How to Design Equity Compensation Plans. December 2, Ted D. Rosen Herrick, Feinstein LLP New York, New York

Transcription

1 How to Design Equity Compensation Plans December 2, 2008 Ted D. Rosen Herrick, Feinstein LLP New York, New York

2 Agenda Introduction to Types of Equity Compensation Plans- Ted D. Rosen, Counsel, Herrick, Feinstein LLP Tax Considerations for Equity Compensation Plans Fred Green, Counsel, Herrick, Feinstein, LLP Valuation Issues William Johnston, Managing Director, Empire Valuations What is Phantom Equity or Synthetic Stock? Gary Young, Partner, Herrick, Feinstein LLP Q & A

3 Choosing a Vehicle Stock options Restricted stock Phantom stock Stock appreciation rights Other approaches

4

5 Equity Compensation Plans Tax Consequences Fred Green Herrick, Feinstein LLP December 2nd, 2008 New York, NY

6 Equity Compensation When is it taxed? How much is taxed? What kind of tax is it? (capital gain vs. ordinary income)

7 Stock Options General Rules When is it taxed? No tax when the option is granted Income is recognized and taxes paid when the option is exercised How much is taxed? The difference between the fair market value of the stock on the date of exercise and the exercise price paid for the stock is recognized as income What kind of tax is it? Ordinary income Employer gets a corresponding tax deduction and has an obligation to withhold

8 Incentive (Qualified) Stock Options When is it taxed? No tax when the option is granted No tax when the option is exercised Taxed when the stock is sold; provided that the recipient sells the stock more than 2 years after the option is granted and more than 1 year after the option is exercised How much is taxed? The difference between the proceeds received upon the sale of the stock and the exercise price paid for the stock is recognized as income What kind of tax is it? Long term capital gain Employer gets no corresponding tax deduction

9 Stock Appreciation Rights (SARs) When is it taxed? No tax when the SAR is granted Income is recognized and taxes paid when the SAR is exercised How much is taxed? The difference between the fair market value of the stock on the date of exercise and the base value of the SAR is paid upon exercise of the SAR and recognized as income What kind of tax is it? Ordinary income Employer gets a corresponding tax deduction and has an obligation to withhold

10 Restricted Stock - General Rules When is it taxed? No tax when the restricted stock is granted Income is recognized and taxes paid when the restricted stock vests How much is taxed? The fair market value of the stock on the date the restricted stock vests (is no longer subject to a risk of forfeiture) is recognized as income What kind of tax is it? Ordinary income Employer gets a corresponding tax deduction and has an obligation to withhold

11 Section 83(b) Election for Restricted Stock Recipient of restricted stock must make election within 30 days after the grant of the restricted stock When is it taxed? Income is recognized and taxes paid when the restricted stock is granted How much is taxed? The fair market value of the stock on the date the restricted stock is granted is recognized as income What kind of tax is it? Ordinary income Employer gets a corresponding tax deduction and has an obligation to withhold

12 WARNING SECTION 409A OF THE INTERNAL REVENUE CODE MAY CHANGE THE TAX RESULTS

13 What is Section 409A? Detailed requirements for non-qualified deferred compensation plans including rules limiting when such deferred compensation can be paid. If you fail to comply with the requirements of Section 409A: The recipient must recognize the income when he has a legally binding right (i.e., vests) in the deferred compensation (without regard to when the compensation is paid) The recipient is subject to a 20% penalty tax and interest on the deferred compensation

14 How Are Equity Compensation Plans Treated Under Section 409A? So long as the exercise price of an option or the base value of an SAR is equal to or greater than the fair market value of the stock on the date of grant of the option or SAR, then the option or SAR is excluded from coverage under Section 409A; the compensation to the recipient must be based solely on the appreciation in the value of the stock If the exercise price of an option or the base value of an SAR is less than the fair market value of the stock on the date of grant, then the option or SAR is treated as a form of deferred compensation and subject to Section 409A Restricted stock that is subject to a substantial risk of forfeiture is not subject to Section 409A

15 Equity Compensations for Partnerships and LLCs Profits Interests - An interest will qualify as a profits interest if, on the date of grant, the interest would not be entitled to a share of the proceeds if the entity s assets were sold at fair market value and the proceeds were distributed in a complete liquidation There is no taxable income upon the receipt of a profits interest and no taxable income when the profits interest vests

16 Valuation Key Considerations PRESENTATION BY: William A. Johnston, ASA Managing Director December 2, 2008 Herrick, Feinstein LLP New York, New York

17 Common Errors Use of Very Low Values per Share with No Supporting Analysis/Thought Process Use of Rules of Thumb Using Market Multiples Inappropriately Treating All Shares Equally When Have Different Equity Classes 10:1 Ratio (Per Share Value of Preferred to Common) Current Value Method (Total Equity Value Less Liquidation Preference = Common Value)

18 Information Needed for Valuation Projections (unless revenue/earnings are stable) Historical Financial Statements Shareholder Agreements, By-laws etc. that Outline Attributes of Equity Securities Details on Arrangements that Might not be at Market Rates Officer Compensation Building Rented from Related Party Information on company Customers (concentration, retention rate, etc.) Competitors Key people (and risks related to) Ownership/Capital Structure Etc.

