equity compensation for startups
TRANSCRIPT
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Equity Compensation for StartupsNo cash? … No problem
Drexel Entrepreneurial Law ClinicPresenters: Robert Bean, Nick Bridge, Michael Delaney, Marco Di Prato
Panelists: Chris Miller (Pepper Hamilton), Steven Poulathas (Flaster Greenberg)
Clinic Director: Steve Rosard
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#PTW15
@PhillyTechWeek
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Thank You to Our Sponsors
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Agenda
• Student lawyer introductions• Why give equity compensation• Types of equity compensation• Tax consequences• Regulatory obstacles
– Valuation – Securities Compliance
• Other considerations– How much equity to issue – Process of issuing – Documents – Vesting– Transfer restrictions – Buyback
• Q&A
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Why Grant Equity Compensation?
• Align interests
• Attract & retain talent
• Improve productivity
• No cash
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Equity Compensation Types:Corporations and LLCs
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Corporate Equity
• Stock Awards
• Options
– Incentive Stock Options (ISOs)
– Non-Qualified Stock Options (NQSOs)
• Phantom Stock
• Stock Appreciation Rights (SARs)
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Stock Awards & Options
Stock Awards
• Represent ownership in the corporation
• Typically subject to vesting– “Restricted Stock Award”
Stock Options• Right to buy company stock in the future
at a specified price• Options also typically subject to vesting• Not a shareholder until exercise• ISO – favorable tax treatment
– IRC § 422– Only for employees– Pursuant to approved plan– $100,000 annual limit– Non-transferable – 10 yr. term max– Exercise price must be at least FMV– Holding periods
• NQSO– Any option other than an ISO
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Phantom Stock & SAR
Phantom Stock
• Account credited with hypothetical or "phantom" shares
• Increases or decreases, based on the company’s stock and phantom dividends
• No exercise, settled upon vesting
• Settled in cash or stock
Stock Appreciation Right
• Contractual right to receive cash or stock equal to the appreciation in value of the company’s stock from date of grant
• No cost to exercise, unlike an option
• Settled in cash or stock
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LLC Equity Alternatives
• Capital Interests
• Profits Interests
• Units Options
• Phantom Units
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Capital Interests and Profits Interest
Capital Interests
• Stock award
• An immediate ownership interest in the LLC’s assets and future profits
• May be voting or nonvoting
Profits Interest
• Hybrid
• An interest in the LLC profits and/or appreciation in value.
• Valuation required at grant
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Option and Phantom Units
Unit Options
• Same idea as C-corps
• Alternative to outright interest
• Exercise price can equal the FMV on the date of grant
• Option to acquire profits interest or a capital interest
Phantom Units
• Contractual rights that look and feel like equity
• Really a bonus plan under which the bonus amount is calculated using a formula related to the LLC’s financial results
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Tax Consequences
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Tax Consequences
Stock Award
• Ordinary Income = Fair Market Value – Amount paid
• Corresponding deduction– Same time and amount of
ordinary income recognized by recipient
Restricted Stock Award
• No tax at grant because subject to a “substantial risk of forfeiture”
• Tax at vesting
• Unless, 83(b) election is made
• Pay tax up front, start holding period
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Tax Consequences - Options
NQSO
• No tax at grant or vesting
• Tax at exercise = FMV at exercise – exercise price
• Corresponding deduction
ISO• No tax at grant, vesting, or
exercise
• Tax upon sale– If holding period is met, capital
gain = sale price – exercise price
– If sold before holding period met:• Ordinary Income = FMV at exercise
– exercise price.
• Any amount above FMV at exercise is capital gain
• However, benefits often Illusory
• No deduction unless there is a disqualifying disposition
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Tax Consequences – Cont’d
Phantom stock
• No tax at grant
• No tax at vesting if in compliance with 409A
• At settlement, if compliant with 409A, ordinary income = FMV of stock or cash received
• Corresponding deduction
SAR
• No tax at grant or vesting
• On exercise, ordinary income = amount of cash received or FMV of the shares received.
• Corresponding deduction
• 409A
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Tax Consequences – Capital Interests
Tax Consequences to Recipient
• Taxable event upon vesting or lapse of substantial risk of forfeiture (or 83(b) election)
• Compensation income
• Income = FMV of interest minusany amount paid for interest
• Treated as a member of the LLC
Tax Consequences to LLC
• Entitled to a deduction equal to the amount of income recognized by the recipient
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Tax Consequences – Profits Interests
Tax Consequences to Recipient
• Generally, not taxable if the receipt is contingent upon providing of services for the benefit of the LLC in a member capacity or anticipation of being a member.
