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Compensation Strategies and Issues for Start-up and Emerging Companies

This article was originally published in the July 2001 issue of Interface Tech News.

 

You’ve just met a talented person who would be a tremendous addition to your company. This candidate would step right in and contribute substantially to the development of your number one business priority. The candidate also represents that elusive and extremely valuable attribute of being a seasoned veteran, having worked in a key position with a company that went public and generated significant returns for its investors. This is the type of person who can not only help guide your business internally through its growth, but who can also attract, and engender trust with, important potential investors and corporate partners.

All of this is great, right? The only problem is, the current investment climate is creating great pressure to retain cash, so how do you attract this key person to join your company? The notion of just dangling stock options in front of this candidate probably won’t be enough to land the better candidate unless the candidate is financially secure and considers your company an extremely valuable opportunity, after conducting their due diligence. What will this person expect and what might they be able to attract from your competitors in the marketplace? And, if you do decide to offer an especially attractive package to this person, do you know how to structure it in a way that protects the company’s investment in this person, and doesn’t inadvertently violate any employment or securities laws, or create a tax or accounting nightmare? Let’s review the answers to these questions, so that you’ll be equipped to assess and act upon the opportunity the next time you meet a talented candidate you want to hire.

The Current Environment

As an employer in today’s marketplace, the fact that you are hiring at all represents a significant opportunity for some of the tens of thousands of people who have lost jobs in the high tech marketplace. Layoffs from dot-com businesses approached 20,000 people as of April, 2001, according to Challenger, Gray & Christmas, and the nation’s unemployment rate is expected to reach five percent this year. Professional recruiters in the high tech market indicate (contrary to popular press reports) that a substantial majority of these former “dot-commers” are willing to take another job in a start-up or emerging-stage company. As a result, companies today should find it somewhat easier to find good people looking for a new job.

Ironically, it may not be easier to hire these good candidates, as job seekers have recalibrated the elements of an attractive compensation package. Whereas the “upside” elements of a compensation package (primarily the number of shares and the vesting schedule in stock options) had been of primary importance 12 to 18 months ago, today’s job seekers are focusing on the “downside” scenario, as most people are painfully aware of the impact of losing a job with little or no advance warning, and holding only worthless stock options.

This means that the cash elements of a compensation package are much more important in the current economy, and the equity compensation element is no longer the determining factor for most job seekers. Base salary, particularly for executive level employees, has been increasing and there are greater demands for signing and annual bonuses paid in cash. Reflecting the shift in focus to the downside scenarios, and seeking a “safer” position, many job seekers are also demanding that severance benefits be established at the time of their hiring. Job seekers are also seeking to be compensated for relocation expenses, and even re-relocation expenses should jobs not work out. And, as part of the increased sense of mortality that a down stock market creates, job seekers are paying much greater attention to their benefit package, including life and health insurance, and the things which allow them to spend more time with their families, namely 401(k) plans and vacation time.

But don’t think that the renewed focus on cash means that the demand for stock options has abated. It hasn’t. In fact, sophisticated job seekers are showing much greater understanding of the alternatives a company may provide in their equity compensation. Having suffered or seen others suffer unanticipated problems with stock options (which problems always existed but have only been tremendously amplified during the market’s incredible run up and collapse), job seekers are much more concerned with the structure of their equity compensation and, frequently, come to a company with firm ideas on how their package should be crafted. It therefore behooves you to have a good understanding of how you want to structure any equity compensation.

Equity Compensation

Utilizing equity to motivate and retain employees has long been a critical tool for start-up and emerging companies, but the significance of stock options as a compensation tool has dramatically increased during the last ten years. The number of employees holding options has skyrocketed from one million to ten million since 1991, and the grant value of these outstanding options is approximately $1 trillion, according to two studies recently reported by The Wall Street Journal. But the somewhat recent emphasis on the potential windfall gains from such compensation has been a mixed blessing for employers.

Offering the potential for such windfall gains has allowed many companies to hire talented people who would usually not even consider working for a start-up, or would demand much greater cash compensation than a fledgling company could afford. On the other hand, the increased focus by employees upon the immediate value of these options and their unrealistic expectation of short term rewards have created problems for employers, as the struggle to maintain the attractiveness of options in a down market has created great pressure for companies to insure their options stay “in the money,” notwithstanding the very real negative effect the company’s investors are suffering.

