five key steps to a successful private company equity plan · from determining the right...

Five Key Steps to a Successful Private Company Equity Plan

© 2015 Certent l All Rights Reserved l Five Key Steps to a Successful Private Company Equity Plan 2

In order to compete in today’s market, more and more private companies are developing equity award programs to attract top talent. There are a few critical first steps to designing a comprehensive and successful equity program. Considering all the key stakeholders across departments will ensure an open line of communication. Equity compensation touches many job functions, and it is crucial to gather everyone from the beginning. You will also need to decide who will be eligible for the equity program, executive-only or broad-based, and what percentage of shares the company will dedicate to the equity plan. There are a myriad of award types that you can offer to your participant pool, all with specific accounting and administrative implications. The day-to day management of an equity program is complex, and the tools you use to maintain the administrative elements and financial reporting can make all the difference. There are also a few key considerations to selecting the right system of record for your company. From determining the right stakeholders to establishing key design factors, this white paper will provide you with practical advice for creating a solid stock plan foundation.

Introduction

5 Key Elements to a Successful Plan

Assemble the Dream Team

Determine eligibility

Establish equity percentages

Choose appropriate award vehicles

Evaluate a system of record»»»»»

Legal Counsel Regulatory ConcernsDocument DraftingPlan InterpretationScope/breadth of plan


There are numerous departments and job functions across a company that are directly or indirectly involved in stock plan creation and management. Before you can accurately create a plan and execute, it is essential to gather each stakeholder in the process so they can bring their individual expertise and contribute to the plan design. If you do not include members across the entire organization, you may find yourself wasting precious time and energy designing a plan that is not feasible due to regulatory, accounting or administrative hurdles. Among the roles you should consider in your Dream Team are CFO, Legal Counsel (inside or outside), Accounting, Human Resources, the Board of Directors (or Compensation Committee) and an outside Compensation Consultant. Depending on the scope of your specific organization, the roles and duties will likely vary, but for most this is a good place to start.

There are lots of decisions to make – Who will be eligible? How much equity will the company give out? What award types will the company use? How will you track the equity program? Start by clearly defining goals, and include all key stakeholders to facilitate decision making on each of these key factors.

What Does the Team Look Like?

CFO Tax ImplicationsFinancial ReportingAccounting

Comp Consultant PlanningResearchStrategy

HR/Payroll Plan ImplementationPlan AdministrationPlan Document InterpretationEmployee CommunicationsVendor Relationships

BoD/Comp Committee Shareholder InterestsApproval

Accounting/Tax Department AccountingFinancial ReportingExpenseTax Implications

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In building your plan, consider which employees will be eligible to receive equity. Are you planning to roll out a broad-based plan where all employees may take part? Or an executive-only plan focusing on senior management within the company? Both methods of share allocation have their pros and cons and distinct differences when it comes to employee perception.

Who should be Eligible?2

A broad-based plan is a great way to create an ownership culture. By giving shares to everyone, employee interests are aligned with the company goals. As the company continues to grow and succeed, the employee shareholders see a direct return on their efforts.

The primary advantage to a broad-based program comes in the form of retention and recruiting. Private companies can be at a disadvantage to public companies in attracting and retaining talent if equity is not offered alongside salary and bonus components. Broadening the participant pool can allow you to recruit talented employees at all levels of your organization and keep them longer; employees who participate in an equity plan are less likely to leave and forfeit their awards.However, in considering a broad-based plan, the lack of liquidity can be a concern. The liquidity of equity awards in a private company is much less than that of a public company, since the stock does not have value in a public market.

Another concern of broad-based equity plans is that the shares reserved for and ultimately issued to employees under the plan reduce the percentage of the company owned by the existing, founding shareholders – a concept known as dilution. The more shares needed to fund the plan, the more dilution the existing shareholders suffer. Based on the funding and shareholder makeup of a particular organization, decisions will need to be made regarding acceptable levels of dilution.