• Not a taxable event if certain conditions are met. – Not related to a substantially certain
and predictable stream of income
– Not sold within 2 years
– Not a LP interest in a publicly traded P
Restricted Profits Interests
• If subject to vesting, still not a
taxable event if:– The 3 conditions are met
– Recipient treated as an owner from the date of grant
– No deductions made based on the profits interest at grant or vesting
• Although not required, still a good idea to make an 83(b) election
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Tax Consequences – Profits Interests
Tax Consequences to LLC
• No deduction available
• Redemption or sale of profits interests affected by short term or long term capital gain
Restricted Profits Interests
• Same as previous slide
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Tax Consequences - Membership
• Treated as a partner rather than an employee
• Form 1065 and Schedule K-1
• LLC not subject to withholding
• Self-employment taxes
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Tax Consequences –Unit Options and Phantom Units
Tax Consequences on Options
• Same concerns as C-corp options
• Upon exercise of an option to acquire a capital interest, same tax result as with NQSO; LLC gets a corresponding tax deduction
• Exercise of an option to acquire a profits interest is generally not taxable and thus no deduction for LLC
Tax Consequences to Phantom Units
• If set up correctly, taxed like phantom stock
• Recipient subject to tax upon receipt of payment
• LLC receives a tax deduction
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§409A
• Applies to non-qualified deferred compensation
– Any income earned, but not paid in same year
• Options, SARs, Phantom Stock/Units
• Penalty for non-compliance:
– Immediate tax upon vesting, which is subject to a 20% excise tax (in addition to the ordinary income tax) plus interest and possibly an additional state tax penalty
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§409A Compliance
• Applicable exemptions:– Exercise price for options and SARS should be set at > FMV at grant date. – Settling of phantom account within 2 ½ months following year of vesting
• Permissible Payment Triggers/Events– Separation from service – Death– Disability– Change of control– Unforeseeable emergency– Specified date or a payment schedule under which neither of
the parties can affect the timing of the payments• Acceleration not permitted• Election to defer must be made before performing the services
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Corporate Comparison
Stock Grant- Real equity- Entire value of stock- Corresponding deduction
Phantom Stock- Contractual, not equity- Entire value of stock- Subject to §409A- Corresponding deduction
Options- Real equity (when exercised)- Appreciation in value only- Must pay to exercise- ISO: favorable tax treatment to holder
(although often illusory), possibly no deduction
- NQSO: ordinary income, deduction- Subject to §409A
SAR- Contractual, not equity- Appreciation in value only- Subject to §409A- Corresponding deduction
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LLC Comparison
Capital Interests- Share the whole pie- Members- Taxable event on grant or vesting - Capital gains, maybe- Corresponding LLC deductions
Profits Interests- Share future pieces of pie - Members- Not a taxable event- Capital gains, maybe - No LLC deductions - Complex valuation and accounting
Unit Options- Can be capital or profits- Nonmember until exercise - Nontaxable until exercise - Ordinary income - Corresponding LLC deductions- Subject to §409A
Phantom Units - Disguised bonus plan - Nonmember status remains- Nontaxable until payment- Ordinary income- Corresponding LLC deductions- Avoids accounting complexities - Subject to §409A
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Startup Valuation
More An Art Than a Science
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Valuation - Introduction
• Why perform a valuation?
– Avoid future repercussions for noncompliance
• IRS scrutiny
• Investor/buyer due diligence
• Two levels of valuation:
– Ordinary Valuation: When issuing Profits Interest, Restricted Stock Units, Common Units/Stock
– §409A Valuation: When issuing Options, Phantom Equity, Stock Appreciation Rights
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Valuation - Ordinary
• How to perform an ordinary valuation?
– Independent Appraisal
– Internal Valuation
• Must be good faith number based on
reasonable metrics of company value
• What is the optimal number?
– As low as reasonably possible
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Valuation – §409A
• A non-publicly traded company must determine the fair market value of its stock by reasonable application of a reasonable valuation method.
