Stock Options, RSUs and Other Awards: Key Design Considerations for Emerging Companies

Transcription

1 Stock Options, RSUs and Other Awards: Key Design Considerations for Emerging Companies Stock Options What Is a Stock Option? A compensatory stock option is typically a right to purchase a fixed number of shares within a fixed period of time at a fixed price, generally following the satisfaction of service-based and/or performance-based vesting conditions. General Pros and Cons. Stock options are favored by employees because they provide a way for employees to participate in the company's growth and potentially end up with a huge profit and because they generally have no tax consequences until the employees exercise the options (for NSOs) or sell the shares (for ISOs). They are also the most familiar form of equity compensation for most employees and may therefore have the greatest incentive effect. However, stock options are not always favored by shareholders for a number of reasons: they are more dilutive than stock awards; they provide a less effective incentive because of the risk of being "underwater", and they entitle the holder only to participate in the increase in per share value above the option exercise price, thereby motivating employees simply to maximize the share price in the short term so they can make a quick profit. Accounting Treatment. Assuming that the options will be settled for shares of the company's stock and not for cash, the options will be accounted for as equity awards under FASB ASC Topic 718 (formerly FAS 123R), which is preferable to the alternative liability award treatment (similar to variable accounting treatment under APB 25). Types of Stock Options. There are two basic types of stock options: Incentive Stock Options (ISOs) can provide certain tax advantages for the holder (as compared to NSOs): no tax withholding or FICA payroll tax. As a practical matter, few individuals satisfy the holding requirements for ISO tax treatment, but many still perceive ISOs as preferable to NSOs. Even if the option holder fails to satisfy the holding periods, the company gets no tax deduction with respect to ISOs. In addition, with ISOs the company recognizes no anticipated tax benefit under Topic 718, and therefore ISOs have a greater expense impact on the financial statements. However, ISOs are exempt from Internal Revenue Code Section 409A deferred compensation requirements (note that this is only true if the ISOs satisfy the applicable requirements for ISO treatment). ISOs involve a number of administrative burdens for the company: tracking compliance with ISO requirements, including the $100,000 limit; tracking shares for potentially disqualifying dispositions; and IRS reporting on Form 6039 and employee information statement on Form 3921 (or equivalent) for ISO exercises. ISOs also provide less flexibility for modifications and methods of exercise (e.g., no "net" exercise, no expanding payment methods), which can hamper the company's ability to efficiently handle these options,

2 including, for example, when an employee terminates employment, in connection with an M&A transaction and if the ISOs become "underwater" and should be repriced. Nonqualified Stock Options (NSOs) are the most widely used form of stock option. Because NSOs are taxed upon exercise, and the holder decides when to exercise, they allow the holder to control when he will be taxed. Most holders of options for private company stock tend to wait until the eve of a sale or other liquidity event before exercising their options. NSOs provide another benefit because the company gets a tax deduction when the option holder is taxed. In addition, the company recognizes an anticipated tax benefit with respect to NSOs, which effectively reduces the expense recognized with respect to NSOs as compared to ISOs. However, NSOs must be granted with an exercise price that is at least equal to the fair market value of the underlying stock on the grant date and contain no additional deferral feature, or else they will be subject to Section 409A deferred compensation requirements. NSOs that are granted with an exercise price less than the fair market value of the underlying stock on the grant date must be structured to comply with Section 409A or else the option holder will be taxed when the NSO vests, plus incur a 20% tax penalty. Restricted Stock Units What Are RSUs? Restricted stock units (RSUs) are rights to acquire stock (or cash based on the value of the stock) without paying any exercise price in the future upon vesting on specific dates or when specific events occur (i.e., an IPO, a change of control of the company, termination of employment, etc.), where the specific dates or events that will trigger vesting and payment of the RSUs are specified by the company as part of the RSU grant. Companies may also structure RSUs when they grant them to defer the payment of the RSUs (i.e., the issuance of shares or cash) to specific dates or events that will occur after the RSUs vest. Stock options, by contrast, are rights to acquire stock in the future by paying a specific exercise price. How Are Employees Taxed on RSUs? Employees are generally not taxed with respect to the RSUs until the date the employee receives payment of the RSUs (i.e., shares of stock or cash) either at vesting or at a specified later date, and employees have basically no ability to control the timing for when they will be taxed on the RSUs. The full value of the stock or cash that the employee receives on payment of RSUs is taxed as ordinary income. This can be a serious problem: Facebook had to disclose the need to fund this tax withholding obligation as a material risk in connection with its IPO. Properly structured stock options, on the other hand, are not taxed until they are exercised, which allows employees to control the timing of when they will be taxed on the stock options. What About Tax Withholding? From the company's perspective, there is no regular income tax withholding obligation until the RSU payment date. On the RSU payment date the company must collect and deposit with the IRS the required tax withholding on the value of the shares (or cash) it pays with respect to the RSUs. However, if the payment of the RSUs is deferred beyond the vesting, the company is required to withhold (i.e., collect and deposit) FICA on RSUs 2