Broad-Based Executive-Only

Executive-only incentive plans allow companies to use limited equity and focus those shares where they can make the most significant impact. It is essential to company growth and strategy to retain senior executives, as they can have a large influence on corporate performance. An executive-only plan can also be less of an administrative burden than a broad-based equity plan. Since there are fewer participants and grants to oversee in an executive-only plan, administration costs and resources are generally not stretched as thin. At private companies, there tend to be fewer resources for stock plan administration, and companies should consider the ongoing administrative burden when deciding how many employees to include.

Corporate culture is among the greatest concerns of an executive-only stock plan. With broad-based programs, all employees feel like a piece of the puzzle and benefit from a strong ownership culture. When only executives are granted equity that benefit quickly becomes an opportunity cost.

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When carving out a percentage of equity, companies should consider the type of plan, industry norms, company size and any exit strategies. There is no one-size-fits-all template, but below are a few benchmarks to consider. Ultimately each organization’s unique set of circumstances will inform the optimal course of action.

Historical averages will show that in executive-only plans, the median tends to be right around 10% of the company stock allocated for the equity plan. Of that, typically almost half is granted specifically to the CEO, while other senior officers make up between 1% and 2.5% each. Although this appears to be a reasonable starting point, a variety of factors can make the 10% standard a poor rule to live by. For starters, 10% of a company with a large valuation represents quite a bit more money than a company worth a fraction of that. Due to this disparity in company value, history dictates that larger, more valuable companies tend to issue a lower percentage of equity to their senior executives. On the contrary, smaller, more volatile companies must offer a comparatively higher percentage of the company to attract and retain key talent. Recruiting environment can also be a large factor in determining equity percentage, as the expectations differ from the Bay area to Boston.

In the realm of broad-based plans, historical norms have seen around 12% of the company’s equity granted to employees. The percentage depends greatly on industry. What may be typical for a life sciences company, may not be so for a technology, financial or industrial firm. Consider analyzing available data on public companies to gather benchmarks for your set of circumstances. If your company sees an IPO on the horizon, referencing public companies in the same sector should already be part of the conversation.

How Much is the Right Amount?3

Different types of awards carry different pros and cons. When designing an equity plan for your private company, it is essential to consider what equity vehicle or vehicles are right for your corporate structure and level of resources. There are a number of equity types, and this blueprint explores three popular choices: stock options, restricted awards and phantom shares. (Note that this discussion is focused on corporations. For private limited liability companies, there is another type of common incentive, called a profits interest that is beyond our scope.)

What Type of Awards?4

Convey Ownership

FMV Valuation

Tax Timing

Phantom Income

EmployeePerception

Stock Options

✔

Company must appreciate for award to retain value

must exercise to own

At liquidity

Phantom Shares(Sale Bonus Plan)

✔

Not perceived as real equity, must wait for company sale

At liquidity

Restricted Stock (RSUs)

✔

✔

✔

Actual ownership, shares always worth something

At vesting


Stock Options

Restricted Stock/RSUs

Phantom Shares (Sale Bonus Plan)

As the name suggests, phantom shares do not involve actual shares, but are instead settled in cash. There are many types of phantom shares. One common type is tying the phantom shares to the sale of the company. At the time of sale of the company, the participant receives a percentage of cash proceeds based on the appreciation in the value since the time they received the award - effectively a bonus. Payment is always treated as ordinary income, leaving no room for capital gains under a phantom program. Employees must be with the company at the time of sale in order to see a return, which makes phantom shares a strong retention tool. Because of their less tangible nature, phantom shares do not align goals or create the same ownership culture as with other award vehicles.

Restricted stock is an award of actual shares subject to a vesting schedule. Restricted stock units (RSUs) are maintained as a bookkeeping account until vesting, when the actual shares are issued. Unlike options which require appreciation in the stock price in order to realize any value, restricted shares are typically worth something, even if the stock value goes down. The lack of an exercise price also yields a higher perceived value to the employee, due to a more tangible sense of ownership, and allows the company to deliver the same dollar value with less actual shares issued than an option award.