• What’s Reasonable?– Must take into account all available
information that is material to the
value of the company
• Two Relevant Safe Harbors– Independent Appraisal
– Illiquid Startup Valuation
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Valuation – §409A Illiquid Startup Valuation
• Valuation satisfies §409A if:– It is prepared by someone who is reasonably qualified
based on significant knowledge, experience, education or training
• Who Qualifies for this Exception?– Startups that
• Have been conducting business for
less than ten years
• Have no publicly traded securities
• won’t be acquired within 90 days or go public within 180 days, and
• Have common stock that is not subject to obligations to purchase the stock
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Valuation – What Factors do I Need to Consider?
• Hard Numbers– Historical profits, tangible assets, cash flow and
liabilities
• Soft Numbers– Income and cash-flow projections
• Intangible Assets– Patents, brand names, quality or reputation of
management, location, goodwill
• Other– Market value of stock or equity interests of
similar companies, evaluation of the state of the industry
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Securities Compliance
Restricted Securities: Cannot Be Issued, Except When They Can.
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Securities – How Do They Affect Me?
• Every offer or sale of a security must, before it is offered or sold in a state, be registered or exempt from registration under both federal securities laws, and the laws of the state(s) in which the security is offered and sold
• If an offering fails to comply, the company risks the following:– Recipient sues company for:
• Rescission of the of the equity grant• Damages if the investor sold thesecurities for less than he bought them
– Damaging chances of future investment or sale
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Securities – Exemptions for Employee Compensation
SEC Rule 701 Exemption
• Allows limited amounts of equity to be issued as employee compensation
State Securities Exemptions
– Laws of Recipient’s state of residence apply to equity grants
– PA Blue Sky laws have an exception where securities that are being issued in good faith reliance that the transaction qualifies for an exemption under SEC Rule 701
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Securities – What Offerings Qualify Under Rule 701?
• Offerings over any consecutive 12-month period, the sum of which do not exceed the greatest of:
– $1 million in aggregate sales price
– 15% of the total assets of the company
– 15% of the outstanding amount of the
class of securities being offered
• What is the Aggregate Sales Price?
– The sum of consideration paid in exchange
for the equity
Determined when an option is granted
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Granting Equity: Other Considerations
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How Much Equity to Issue
• Will vary throughout the different stages of a company’s growth• Non-Founder employee ownership typically ranges from 10-20%
• Early employees granted equity in terms of points i.e., 1%, 2%, 5%, 10%
• After core group of employees assembled, Company should grant equity in amounts based on the dollar value of equity
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Process of Issuing Equity
• After determining what type of equity to issue the company will have to:– Approve issuances pursuant to organizational documents
• May require approval of existing members and/or a Board of Directors
– Determine Fair Market Value of company
– Ensure compliance with regulations
– Execute Documents
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What Documents do you need?
Company will need to
• Document granting the particular incentive equity such as:
– Profits Interest Grant
– Restricted Unit Grant Agreement
– Option Agreement/Option Exercise Agreement
• Documents related to particular relationship – Employment Agreement,
– Advisory Agreement,
– Independent Contractor Agreement
• 83(b) Election
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Vesting – A Primer
• What is Vesting?– Contractual device preventing transfer of equity to the
employee until certain time or performance based conditions have been met
• Common Forms– Time Based Vesting– Performance Based Vesting
• Why do I Want Vesting?– Incentivize employees to stay– Improve productivity– Keep control of equity
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Vesting – Acceleration
– What is Acceleration?
» When the unvested equity awards become vested on the occurrence of certain events following the buyout but before the end of the applicable full vesting period.
• Types of Acceleration:
– Single Trigger – Acceleration based on a single event, like company sale
– Double Trigger – Acceleration based on two events, such as company sale and termination of service
• Should there be Acceleration on a Sale?
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Transfer Restrictions
• Right of First Refusal– Contractual right prohibiting equity holder from selling equity to a
third-party without first giving the company and/or Members of a company the opportunity to purchase equity on same terms
– Requirements:
• Bona Fide Offer
• Written Notice to Company and Members
• Period of time for Company and/or Members to exercise this right
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Buyback rights
• Provides the company the right to repurchase equity issued in certain circumstances - such as termination, with or without cause, death/disability, or other involuntary transfers
• Termination for cause– Generally, for a discounted price
– “For Cause” generally includes:• Intentional wrongdoing by the employee.
• Fraudulent conduct by the employee.
• The employee's theft of company property.
• The employee's substantial failure to perform job duties.
• Intentional breach of company policies by the employee.
– What about poor performance?
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Any Questions?
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