This conflict has been highlighted by the increasingly hostile reaction of public company stockholders to company proposals to modify or increase stock option plans. Whereas the approval of stock plans was usually a non-controversial proposition, 22% of stockholders who voted opposed stock plan proposals in 2000, according to the Investor Responsibility Research Center in Washington, and a relatively large number of stock plan proposals were rejected. Citrix Systems, Inc., a developer of application server software headquartered in Fort Lauderdale, Florida, was hit with a suit from a major stockholder when it tried to increase the number of shares available for its stock plans, in no small part due to the fact that existing stockholders would have been diluted by 73% if all of the additional options were granted.

Despite this hostility to a perceived misuse of equity compensation, no one – not even investors in technology companies – is suggesting that companies eliminate equity compensation as a key component of an overall compensation package. The benefits to the company, when properly managed, are too great, especially in a start-up and emerging company. First of all, a company’s stock is a form of currency and, unlike cash, the only type which private companies are allowed to print. Second, the allure of the “big hit” from a successful IPO or acquisition can inspire employees to work hard, for less cash than they otherwise might. And, third, the proper structuring of a vesting schedule can be a great employee retention device. So the key is establishing a stock plan that makes sense.

Structuring a Stock Plan

The most typical types of equity compensation for start-up and emerging companies are stock options and restricted stock grants. The issuance of options and restricted stock should generally be done pursuant to a written plan document. The plan document contains the rules for the granting, pricing, exercise, termination, payment, vesting and acceleration of vesting, and other rules for the options and restricted stock grants, and the administration of the plan. The Board of Directors and the stockholders of a company adopt the written plan, and the company typically establishes standard forms of option and restricted stock agreements. In addition to the obvious benefit of improved clarity and consistency in the operation of a stock compensation program, a written plan document and written option and restricted stock agreements are critical to satisfy certain exemptions from the registration requirements of the federal and state securities laws (as stock options are securities subject to regulation).

While it may seem obvious that you need to determine the number of shares of stock you wish to allocate to the plan, the timing for this is critical. Assessing the need for shares should be a component of a company’s business plan and integrated into the original capital structure of every company. Establishing a reasonable percentage of the company’s shares in reserve for future grants enables the founders to avoid being substantially diluted when the first sophisticated investors insist that a large number of shares be reserved for future issuance to employees and others, and that such reservation of shares occur prior to their investment. Needless to say, the investors will not usually agree to either increase the valuation of the company at that point or allow the shares to be reserved after their investment, so the founders and other existing stockholders suffer all of the dilution associated with the stock plan shares. And, since the size of the reserved pool of shares is often substantial (10% – 25% depending upon the company’s circumstances), the dilution can be significant.

You should consider the amount of shares necessary to fulfill the company’s needs through at least an 18 month period. The size of the pool is a function of the number of key employees that the company will need to hire, and the number of shares that those new employees will expect in stock options. In order to make this determination, the company’s hiring models should reflect the market rate of equity, in terms of percentage ownership, for a company at its particular stage of development. This information also varies depending upon the market, and your professional advisors and investors should be able to help you understand what the market rate is for your company. As an example, a vice president-level employee might expect to receive options representing two to five percent for a pre-financed company and from one to two percent (possibly higher for a superstar) of a post-first round financed company, with other employee percentages decreasing substantially below the vice president-level. Of course, if there are major positions to be hired, especially a CEO, the percentages may be substantially higher. It is not unheard of for an experienced, successful CEO to be awarded options for 10% of a company.

One of the most critical elements of a stock compensation program is determining the vesting schedule of stock options and restricted stock. The imposition of a vesting schedule is the key to stock options and restricted stock serving as retention devices for a company. Until shares or the option rights have vested, the recipient does not have unfettered ownership and may in fact forfeit such rights if the milestones in the vesting schedule are not satisfied. A typical vesting schedule is measured on a calendar, so that rights vest over time. This need to continue working with the company tends to be a substantial motivational tool, particularly if the company’s shares are appreciating in value. Many venture capitalists will look for a four year vesting schedule, with no vesting until after the first year anniversary of a recipient’s employment, and periodic vesting on a linear basis thereafter. Although the vesting schedule can be as frequent as desired, the schedule is usually on a monthly or quarterly basis.