19 General Methodologies Discounted Cash Flow Develop Projected Free Cash Flows for Business Discount Projected Free Cash Flows to a Present Value Necessary for Growth Companies or Companies That are not Profitable Guideline Company/Transactions Looks at Publicly Traded Companies or Recently Acquired Companies Apply Guideline Company Financial Multiples to Subject Company Most Common Multiples are EBITDA and Earnings Based (or Revenue Based if not Profitable) Most Useful with Good Comparables and Stable Performance Net Asset Value Looks at Value if Assets Sold in a Liquidation Scenario Often Only Used if Liquidation Likely or Highest/Best Value using this method

20 Key Valuation Considerations Growth Prospects Potential Market Size Competitive Advantages/Disadvantages First Mover Status/Market Leader? Strength of Management Team Proven Track Record? Risks in Achieving Projected Performance Company Size and Concentration Risk (Customers, Mgmt, Etc.)

21 Assessing Projections How do Projected Figures Compare to Historical Performance? If Improved Growth/Margins Projected, Why? Does it Make Sense for Both Growth and Margins to Improve? Corroborate through Industry Data on Typical Growth/Profit Margins If New Projects Expected, what is Past Track Record with Successfully Implementing New Projects?

22 Assessing Market Multiples Key Factors That Influence Market Multiples: Size Growth Prospects Profitability Capital Structure (e.g., effect of large cash reserves or large levels of debt) Normalization Adjustments Need to be Made to Measures Used for Non-Recurring/Extraordinary Items

23 Equity Compensation Plans Phantom Stocks Gary Young Herrick, Feinstein LLP December 2 nd, 2008 New York, NY

24 Two Important Principles: No good deed goes unpunished Success in life and business is about risk management and the art of taking risks What are executive compensation risks?

25 Why Phantom or Synthetic Stock? Create future expectation without present cost Instill entrepreneurial spirit in your employees Encourage productivity and loyalty Minority shareholders have rights Deferred compensation arrangement A contractual employee benefit Golden handcuff component

26 What is Phantom Stock? Performance-based compensation program Contingent right to share increases in value Unsecured promise to pay Multi-year performance period Usually settled in cash Typically reflects underlying actual stock value IRC 409A defines three key elements of non-qualified deferred compensation : Deferred compensation Plan must be in writing Substantial risk of forfeiture

27 How is Phantom Stock Different From Stock Plans? No investment by employee No stock certificates issued No legal equity ownership No voting rights exist Dividend equivalents rarely provided Accounting and tax treatment differ significantly Greatest advantage is flexibility

28 Typical Phantom Plan Operation Value formula determined Target compensation level established Phantom shares/units awarded at beginning of period Initial value zero (appreciation plan) or estimated FMV (value plan) Payment at end of fixed performance period

29 Technical Plan Design: Performance Measurement Actual equity value Market value Private transactions Estimated equity value Formal appraisal Formula Determinants of equity value Revenue growth Profit Return on investment Drivers of equity value Unit volume Customer base Cycle time

30 Traditional Plan Design: Vesting and Exercise Usually time-based vesting Incremental vesting Cliff vesting May be performance-accelerated May be event-triggered Primarily end-of-cycle payouts Lump sum Stream of payments

31 Regulatory Considerations Rule 701 exemption under SEC rules ERISA Title I IRC Section 409A The American Jobs Creation Act All NQDC arrangements must follow Section 409A unless specifically exempted The new rules don t cover certain things NQDC plan distributions are permitted only in certain events Significant penalties for noncompliance Substantial risk of forfeiture Short-term deferral

32 Regulatory Considerations (cont.) Under new rules of Section 409A: NQDC plan distributions are permitted only in the event of: Separation from service Disability Death Specified time or fixed schedule Change in employer control Exceptions to every rule Participant waiver or acceleration Amounts under $10,000 Employment taxes Participant s election to defer compensation must be made no later than the end of the preceding tax year

33 Equity Compensation Plans Fred Green Ted Rosen Gary Young William Johnston Herrick, Feinstein LLP Herrick, Feinstein LLP Herrick, Feinstein LLP Empire Valuation (212) (212) (973) Consultants, LLC (212)