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Lurking Dangers: Pitfalls to avoid when managing your equity incentive plans

This article highlights some of the problems that organizations encounter when trying to optimize equity incentive plans for their employees.

Don’t get trapped by your equity incentive plan.

The purposes and benefits of equity incentive plans for private emerging companies are well covered in the literature and on the web. Therefore, in this article I will highlight some of the problems that organizations encounter when trying to optimize equity incentive plans for their employees.

The typical equity incentive plan provides for the granting of stock options to purchase common stock to employees, board members and consultants.  Incentive Stock Options (“ISOs”) may be granted only to employees, and have some favorable tax treatment potential vs. non-qualified stock options, which are granted to board members and consultants (and some times to employees in certain circumstances).  Many plans also provide for restricted stock grants, which allow the grantee to purchase their share allocation upon the grant, but with the company’s right to buy back the shares that have not vested, typically consistent with the stock option vesting schedule.  The benefit of restricted stock is that the holding period for capital gain purposes may begin upon the grant date, rather than when option shares are actually purchased over a vesting period, if the holder so chooses in a filing called a Section 83(b) Election.

Even in a well-constructed equity plan, however, there is the potential for companies to take certain actions which could get the grantees, the organization, or both in a financial pickle.  In my experience the principal issues involve common stock valuation and the use of restricted stock.

Common Stock Valuation

Stock options must be granted at a minimum of fair market value (FMV).  Failure to do so will subject the grantee to an ordinary tax on the difference between the strike price and FMV, plus a 20% penalty. Since a private company’s stock is not readily tradeable on an established securities market, the IRS requires that the FMV of that stock be determined according to a methodology know as a 409A valuation, and that the valuation be documented in a written report.

It is theoretically acceptable for a 409A valuation to be performed internally, and this may be tempting in order to save the cost of an independent appraiser.  However, most tax advisors believe that independent trained and experienced valuation professionals are the only safe option.  Such valuations have become less costly over recent years, and some professionals are offering this service on a monthly subscription basis.  Options should be granted within 12 months of the valuation, and valuations should be performed more frequently if the company has achieved milestones that would increase its value.  A valuation should definitely be completed after any new equity financing.

Use of Restricted Stock

Because of the additional complexity of administering restricted stock, most companies have limited their use to senior executives, although I have seen cases where they were offered to all employees.  The biggest downside to restricted stock is that they are no longer “options”; that is, the full exercise price of the shares must be paid upfront, without knowing the ultimate realizable value of the shares.  To offset the negative cash flow aspect, some companies have either loaned the employee the full purchase price of the shares, or given the employee a bargain purchase price and loaned them the amount of the tax due for the difference between the strike price and FMV.  Neither of these alternatives is advisable.

First, in order for a loan given in connection with a stock grant to not be considered a taxable event, it must be “full recourse”; that is, the loan is due and payable on a known timetable and is due for the full amount of the loan, plus interest, regardless of the value of the stock.  So, if the loan becomes due when the stock value has decreased (and is often illiquid), then the employee is on the hook for the full balance.  The company may be willing to forgive the loan at this point, but the amount of the forgiveness then becomes an ordinary income taxable event.

Another workaround would be for the company to repurchase the shares from the employee in order to reduce the balance of the loan.  However, since the current FMV of the shares has likely reduced from the original grant price, the loan would not be fully offset, or any premium paid for the shares by the company would subject the employee to an ordinary gain.  Nevertheless, under these circumstances it probably makes sense to repurchase the shares at FMV to minimize the loan balance.

To summarize…

In order to avoid negative tax consequences, or nasty surprises later (which often come to light at a liquidity event or the winding up of the company), my informal advice would be to always grant options at an FMV based on a current, independent 409A valuation, be very careful about the use of restricted stock, and never provide loans to support a restricted stock grant.  Finally, always consult a qualified attorney before implementing an equity incentive plan or considering any of the actions discussed above.  The qualifications you should look for include technical and legal expertise, as well as the real-world experience to understand what could go wrong.