Stock Option Basics

Stock options are the most common method of providing equity compensation. A stock option simply grants the recipient the right to purchase stock at some time in the future at a specified price. The two primary types of stock options used are incentive stock options (“ISO”) and non-qualified stock options (“NQO”). The key distinction between ISOs and NQOs is that the ISO is a creature of the tax code and, so long as the tax code rules are followed, enables a recipient to obtain more favorable tax treatment with respect to the gain recognized (measured by the amount of appreciated value in the underlying shares over the per share exercise price paid for such shares under the option). An ISO enables the recipient to defer the taxation of any gain until the time the shares purchased upon exercise of the option are sold and the gain is taxed at capital gains rates. The NQO, on the other hand, generally becomes taxable upon the exercise of the option, which is not very attractive unless there is a means for liquidating at least some of those shares, and any gain is taxed at ordinary income rates.

In order to qualify as an ISO, there are a number of somewhat complicated and strict requirements that must be satisfied by the terms of the option itself, and by the option holder. Among the requirements for an ISO are the following: (1) the option may only be granted to employees, and generally will terminate 90 days after the termination or change in status of such employment (i.e., to that of an independent contractor); (2) the option must have an exercise price per share equal to the fair market value of the underlying shares, unless the recipient owns more than 10% of the company, in which case the exercise price cannot be less than 110% of the fair market value; (3) purchased shares must be held for more than one year after exercise and more than two years after the date of the option grant; and (4) there is a limit of $100,000 in fair market value of stock (as measured on the date of grant) exercisable for the first time during a calendar year. The NQO does not have to meet these statutory qualifications (hence, “non-qualified”), and the failure to strictly satisfy the ISO requirements will result in the option being treated as a NQO, even if the option is described as an ISO or the non-compliance is unintentional.
While ISOs do provide a tax advantage for the recipient, the company that granted the ISO is generally not entitled to a deduction either upon the issuance or exercise of the ISO, notwithstanding the obvious compensatory purpose of the option. NQOs, on the other hand, generally provide the issuing company with a deduction equal to the amount of ordinary income the option holders recognize at the time of exercise. This distinction in the company’s tax treatment is typically of little consequence for start-up and emerging companies as there is typically little if any taxable income, so the potential favorable tax treatment available to employees from issuing ISOs is usually considered a valuable benefit. As a practical matter, despite the typical demand for ISOs by employees in start-up and emerging companies, ISOs are frequently disqualified due to the fact that most employees do not exercise their options until the time of a liquidity transaction, and the resulting sale of the underlying shares does not satisfy the holding period requirement.

Restricted Stock

Restricted stock is an alternative form of equity compensation, which, in some circumstances, is significantly more advantageous to the recipient than stock options. A company may issue shares to virtually anyone (subject to applicable securities laws), and, so long as applicable corporate law is satisfied with respect to the consideration delivered to the company for the shares (typically requiring delivery of cash, promissory note or the prior performance of services equal to at least par value), at virtually any price. The stock is considered “restricted” because it will be subject to certain restrictions (like a vesting schedule) which, if not satisfied, may result in forfeiture of the shares or the right of the issuing company to re-acquire the shares for a nominal sum. The holder of restricted stock will have the rights of a stockholder, including the right to receive dividends and vote, but typically is prohibited from transferring the shares.