3 when they vest even if the RSU payment date will occur later. When a large number of RSUs end up having the same payment date, this triggers a huge amount of tax withholding obligation that will either use up a significant amount of company cash or require dumping a large number of shares on the market to generate the cash for the tax withholding payments, which can put significant downward pressure on the stock price. The company is not required to collect or deposit any tax withholding on exercise of an ISO (even if the employee ends up selling the shares purchased on exercise of the ISO before the minimum holding period has been met), but the company is required to collect and deposit the required tax withholding on exercise of a nonqualified stock option. Accounting Treatment for RSUs. The value of an RSU award is measured on the grant date based on the number of shares subject to the RSU award and the current fair market value per share of stock and this value is recognized for financial statement purposes over the vesting period as a non-cash compensation expense. Why Use RSUs Instead of Stock Options? There are four main reasons why companies may decide to switch to using RSUs instead of stock options. Stock price is not expected to continue increasing. RSUs are frequently used by public companies that do not expect consistent stock price increases to avoid situations in which stock options end up underwater or do not provide an effective incentive because of the small spread between the stock option exercise price and the future stock price. Private companies (especially pre-ipo companies) may consider using RSUs to address the same risks that result from the uncertainty in the value of the company's stock leading up to the IPO (i.e., to avoid granting stock options that end up underwater because the company overestimated the value of its shares). However, for a company anticipating continuing stock price increases, RSUs do not offer the same opportunity for increased value as do stock options, so RSUs may not provide as effective an incentive. RSUs enable pre-ipo companies to avoid Section 409A concerns when addressing "cheap stock" issues. Granting RSUs instead of stock options in the 12- to 18-month period before the IPO also helps a company avoid running into additional Section 409A issues that may arise in connection with addressing "cheap stock" issues with the SEC when the company files for its IPO. These issues could otherwise cause concerns for Section 409A purposes about how the company valued its stock during that period for purposes of setting stock option exercise prices where the company will likely have to recognize additional non-cash compensation expense on its financial statements. RSUs enable pre-ipo companies to avoid SEC registration or disclosure requirements. A pre-ipo private company that anticipates having too many stockholders may decide to switch to granting RSUs to avoid exceeding the applicable limit for holders of any "class" of securities for purposes of the SEC's Section 12(g) registration requirement. The JOBS Act changed these limits, which removes this as a compelling reason for a pre-ipo private company to use RSUs. However, if a company relying on SEC Rule 701 to exempt grants under its equity compensation programs grants awards with a value of $5 million or more in 3

4 any 12-month period, Rule 701 requires the company to provide all holders of awards under the equity compensation programs with significant disclosure, namely financial statements and risk factors. Because an award of RSUs has more intrinsic value than an award of stock options, a company may be able to manage the value of the awards it grants under Rule 701 and stay under the $5 million threshold by switching to RSUs. RSUs enable pre-ipo companies to avoid having additional stockholders and secondary trading. Because RSUs granted by a pre-ipo private company typically are structured not to be convertible into stock until after the IPO, using RSUs, instead of regular stock options that employees can exercise to become stockholders anytime, allows the company to avoid creating additional stockholders, and to limit the shares that could be sold by employees to third parties before the IPO. However, this may make the RSUs a less effective incentive. Other Equity Awards Restricted Stock Awards Restricted Stock Awards (RSAs) are awards of actual shares (as opposed to options) that are issued subject to restrictions, such as a reverse vesting schedule tied to continued employment or the achievement of performance goals, or both. The holder is treated as a shareholder as soon as the RSA is granted and will be able to vote the shares and receive dividends. RSAs can be granted in consideration of services or can be sold for cash consideration (or some combination of the two) they are usually granted in consideration for services and subject to restrictions. Because RSAs have value when granted, typically retain at least some value (even if the stock price declines), result in more immediate share ownership and typically do not involve any cash payment in exchange for receiving the shares, RSAs typically represent one-third to one-half the number of shares as a comparable option grant. How Are RSAs Taxed? RSAs are taxed when they vest, unless the holder files an election under Internal Revenue Code Section 83(b) with the IRS within 30 days after the RSAs are granted to elect to be taxed immediately. The holder cannot recover the taxes paid on the RSAs under this election even if the RSAs never vest. RSAs are exempt from Section 409A. Especially with performance-based vesting, the timing of taxation can be unpredictable and can present a hardship to the holder if a significant amount is due for tax withholding. The company must require payment for tax withholding to be tendered immediately on the vesting date. If the tax withholding is paid to the company in shares of the company's stock, these shares are considered "repurchased" by the company. To repurchase shares, the company must have determined that the purchase was a good use of company funds, and the company must have sufficient available funds to make the purchase under state corporation law. Stock Appreciation Rights (SARs) 4

