend rates should apply on the dividends (not ordinary received at time of payment taxed at ordinary income rates As long as payment/ settlement is made no later than 2.5 months following the end of either the company s tax year or the recipient s tax year in which the award vests, the award should qualify for IRC Section 409A s short-term deferral exception and, consequently, will not be subject to the requirements of IRC Section 409A; otherwise, payment/settlement must be scheduled to occur on a predetermined permitted distribution date under IRC Section 409A Dividend equivalents are taxed at ordinary income rates (not the dividend rate) deduction

5 income rates) Accounting Treatment equal to fair value at date vesting period equal to fair value at date vesting period stock-settled SARs at date vesting period cash-settled SARs marked to market throughout vesting period and charged to earnings (i.e., liability award subject to variable accounting) If company has choice of settling SARs in cash or in stock and company has history of settling in cash or will settle in cash if asked to do so by the holder, then treated like cash-settled SAR equal to fair value at date vesting period (for restricted stock, fair value will equal fair market value) stock-settled phantom shares at date of grant amortized over vesting period (for phantom shares, fair value will equal fair market value) cash-settled phantom shares marked to market throughout vesting period and charged to earnings (i.e., liability award subject to variable accounting) If company has choice of settling phantom shares in cash or in stock, if company has history of settling in cash or will settle in cash if asked to do so by the holder, then fair value of SARs marked to market throughout vesting period and charged to earnings Key Advantage to Company or Employee Tax event only when exercised, which is generally within employee s control Holder can get capital gain treatment Tax event at time of sale of Convenient for holder (low transactions costs) Cash-settled SARs are non- A-5 By making a Section 83(b) election, holder can elect to get a basis at grant and therefore long-term capital gains treatment if the Can be vested without triggering need for tax liquidity (tax is delayed until settlement is scheduled to occur at a

6 underlying shares (or at time of exercise for AMT purposes), which is generally within employee s control dilutive and stock-settled SARs are less dilutive than, e.g., options because only the number of shares equal to the spread value need to be issued on exercise shares are held for one year If the employee pays FMV for restricted shares at the time of grant, can avoid ordinary income by making However, if restricted shares have a significant fair market value at the time of grant (which might be the case in an established private equity portfolio company), employees often do not make Section 83(b) elections to be taxed at grant because of the risk that they will not satisfy the vesting conditions and lose the shares after having paid taxes on them future date following vesting date, other than the Social Security and Medicare tax, which applies at time of vesting) Design opportunities are flexible (subject to constraints under IRC Section 409A) Assuming no purchase price, the award is never underwater A-6

7 Key Disadvantage to Company or Employee No capital gain If option slips underwater, little perceived value to employee Must hold for one year after exercise to receive favorable tax treatment; must exercise quickly after termination of employment No capital gain Need for tax liquidity at vesting (or at grant if employee makes an IRC Section 83(b) election, unless FMV is paid) No capital gain If option slips underwater, little perceived value to employee A-7

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