There is generally no tax upon receipt of restricted stock. Rather, the recipient will recognize ordinary income equal to the difference between the fair market value of the shares on the date of vesting and the price paid for the stock, at the time and to the extent that the restrictions lapse or are satisfied. Accordingly, the tax treatment of a holder of restricted stock is very similar to the holder of a NQO. One extremely important difference is that the holder of restricted stock may elect to be taxed under Section 83(b) of the Internal Revenue Code by filing notice of such election within thirty days of the date of receipt of the stock. Upon making such election, the recipient will accelerate the tax so it is triggered by the receipt of the stock, and will be based upon the difference between the fair market value of the stock and the amount paid for the stock, and assessed at ordinary income rates. The two key advantages to making this “83(b) election” are: (1) the holder can avoid a potentially larger tax which would be triggered at the time the restrictions lapse, and the value of the restricted stock is substantially greater in value and (2) the capital gains holding period begins upon receipt (as opposed to upon vesting) so that the opportunity to have future appreciation taxed as long-term capital gains is maximized. However, this strategy loses its attractiveness as the amount of the tax due upon issuance increases because, not only must the recipient pay a tax based upon an illiquid asset, but if the stock decreases in value or the stock is subsequently forfeited, the recipient cannot recapture the tax payment by declaring a loss or amending the prior year’s tax returns.

Phantom Stock

Phantom stock and stock appreciation rights (SARs) are alternatives to true equity compensation. Each of these are similar to a stock option program in that the value associated with the benefit typically is related to the value of a company’s stock, but they are really just bonus programs, typically providing the participants with a cash payment, and not equity. A company implements these arrangements with a plan and a contract between the company and the recipient that provides for the payment of cash upon the occurrence of certain circumstances, typically a liquidity event for the company. The most common structure will establish a “base value” for phantom shares or SAR units that equals the value of the company’s common stock. If the recipients are fortunate, the value of the company’s common stock will appreciate in value, resulting in a greater benefit. Depending upon the sophistication of the plan and the desire of the company, the company (usually by its Board of Directors on some regular recurring basis) or an outside appraiser will determine the value of the common stock. A company implementing a phantom stock or SAR plan has great latitude to determine the rules of the plan. For example, some plans will permit a participant who is severing a relationship with the company to cash out some or all of the appreciated value of their phantom stock, typically subject to a vesting arrangement. Other plans limit the payment obligation of the company to a certain set of circumstances, such as the sale of the company. Phantom stock programs are most commonly used in closely-held companies in lieu of stock options, with the most common reasons including: S corporation rules limiting the number of stockholders, the fear of minority stockholder issues, a desire to limit the proceeds of a liquidity transaction to limited owners and a desire to limit access to a company’s financial and other “secret” information.

Legal Traps for the Unwary

Now that you have some sense for what the market is demanding, and a general background for the types of equity compensation programs, let’s pause and consider some potential traps for the unwary marking the employment and compensation landscape. There are some substantial penalties that may be assessed a wayward company, and some of these penalties, including criminal convictions, may also be asserted against the individual officers and directors of a company. Due to the substantial risks associated with such violations, sophisticated investors and potential acquirors will focus a great deal of attention on the employment practices and compensation arrangements of a company before they engage in a transaction, and problems in this area of a diligence review are one of the few items that have the potential of killing, or at least substantially delaying, a deal.

Employee or Independent Contractor

One of the most common problems start-up companies encounter is the characterization of individuals working for the company. Invariably, early stage companies treat workers as consultants (or independent contractors), and thereby try to avoid setting up payroll and complying with withholding and other federal and state obligations. Although state law varies on this issue, there are some common criteria which, if present, will usually be found to define an employer – employee relationship, the most common of which include: the company controlling the time, place and manner of worker performance; the company furnishing the worker’s tools and supplies; the existence of company provided training; and the worker’s integration in the operation and systems of the company. Failure to properly characterize an individual may result in substantial penalties. The taxing authorities may claim unpaid withholding, plus penalties and interest on the unpaid amount, the unemployment division may seek to collect its share of unpaid insurance or other fees, and the employee may become entitled to demand overtime pay and benefits.

Exempt or Non-exempt

Many companies that do properly treat an individual as an employee, wrongly classify that individual as an exempt, or salaried worker, and do not pay overtime. Federal and state laws dictate which employees may be classified as exempt. The danger here is not paying overtime to someone who should have been receiving it. The most common categories of exempt employees for white collar positions are professional, executive and high level administrative positions, but these broad categories belie a number of specific guidelines and even minimum salary requirements which must be satisfied in order to safely treat the employee as exempt. For example, under federal law, in order to qualify as an exempt “professional,” the employee must be primarily engaged in the performance of work requiring “knowledge of an advanced type in a field of science or learning acquired by a prolonged course of specialized intellectual instruction and study, as distinguished from a general academic education.”