On the flip side, there are some vesting and tax considerations to consider. Depending on whether an 83(b) election is made, restricted stock is taxable at grant or upon vesting. An 83(b) election requires the employee to pay taxes up front, in hopes that the value goes up and they will avoid a higher tax at vest. If no 83(b) election is made, the employee will be taxed upon the vesting of the shares. Unlike options, which do not incur phantom tax, restricted shares do incur a tax liability that must be paid by the employee before the award can be cashed out. The company must also seek 409A valuation, just as with options.

Stock options are generally recognized and understood by employees. Because of their popularity, a less significant investment in educating employees may be required. Options are focused on stock price appreciation, which aligns well with the interests of the other shareholders. By also adding performance vesting into the mix, the option incentive can be concentrated not only on the passage of time, but company performance criteria as well. Another advantage of a stock option program is the potential to control the timing of a taxable event and the possibility to avoid tax consequences until a liquidity event occurs, thereby avoiding phantom tax concerns (i.e., delaying exercise until liquidity). There are a few challenges to offering stock options. First, option programs require a valuation of Fair Market Value (FMV) to determine the minimum exercise price, otherwise known as a 409A valuation. This can often be a show-stopper due to the cost and uncertainty of acquiring an outside valuation. Additionally, because most employees hold options until the liquidity event, perversely, it is often only ex-employees (who would otherwise forfeit the options) that tend to take advantage of capital gains treatment by exercising prior to liquidity. Certain participants may also find themselves subject to Alternative Minimum Tax (AMT) as a result of the spread realized on exercise.

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A recent survey conducted at Certent indicated that a majority of privately-held organizations choose to manage equity compensation using spreadsheets. For a start-up just beginning to issue equity, spreadsheets can be an effective way to manage your plan, but as your cap table and equity recipients expand, you will likely outgrow the functionality basic spreadsheets provide.

When evaluating systems of record to meet the needs of your organization, one of the most important elements is scale. A solution must allow your company to grow, and it must grow with you. Otherwise, you may find yourself held back by the limited functionality the system you choose can provide. With spreadsheets, there are only so many manageable fields an administrator can juggle while still maintaining the integrity of the database. What if there is an error in one of the formulas? How many participants/awards will be erroneously calculated using bad data?

Beyond scale and data quality, another major concern is visibility. Having an accurate and dependable audit trail can save money, headaches and late nights down the road – particularly when staffing changes occur. Similarly, ever-changing regulations can create challenges over time for those using a static system. A SaaS solution will be updated as rules and regulations change, and can provide peace of mind that your organization remains compliant.

And finally, be sure to consider data back up and safety. If your organization is leveraging spreadsheets, and those workbooks were somehow lost or erased, what would you do? A cloud-based solution eliminates the need to rely on your computer or server to retain your data – and safety measures have been set in place to ensure data is fully backed-up and encrypted.

When evaluating the right records system for your company, start with your end goal in mind. If your organization’s desire is to go public, keep in mind that some solutions cannot support that transition and you will need to migrate to a different platform. Consideration of the future of your equity plan and corporate goals will guide you towards the right solution for your company.

Where to Manage the Program?5


ConclusionEquity plan design is complex, and taking a step-by-step approach to laying the ground work will set you in the right direction. Gathering key stakeholders, deciding what level of employees will be eligible, determining the right percentage of equity to offer, assessing the right type of equity awards for your company, and selecting an appropriate records system are all crucial elements to focus on throughout the plan design process. A detailed plan will help you avoid any unforeseen administrative or accounting challenges. Find out more about equity plan management at www.certent.com.

Since 2002, Certent Inc. has been making it easier for companies to meet their financial compliance requirements. Certent’s user-friendly, web-based technology streamlines equity plan management, financial reporting for ASC718, and financial filings (in XBRL and HTML) with the U.S. SEC. With technology based on in-depth accounting expertise, an open ecosystem of industry partners, and an expert services organization focused on customer success, Certent has helped more than 1,300 companies worldwide innovate their financial compliance processes. For more information, visit www.certent.com.

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Contributing AuthorsMichael AndresinoPartnerPosternak Blankstein & Lund [email protected]

Denise Scoville-GlackinImplementation Manager, Certent Thought LeaderCertent, [email protected]

Matt WardManaging Director Board Advisory, [email protected]

five key steps to a successful private company equity plan · from determining the right...

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