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Equity Compensation Plans

Equity compensation is non-cash, long-term incentive compensation that represents ownership interest in

a company. The two most common forms of equity compensation are stock options and restricted stock.Companies use equity compensation to reward their executives in order to:

Align executive and stakeholder interests

Attract, motivate and retain talent Promote capital accumulation

Equity compensation encourages executives to develop stakeholder mentality, which, in turn, encourages

company-focused decision-making on the part of executives.

CRI has designed equity compensation plans for companies across various industries. Depending on the

companys goals and objectives, equity plans can include:

Start-up technology companies often have difficulty recruiting and retaining talented employees.

These companies need to attract high quality employees to build their businesses; however, theyoften lack the financial resources to offer their employees competitive salaries. One way to help

level the compensation playing field between start-ups and established companies is with equity

compensation.

Equity compensation is non-cash compensation that represents an ownership interest in the

company. The two most common forms of equity compensation are stock options and restrictedstock. Due to the variety of legal, accounting, and tax issues that are involved with equity

compensation, proper planning is critical. Therefore, a company should seek legal and

accounting advice before implementing an equity compensation plan.

A stock option is a right to purchase shares of a companys stock at a predetermined price, which

is referred to as the exercise price. The right to exercise the option and purchase shares of acompanys stock generally accrues, or "vests," over a period of time. The vesting of options over

time creates an incentive for the employee to remain with the company to build its value. Option

holders are not stockholders and thus are not entitled to vote their option shares or otherwise

exercise any other rights of stockholders. All or a portion of the vesting of options often

accelerates upon the sale of the company, unless the buyer assumes the options under its plan.Conversely, if an employee leaves the company, the vesting of stock options ceases, and the

employee usually has a limited period of time to exercise the options that were vested on theemployment termination date.

There are two types of stock options: incentive stock options ("ISOs") and non-qualified stockoptions ("NQSOs"). In the case of ISOs, and generally in the case of NQSOs, there is no tax to

the option holder when the option is granted or when the option vests. The crucial distinction


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between ISOs and NQSOs is when the option is exercised. Generally, there is no tax to the

option holder when ISOs are exercised. (However, the option holder may be subject to

alternative minimum tax when ISOs are exercised.) When NQSOs are exercised, the optionholder is subject to ordinary income tax on the difference between the exercise price and the fair

market value of the stock on the date of exercise. The option holder is subject to capital gains tax

on the sale of the stock that was purchased upon the exercise of ISOs and NQSOs. This tax is onthe difference between the sales price and, in the case of ISOs the exercise price, and in the caseof NQSOs the fair market value of the stock on the date of exercise.

Under the Internal Revenue Code, a stock option must satisfy several criteria to qualify as an

ISO. Principal among these is that ISOs may be granted to employees only, and the exercise

price of ISOs must be equal to or greater than the stocks fair market value on the grant date.

NQSOs may be granted to non-employees, such as outside directors or advisors. The exerciseprice of NQSOs may also be less than the stocks fair market value on the grant date.

While stock options are appropriate for most employees, a companys founders generally

demand the voting and other rights of stockholders. However, the founders may desire to ensurethat the stock owned by all of the founders is at risk and thus subject to forfeiture if a founder

leaves the company. This motivates all the founders to work hard to build the companys value,and if the stock of a departing founder is forfeited, it can be used to hire a replacement thusminimizing the dilution to the remaining founders. In addition, investors may wish to ensure that

the founders are motivated to remain with the company to build its value. Restricted stock fulfills

these objectives and is often used as a form of equity compensation for founders.

Unlike the grant of stock options, the grant of restricted stock is the issuance of shares of the

companys stock. A holder of restricted stock can vote the shares at stockholdermeetings andhas all of the other rights of a stockholder under applicable corporate law.

Restricted stock is generally subject to a repurchase right that allows the company to repurchasea portion of the founders stock if his or her employment is terminated by the company for cause,

or if the founder voluntarily resigns within a certain period of time. This repurchase right lapses

over time, freeing the stock of the restrictions in much the same way that stock options aresubject to a vesting schedule.

The founder is subject to ordinary income tax as the restrictions lapse in an amount equal todifference between the purchase price of the shares and the fair market value of the stock at the

time the repurchase restrictions lapse. However, the founder can file a "Section 83(b) Election"

with the IRS within 30 days of the grant of the restricted stock to accelerate this tax to the grant

date. If this election is made the founder is subject to ordinary income tax upon the grant of therestricted stock equal to the fair market value of the stock on the grant date. In either case, the

founder is subject to capital gains tax when the stock is sold.

The two most common forms of equity compensation, stock options and restricted stock, serve

similar, yet different, purposes in structuring a companys compensation plan. Proper use of

equity compensation is important in building a start-up company as it helps ensure the hiring,motivation, and retention of quality employees.


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This article was published in the May 2001 issue of the Triangle TechJournal.


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The Basics of Equity Compensatio


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