ATTRACTING AND RETAINING KEY EMPLOYEES WHILE PROTECTING YOUR BUSINESS

Transcription

1 ATTRACTING AND RETAINING KEY EMPLOYEES WHILE PROTECTING YOUR BUSINESS Presented By Robert M. Hale Marian A. Tse H. David Henken Joseph A. Piacquad David A. Elchoness Sarah H. Minifie Copyright 2000 Labor and Employment Department, ERISA/Employee Benefits Department and the Private Equity Group of Goodwin, Procter & Hoar LLP. All rights reserved, including the right to reproduce these materials or portions thereof, in any form, except for the inclusion of brief quotations in a review. All inquiries should be addressed to Labor & Employment Law Department, Goodwin, Procter & Hoar LLP, Exchange Place, Boston, MA or visit our website at to access seminar materials presented today as well as materials from earlier seminars.

2 TABLE OF CONTENTS PAGE PART I EXECUTIVE COMPENSATION... 1 I. STOCK-BASED COMPENSATION... 1 A. INTRODUCTION... 1 B. INCENTIVE STOCK OPTIONS General Availability Tax Consequences to Employee Tax Consequences to Employer... 2 C. NON-QUALIFIED STOCK OPTIONS Availability Tax Consequences to Optionee Tax Consequences to Employer... 3 D. RESTRICTED STOCK Availability Tax Consequences to Recipient Tax Consequences to Employer... 4 E. ACCOUNTING TREATMENT OF OPTIONS General Fixed Accounting under APB Variable Accounting under APB Special Considerations under APB FAS 123 Applies to Options Granted to Consultants... 6 F. ACCOUNTING OF RESTRICTED STOCK General Fixed Accounting under APB Variable Accounting under APB FAS 123 Applies to Restricted Stock Granted to Consultants... 7 II. RECENT DEVELOPMENTS IN EXECUTIVE COMPENSATION... 7 A. VESTING TREND... 7 B. BROADER OPTION PARTICIPATION AND LARGER EQUITY POOLS Broad-Based Plans Equity Pools... 8 C. STOCK PURCHASE LOANS... 8 D. FORFEITABLE STOCK DEFERRAL PREMIUM... 9 E. TRANSFERABLE OPTIONS Overview Gift Tax Consideration Income Tax Consequences (i)

3 F. REPRICING UNDERWATER OPTIONS Overview Corporate Governance Designing the Option Repricing Program Proxy Disclosure Accounting Considerations III. TREATMENT OF EQUITY UPON SALE OF COMPANY A. OVERVIEW B. FULL ACCELERATION VS. PARTIAL ACCELERATION C. BUSINESS CONCERNS D. ACCOUNTING CONSIDERATIONS Purchase Accounting Pooling of Interests Accounting E. TAX CONSIDERATIONS IV. EMPLOYER PROTECTIVE PROVISIONS IN EQUITY COMPENSATION A. LIMITED WINDOW TO EXERCISE POST-TERMINATION B. REPURCHASE RIGHTS C. RIGHT OF FIRST REFUSAL D. DRAG ALONG RIGHTS E. NON-VOTING SECURITIES F. OPTION CLAWBACKS V. GOLDEN PARACHUTE RULES A. OVERVIEW B. PARACHUTE PAYMENT AND EXCISE TAX Three-Times Rule Types of Parachute Payment C. STRATEGIES REGARDING EXCISE TAX General Tax Gross-Up Safe Harbor Cap Payment of Highest Amount With or Without Cap VI. COMPENSATION DEDUCTION CAP UNDER CODE SECTION 162(M) A. GENERAL Publicly Held Corporation Covered Employees Exception for Performance-Based Compensation B. SPECIAL RULE FOR STOCK OPTIONS Performance-Based Compensation (i) ii

