Equity Compensation Structures for Venture-Backed Companies Post-Enron, Post-Market Bust (Part 2)

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

Last week, the authors looked at structuring equity compensation in the down roiund era that the vc and private equity world cant seem to beat. This week, we look at 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.

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?

On the accounting side, there has been one dramatic change - the demise of pooling-of-interests accounting. Perhaps more importantly, the financial community is increasingly beginning to ignore or discount non-cash equity compensation expense in measuring a company's performance.

In poolings, the financial statements of the acquired company were combined with those of the acquiror going backward and forward. Compensation expense from "non-qualifying" options would decrease the acquiror's historical and future earnings. Under currently mandated purchase accounting, the acquired company's historical financial statements are not combined with the acquiror's financials other than in possible pro forma disclosures in footnotes. This suggests that one important cornerstone of the existing compensation structures no longer applies - to optimize the accounting treatment of the private company's equity compensation in order to minimize any adverse effects on the acquiror's "pooled" historical financial statements.

Adverse accounting treatment of compensation at a private company may have an adverse impact on the acquiror's financial statements post-acquisition in the case of unvested options. Under purchase accounting, the cost of assuming vested options is treated as part of the purchase price with no negative effects on earnings.

Similarly, variable expense related to performance-based options does not affect the acquiror's income statement to the extent the performance milestones have been achieved or, as often happens at least for management, the vesting of the options accelerates on the acquisition under the terms of the original option grant. An expense issue remains, however, with respect to unvested, non-accelerated options. The "intrinsic value" of these options at the date of acquisition would be amortized into the acquiror's financial statements as compensation expense over the remaining vesting period. We suggest that the impact of this one circumstance is likely to be minimal because, in addition to the acceleration of many options at acquisition, the successful private company on acquisition most likely would have achieved the performance measures specified in any performance-based option grants. Also, the intrinsic value for "qualifying options" may not be significantly less than for more creative structures.

There is also an increasing change in the perception of the relevance of non-cash compensation expense for "non-qualifying" options. Post-Enron, incentive-based equity, or at least the favorable accounting for it, has taken on something of a public taint. A number of prominent public companies are electing to treat options under an alternative accounting treatment where the fair value of the option at the date of grant is amortized to earnings over the vesting or performance period. The advantage of this model for venture-backed companies is that such values exclude a volatility factor and so result in a lower valuation of the options than would be the case for a public company. This treatment also minimizes the compensation cost volatility associated with variable option grants under the existing prevalent accounting model which arises from changes in the value of the issuer's equity prior to the vesting of such variable options. These considerations make the granting of performance-based options an attractive alternative for companies electing this accounting treatment.

The new accounting regime and new perceptions of the decreasing relevance of non-cash compensation expense, as well as the real-world impracticalities of ISOs, have created an opportunity, particularly for private companies, to revisit the desirability of equity structures that maximize business objectives, but are less sensitive to accounting and tax considerations.

There is another unrelated factor at work here in the current financing "depression" in the private venture-backed technology company market. Dilutive or "down round" financings have become prevalent. In addition, new deal structures, such as preferred stock with multiple liquidation preferences, have significantly dimmed the prospect of common equity holders ever realizing a significant gain. In other words, as a result of greatly reduced enterprise valuations, the required payouts to preferred stock investors resulting from large prior investments and/or multiple liquidation preferences renders unlikely that the common equity will ever acquire significant value. Astute entrepreneurs and professional managers are increasingly seeking different forms of protection from these down scenarios from the company and its venture investors. For these economic reasons, accounting and tax considerations increasingly are taking a back seat in structuring equity compensation, at least for senior managers.

Among the structures that are beginning to emerge are the following:

Performance-based common stock options. Companies are granting common stock options where the options vest based on the achievement of individual or broader-based performance goals. If the goal is reached by a certain date, a portion of the option vests; if the goal is not reached by a specified date, a portion of the option is forfeited. For example, a portion of the option vests when a software developer successfully completes development of a particular module by a certain date, with or without additional vesting for early achievement. Another example is the non-qualified option where the number of shares varies depending on the return outside investors receive on their investment in a liquidity event. In this case, the option might have time-based vesting milestones, but once vested, the option could be exercised posttermination and only on a liquidity event. In an IPO, the option might vest six months after the offering, imposing a built-in lock-up agreement. Thirdly, vesting schedules or the number of shares subject to an option can be made dependent on achievement of company-wide milestones, or a combination of individual and company milestones, which may be dependent on timeframes as well.

Equity-based incentives with dilution protection devices. In the case of negotiated equity grants, the employee could be given a deeply discounted option that vests on performance milestones, so that the employee potentially is rewarded for individual performance even though the equity has not increased in value due to market conditions or other factors not related to individual performance. Employees can be given contractual "make-whole" guarantees, such that on an acquisition, the employee would be entitled to a cash (or stock) payment equal to the difference between the amount actually realized by the employee and the amount that would have been received on the hypothetical basis that all convertible senior securities had been converted into common stock. Alternatively or in addition, an option might specify that the number of shares subject to the option could not go below a specified percentage of the fully diluted equity compensation. A variation on this theme, frequently used by universities that license technology to early stage companies, is to specify that the option represents the right to buy a specified percentage of the fully diluted equity after the company has raised a specified amount of outside capital. Another technique being used is to grant options to buy preferred stock, but that doesn't afford much protection against subsequent down rounds, or subsequent rounds with onerous terms.

Cash incentive payments. Structures that do not utilize restricted stock or stock options are even more flexible and avoid the risk of the dilution of equity-based compensation. A bonus pool could be established payable in cash on an acquisition equal to a specified percentage of the amounts payable to investors in an acquisition, or after the investors have received their original investment together with a specified return. An IPO could be treated as a deemed acquisition of the company at its pre-money valuation, with the employee being paid in stock valued at the IPO price; such a payout would be a taxable event and some liquidity for the equity would be necessary. A similar structure would be for the employee to be contractually entitled to a cash payment equivalent to a "carried interest" on the investors' returns. (There is, of course, a certain irony in that structure.) To the extent such models are contingent upon a specific contingent event outside of the employee's control, they may not have any current accounting implications until such time as the contingency is resolved; this charge would be "washed" in the purchase accounting for the acquisition.

Each of these alternatives has its own advantages and disadvantages. We expect, however, that given the trend away from rigid adherence to historical structures with favorable accounting consequences or perceived tax benefits, a number of these structures will become increasingly commonplace.

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