Equity Compensation Structures for Venture-Backed Companies Post-Enron, Post-Market Bust

Edwin Miller (Morse, Barnes-Brown & Pendleton) and Christopher Lindop (Ernst & Young)

Equity compensation structures at venture-backed start-ups and other private companies have followed a standard pattern for many years - restricted common stock or time-vested common stock options. Historically, there have been three principal structuring considerations for employee equity compensation: business incentives, accounting impact and tax minimization. Although there have been significant accounting changes over the last couple of years that affect equity compensation, as well as changes in market perception relating to non-cash compensation, there has been little change in equity compensation structures. In addition, recent experience has created an increasing awareness on the part of sophisticated entrepreneurs and managers of the potential adverse impact on their equity from down round pricing and deal structures such as multiple liquidation preferences.

Companies and their employees are beginning to explore alternative structures that afford some protection from these events. Among these structures are: performancebased option vesting tied to achievement of individual or company-wide goals; options where the number of shares varies depending on the return outside investors receive on their investment in a liquidity event; "make-whole" guarantees entitling the employee to a cash payment on a liquidity event hypothetically linked to a deemed conversion of preferred equity, with or without a minimum percentage equity guarantee; options on preferred stock; and acquisition/IPO cash bonus pools.

Start-ups typically issue "restricted stock" to founders and to early-stage employees until the stock becomes too expensive for an employee to purchase because of valuations established by venture financings. Restricted stock is preferable to options from the employee's viewpoint since the employee will receive long-term capital gain treatment on a liquidity event if holding period requirements are met. In order to align the employee's incentives to the needs of the business, restricted stock typically has "golden handcuff" vesting provisions - unvested stock is forfeited back to the company at cost upon termination, with vesting occurring in increments over three or four years. For accounting purposes, because the stock is purchased at "fair market value", there is no charge to earnings if vesting is solely time-based and the number of shares is fixed.

After the company receives its first round of convertible preferred stock financing, the common stock typically is valued at a steep discount to the preferred stock price. Even so, the purchase price for restricted stock may be too high. The employee might be permitted to purchase the stock with a promissory note, but there are undesirable consequences to that structure, including the repayment risk in a "downround" (or worse) scenario. Because of these complications, post-financing incentive equity often takes the form of stock options that qualify for so called "fixed accounting."

Stock options can be structured for favorable accounting treatment (i.e., no compensation expense) if they are for a fixed number of shares with a fixed exercise price equal to fair market value of the underlying common stock at grant, and are solely time-vested (as opposed to performance-vested). One structure called a TARSAP mixes performance and time-vesting, but is rarely used due to accounting uncertainties. For tax purposes, if the options are at fair market value and meet certain other requirements of the tax code, they can also be granted as incentive stock options (ISOs). With an ISO, there is no tax or withholding on exercise and if a sufficient holding period is met after exercise, the spread is converted into long-term capital gain.

So what's wrong with this picture?

This question can be put a different way - if accounting and tax considerations were completely irrelevant, how would equity compensation be structured? We suggest that the structures would look a lot different. Further, although tax and accounting considerations are still relevant, we suggest that they may be increasingly less relevant in the post-Enron environment, thus permitting a fresh look at equity structures.

We suggest that the fixed number of shares, time-vested structure for restricted stock and stock options is not optimal from a business point of view. Certainly, it is not optimal in all cases. The business purpose of equity grants is to align the interests of the employee with those of other shareholders. The current accounting rules favor companies that grant options that vest with tenure over companies that grant options that vest based on performance. The employee should be incentivized to be as productive as possible as quickly as possible, not just productive enough to not be fired. Also treated adversely are structures which vary the amount of equity or the price of the grant based on performance or on external equity indexes. Structures with a fixed exercise price below market at date of grant and with time vesting are accounted for with a fixed charge to earnings over the vesting period. Structures where the price varies, or the number of shares varies other than by time vesting, result in a variable charge to earnings measured by changes in the value of the employer's equity over the vesting period. This treatment is particularly troublesome given that there is an open-ended charge to earnings.

As for tax, if the employee is granted an option that is not an ISO (i.e., a "nonqualified option"), the employee recognizes taxable income on the spread at exercise, which in the case of a private company, is not mitigated by the ability to do a simultaneous exercise and sale into the public markets. In reality, even employees who hold ISOs rarely time their exercises and sales to achieve long-term capital gain treatment. In addition, ISOs may create alternative minimum tax problems.

ISOs do have one significant advantage - there is no tax due on exercise, which is particularly useful to a departing employee, who typically must exercise vested options within a short time window after termination. The limited exercise period is not a requirement for an option to be an ISO at grant; however, if the option permits exercise beyond the specified tax-mandated post-termination exercise period, the option is automatically converted into a non-qualified option after that period.

Our thesis as to the new relevance of unconventional structures is simple: ISOs rarely result in long-term capital gain; non-cash accounting charges are irrelevant to a private company; changes in accounting principles have significantly reduced the impact of non-cash compensation charges in an acquisition; and, lastly, even for public companies, non-cash compensation charges increasingly are becoming irrelevant.

Therefore, why not structure employee equity to maximize business incentives? For private companies, accounting measures of performance are not what drives valuations. cash flow and the promise of future financial performance are the real performance measures. Why then are equity grants structured around accounting considerations and not business incentives in private companies? The reason is the anticipated relevance of GAAP performance in an IPO or an acquisition - that is, even if non-cash earnings charges are unimportant for a private company, the impact that the historical financial statements will have on valuations in an acquisition or an IPO is relevant.

For the vast majority of start-ups, the exit strategy is a sale to a strategic buyer rather than an IPO. This trend is being reinforced in our public capital markets where the economics, market mechanisms and the diminished interests of bankers, analysts and institutional investors render all but a handful of small public companies almost invisible. It is in the rarefied atmosphere of public equity where the highest sensitivity to the accounting for option grants exists - where the word "dilution" refers to a reduction in earnings per share rather than a shift in economic value of equity rights. Even there, the sensitivity is diminishing.

This has always been the case. What has changed?

Tune in next week for the conclusion of the article and to find out what has changed. The authors also discuss how astute entrepreneurs and professional managers are increasingly seeking different forms of protection from these down-round scenarios from the company and its venture investors.

¸ 2002 Edwin Miller and Christopher Lindop. All rights reserved.