Some employees who do not qualify for other white collar exemptions may fall under the “computer professional exemption.” An extension of the professional exemption, this exemption requires that the employee in question possess substantial computer training, experience and duties, and be performing tasks which are analytical or that relate to system design. Data entry employees, employees lacking substantial computer training or extensive computer experience and employees who perform such functions as help-desk support, for example, do not qualify for this exemption. There are similar criteria to satisfy the requirements for this exemption. For example, in order to qualify under the federal exemption, an employee paid on an hourly basis must earn a minimum of $27.63 per hour. Although states are free to pass their own, stricter requirements on top of the federal requirements, Maine, New Hampshire, Vermont and Massachusetts have not enacted their own computer professional exemptions. Significantly, California enacted a law last September requiring a minimum pay requirement of $41 per hour for hourly employees and $7,106.67 per month, or $85,280 annually for salaried employees.

The penalty for improperly categorizing an employee as exempt when he or she should be receiving overtime can be quite severe. If the error is found by government representatives during a Wage and Hour Audit and is found to be innocent in nature, back pay may be the sole liability for the company. However, if an employee discovers the misclassification, such employee may file a private lawsuit for back pay, liquidated damages, attorney’s fees and court costs. Employers who willfully or repeatedly violate the overtime pay requirements are subject to a civil fine of up to $1,000 for each violation, plus potential criminal penalties including fines up to $10,000 and imprisonment.

Commission Problems

Companies frequently find themselves in trouble with salespeople who have a large amount of their compensation paid in bonuses. It is incredible how many companies enter into commission – rich compensation arrangements without documenting the terms under which the employee is entitled to receive commissions and the details associated with the arrangements (defining eligible sales, treating returns and nonpayment issues, specifying the timing for payment, whether or not renewals are included and, if so, whether the employee must be at the company when a renewal is made, etc.). As commissions constitute wages, employees have the opportunity to involve governmental agencies, at no cost, to press the employees’ claims against the company, and the penalties can be extremely significant. Another overlooked element of a commission-rich compensation structure is the requirement to pay a minimum base salary to a salesperson that spends at least 20% of their time in the company’s office.

Options as Wages

One of the more interesting developments that bears watching relative to equity compensation is the growing number of former employees successfully suing their employers claiming that the termination of their employment wrongfully deprived them of benefits under unvested stock options. The claims are asserted in a variety of forms, but typically involve the concept of “fair dealing” and, not surprisingly, often involve facts where an employee was terminated just prior in time to a vesting milestone. A recent, unpublished, federal court opinion in the 9th Circuit construing Massachusetts law, Fleming v. Parametric Technology Corp., suggests that termination of employment just prior to a vesting milestone may violate the employer’s duty of good faith and fair dealing, on the theory that the employee had largely earned the benefit and the employer’s action would deprive the employee of that benefit. This rash of cases has raised questions as to whether the somewhat customary one year “cliff vesting” (where an option holder does not vest at all prior to the one year anniversary) is still a good idea, and some companies have begun to modify traditional vesting milestones so that options vest as frequently as monthly, in order to minimize the effect of a termination just prior to a significant milestone. Not surprisingly, many of these cases turn on the particular facts of the case, so it appears that if you wish to use traditional vesting milestones (annual or quarterly vesting), it is important that the vesting arrangement is clearly spelled out and, particularly with options granted contemporaneous with the hiring of an employee, the terms of the option be spelled out in advance. In this way, an employee will not be able to subsequently argue that the vesting arrangement was implemented after the employee had accepted the job, or other representations as to vesting were made and then breached.

Securities Laws

The issuance of shares by a company is always subject to federal and state securities laws, and entire books have been written about the application of such laws to compensatory stock programs. The consequences for failing to comply with such laws may subject a company and its officers and/or directors to criminal penalties, including jail, and lesser civil penalties including fines, a mandatory offer to buy back the issued shares from the recipients and a future prohibition against using certain exemptions from the securities laws registration requirements, resulting in the company being limited to certain methods of issuing securities in the future that consequently makes the capital raising process significantly more time consuming and expensive. Rule 701 under the federal Securities Act of 1933 (Securities Act), provides a safe harbor exemption from the registration requirements under the Securities Act for compensatory issuances of options or stock to individuals, but not legal entities, so long as the option or shares are issued pursuant to a written plan or agreement, and certain other conditions in the rule are satisfied. There are corresponding rules under many state laws.