5 General Description; Pros and Cons. SARs enable the holder to share in the appreciation in value of the company s stock by providing the right to receive on exercise the difference between the then-current fair market value of the number of shares of stock covered by the award over the value of that number of shares on the SAR grant date. SARs provide an incentive to employees by allowing them to participate in the increased value of the company, but they result in less dilution than options or stock awards. SARs were subject to variable accounting treatment under prior accounting rules (as described below) and, therefore, have rarely been used. In addition, SARs must be granted with a grant or base price that is at least equal to the fair market value of the underlying stock on the grant date and contain no additional deferral feature, or else they will be subject to Section 409A deferred compensation requirements. Types of SARs. SARs can be made payable in cash (cash-settled SARs), in shares of stock (stocksettled SARs) or in a combination of cash and shares, at the company's or the holder's election. Paying SARs in cash avoids the voting rights and minority shareholder protections that would apply to employees who receive shares of stock. If the SARs can be paid only in cash, if the SARs can be paid in cash at the holder's election or if the company has a history or intention of paying the SARs in cash, then the SARs should be treated as cash-settled SARs. Accounting Treatment. Stock-settled SARs are accounted for as equity awards under Topic 718, while cash-settled SARs are accounted for as liability awards. Equity Award Accounting. Under equity award accounting, the company measures the value of each option on its grant date using an option valuation model, like Black- Scholes, and recognizes this amount of non-cash compensation expense in its financial statements over the option's vesting period (expected term). Liability Award Accounting. If the options must be accounted for as liability awards, the company will still measure the value of each option on its grant date using an option valuation model, like Black-Scholes, but the company will have to recognize that amount of expense for the period in which the option is granted. In addition, the company will have to remeasure the value of the option using an option valuation model, like Black- Scholes, as of the end of each quarter and recognize as additional non-cash compensation expense any incremental increase in the option's value. Privately held companies may be able to elect to retain variable accounting treatment (described below) for liability awards. Voting and Control Issues If the current shareholders have concerns about sharing control of the company, the company could do one or more of the following to retain the existing control structure: keep the size of the total equity compensation pool small (i.e., 20% or less of the company s capitalization) 5

6 grant NSOs (as opposed to either ISOs, which may encourage earlier exercise to start holding periods for capital gains treatment of the appreciation, or stock awards, which result in more immediate stock ownership) impose option vesting schedules (comparable to those used by similar companies) to delay exerciseability while providing employees with an incentive to continue employment consider deferring exercisability of options and/or the settlement of RSUs until an IPO or other liquidity event impose a right of first refusal on transfers of any shares received as compensation impose a repurchase right in favor of the company for any holder whose employment with the company terminates impose transfer restrictions require holders to enter into a voting agreement with the founders as a condition of option exercise grant equity compensation awards on a separate class of nonvoting stock Effect of the JOBS Act The JOBS Act amended Section 12(g) of the Securities Exchange Act of 1934, as amended, to raise the threshold at which an issuer must register its securities with the SEC from 500 to 2,000 shareholders of record provided that fewer than 500 such holders are nonaccredited investors and to allow companies to exclude employees receiving company securities under employee benefit plans in an exempt transaction when calculating the number of record holders for this purpose. This provision was effective immediately upon enactment on April 5, 2012, but the SEC is directed to adopt safe harbor provisions. Based on legislative history, the exemption should be construed broadly. o The provision excluding these employees from the definition of holders of record extends the existing limited Section 12(g) relief currently available for options and RSUs, which required the securities to include transfer restrictions and have been issued under the Rule 701 exemption. o The JOBS Act relief should apply to all forms of equity-based compensation, including restricted stock and SARs 6

7 o The JOBS Act relief should also apply to all forms of exemption traditionally relied on for grants to U.S. and foreign employees, including Rule 701, Regulation D, Regulation S, Section 4(2), and the "no sale" theory. Implications: o A private company will have increased flexibility in granting equity compensation as the company's number of employees increases. o Companies will continue to need to review compliance with Securities Act exemptions and applicable state and foreign securities laws, including disclosure requirements. o Companies will have an increased ability to stay private longer and utilize some of the other capital raising provisions that are contemplated in the JOBS Act or otherwise available to them. 7