For most startups and/or small businesses, large sums of cash are not always readily available. Stock options or equity awards are a creative way for companies to incentivize employees or service providers with non-cash compensation. Often, these awards are known as stock option plans, equity incentive plans, or phantom equity. They are provided through a written agreement indicating how many shares the recipient is to receive, and when. Most plans require the recipient to be employed with or providing services to the business for a certain length.
Equity incentive plans are a great tool for startups attempting to attract and retain the best and brightest talent. However, this type of plan is governed by several federal and/or state laws. You must pay attention to how you set up your incentive plan. The following are three of the most common mistakes made by businesses that offer equity incentive plans.
1. Failing to Register the Option or Seek an Exemption
Generally, the offer or sale of stock options must be registered with the Securities and Exchange Commission and state securities agencies in accordance with federal and state securities laws, unless it falls within an exemption. Several exemptions exist for equity compensation plans, particularly if they only apply to a small number of people. The larger the group of people this incentive applies to, the less likely it is that an exemption will apply. However, if you seek the exemption after the incentive has already been offered, the exemption will likely not be offered and you could harm future capitalization of the company.
Most public companies file an S-8 Registration Statement with the Securities and Exchange Commission in order to register employee equity grants. In order to do so, the statement must be filed before the issuance of the award or option. The award or option can only be granted to human beings — not legal entities such as corporations or limited liability companies. The problem that businesses often run into with this is when they attempt to provide an employee incentive plan to a consultant who operates as a separate legal entity. The agreement must acknowledge in this circumstance that the consultant is personally being awarded, not the legal entity. Additionally, the incentives can only be provided to current employees, not those who formerly worked for the company or those who plan to provide services to the company in the future.
2. Not Specifying the Obligations the Employee Must Meet for the Incentive
Certain time-based restrictions or performance milestones determine how one qualifies for the award or option. Many times, the restriction is a time-based (vesting) restriction that lasts three to four years. Typically, vesting occurs once per month or once per quarter after the first anniversary (usually called a “cliff”). So the recipient would receive X amount of stock after the cliff, with the remaining amount vesting over X years.
With the granting of stock, it is common for the recipient’s award to be subject to certain restrictions (including forfeiture) unless the recipient remains at the company or continues to provide services for a specific period of time. In order to provide incentives for meeting certain milestones, the company must clearly state what those milestones will be in the agreement, and how they will be achieved.
3. Failing to Protect the Employee and Company from Tax Consequences
Payment of cash or in-kind is still considered income. This means that the recipient is responsible for the tax obligations on the award or option. Employers may have a withholding obligation on the incentives. Depending on the type of plan and award agreement, the recipient may have to pay tax on the income of the in-kind contribution based on the fair market value of the incentive received. Additionally, the fair market price of the incentive must be set in accordance with federal income tax rules. This is often done through a valuation process provided by a third-party firm. The valuation considers such factors as discounts for lack of liquidity or control, the value of comparable companies, and the short- and long-term likelihood of generating revenue or selling the company.
Incentive plans must be approved with director/shareholder approval for a C-Corp or member/manager approval in an LLC. Additionally, the guidance of tax professionals is crucial to ensure that both the company and the recipient are shielded from adverse tax consequences.
For more information about providing an equity incentive plan for your employees/service providers, contact the Law Office of Elliott J. Brown.