Accounting Issues

The accounting treatment of equity compensation arrangements is also quite complex. Generally speaking, compensatory plans which provide for an option exercise price or stock purchase price equal to the fair market value of the shares at the date of grant will not require an accounting charge to earnings, even if there is subsequent appreciation in the value of the stock. This favorable accounting treatment is known as “fixed plan” treatment. If an equity compensation arrangement does not qualify for fixed plan treatment, however, it may require the company to take a charge against its earnings over the vesting period based on the actual and estimated value of the underlying stock. This can have a substantial adverse effect on the company’s financial statements. If a company issues a NQO or restricted stock with an exercise price or purchase price, respectively, substantially discounted below the fair market value of the shares as of the time of the grant, the company will likely have to take such a charge. A company may also be required to take a charge against earnings if it employs performance-based vesting milestones (i.e., those which are not strictly tied to the passage of time).

Noncompetition Agreements

The imposition of a noncompetition agreement for employees of technology companies is fairly customary. In fact, many sophisticated investors will insist upon such an agreement for at least all key employees and consultants as a condition of their investment (in addition to nondisclosure, assignment of inventions and other covenants). It is very important to understand that some states, such as California, prohibit or substantially limit the permissibility of noncompetition agreements, and that many other states’ courts are increasingly hostile to enforcing these agreements. If you wish to require an employee to sign a noncompetition agreement, the best practice is to clearly make that a condition of employment, so that the agreement is signed prior, or at least contemporaneous with, the commencement of employment. If you wish to obtain a noncompetition agreement from an existing employee, you would be well advised to provide some compensation to that employee in consideration for their agreement, such as the granting of stock options or the payment of cash. Although many attorneys take the view that the benefit of continued employment is adequate consideration, there are a growing number of cases where the threat of termination does not suffice. In fact, last December in California an appeals court found that the termination of an employee who refused to sign a noncompetition agreement constituted wrongful termination, and that the former employee could proceed with a lawsuit seeking damages.

Documenting the Relationship

Every company should have an established set of employment policies (including, as examples, sexual harassment and computer use) and documentation to promote uniform treatment and compliance with applicable laws. A standard letter conveying the terms of employment, typically describing the relationship as “at will,” should specify compensation and benefits, special working conditions and all pre-conditions to employment. It is good practice to require incoming employees to sign agreements containing covenants of nondisclosure and assignment of intellectual property rights and, if desired, noncompetition, in addition to certain other representations regarding their eligibility to work for the company free of other contractual or legal restrictions, on or prior to the first day of work, as a condition of employment. Sophisticated investors will also usually require this. New employees, and consultants working on a company’s premises, should also be required to sign an acknowledgement of receipt of the company’s policies.

Resources

It is critical to have a qualified group of professionals guiding a company in connection with the development of compensation programs and matters arising with respect to those programs. A company should have one person who is responsible for insuring compliance with applicable laws and understanding the company’s programs, even if the primary role of that person is to act as a liaison to the company’s outside advisors. A company’s lawyers and accountants should be experts in these issues because the ramifications of poor planning, implementation or legal compliance can be devastating to a business.

Obtaining good market intelligence is also critical in order to have an opportunity to land the prized candidate, and to keep your valuable employees. Periodic assessments should be part of a company’s standard operating procedure. Again, the company’s lawyers and accountants should be able to assist in this effort. There are any number of sources of data that will help you understand the market. PriceWaterhouseCoopers has a variety of detailed surveys on compensation in particular industries, including breakdowns in the software, telecom and e-commerce markets (which may be found by going to www.pwcglobal.com and searching for compensation surveys). There are also web sites, which provide compensation and benefits information for a variety of job classifications, including www.salary.com . Trade associations also can be a great source of similar information.

With this background, and the assistance of qualified advisors to insure that your desired compensation package will work as you anticipate, you should be ready to land that star candidate. Good luck!