4 PART II DOCUMENTING THE EMPLOYMENT RELATIONSHIP I. OFFER LETTERS AND TERM SHEETS II. EMPLOYMENT AGREEMENTS A. ADVANTAGES AND DISADVANTAGES OF EMPLOYMENT AGREEMENTS Advantages Disadvantages and Words of Caution B. TERMINATION PROVISIONS Standards Severance Period Release III. RESTRICTIVE COVENANTS A. COVENANTS NOT TO COMPETE Goodwill Trade Secrets and Confidential Information Reasonableness of Noncompetition Covenant Significant State Differences Forfeiture for Competition B. NONSOLICITATION OF CUSTOMERS C. NONSOLICITATION OF EMPLOYEES (A/K/A ANTI-RAIDING) IV. PROTECTION OF CONFIDENTIAL INFORMATION & TRADE SECRETS.. 45 A. COMMON LAW AND STATUTORY PROTECTIONS B CONFIDENTIALITY AGREEMENTS V. ASSIGNMENT OF INVENTION RIGHTS A. COMMON LAW RIGHTS Implied Assignment -- Hired to Invent Implied Assignment -- Fiduciary Duties Shop Rights B. ASSIGNMENT AGREEMENTS Limits on Agreements Disclosure of Limits VI. RECENT LEGAL CHANGES WITH RESPECT TO EMPLOYMENT-RELATED VISAS (i) iii

5 ATTRACTING AND RETAINING KEY EMPLOYEES WHILE PROTECTING YOUR BUSINESS PART I EXECUTIVE COMPENSATION I. STOCK-BASED COMPENSATION A. Introduction Companies often use stock-based compensation to incentivize their executives. The types of stock-based compensation most frequently used include stock options (both incentive and non-qualified) and restricted stock. In the case of public companies, the use of stock-based compensation must take into account a myriad of laws and requirements, including securities law considerations (registration, Section 16, proxy disclosure), tax considerations (tax deductibility), accounting considerations (expense charges, dilution, etc.), stock exchange and NASDAQ requirements (shareholder approval), corporate law considerations (fiduciary duty, conflict-of-interest) and shareholder relations (dilution, excessive compensation, option repricing). In order to satisfy the foregoing requirements, equity grants to executive employees of public companies are typically made under a shareholder-approved plan by a compensation committee comprised of independent directors. B. Incentive Stock Options 1. General A stock option is a right to buy stock in the future, generally at a fixed price. There are two kinds of options, incentive stock options ( ISOs ) and nonqualified stock options ( NQOs ). ISOs are a creation of the tax code. If all the statutory requirements are met the optionee will receive favorable tax treatment. NQOs do not provide any special tax treatment to the recipient. 2. Availability ISOs may be granted only to employees. ISOs must be granted at fair market value or higher, and the maximum option term is ten years. In the case of ISOs granted to any 10 percent or greater shareholder, the exercise price must be at least 110 percent of fair market value and the maximum option term is five years. The maximum amount of ISOs that can vest in the same calendar year for any

6 individual is limited to $100,000. This is determined by multiplying the fair market value of the stock against the number of shares that are scheduled to vest in a year. Any option granted in excess of the $100,000 limitation, regardless of how denominated, will be non-qualified. 3. Tax Consequences to Employee There is no tax effect on the employee at the time of grant or vesting. Upon exercise of an ISO, there is no ordinary income to the employee, but the option spread is taken into account in calculating the employee's alternative minimum tax. (a) (b) When the employee sells the underlying stock, if the sale of the underlying stock occurs more than two years from the date of grant and more than one year from date of exercise, then the employee has long-term capital gains equal to the difference between sale price and exercise price. When the employee sells the underlying stock, if the sale occurs within two years from the date of grant or within one year from the date of exercise, the employee has (A) ordinary income equal to the spread (i.e., fair market value less exercise price) that existed at exercise, plus (B) capital gains (long or short term depending on the holding period of the underlying stock) equal to the difference between the sale price and fair market value of the stock at exercise. If the amount of sale is less than fair market value of the stock at exercise, then the amount of ordinary income is limited to the difference between the sale price and the exercise price. 4. Tax Consequences to Employer Subject to Section 162(m) of the Internal Revenue Code of 1986, as amended (the "Code"), the employer has a compensation deduction upon the sale of the underlying stock equal to the amount of ordinary income (if any) recognized by the optionee if the holding period set forth in Section 3(a) above is not met. The employer has no compensation deduction if the holding period is met. 2

7 C. Non-Qualified Stock Options 1. Availability NQOs can be granted to employees, outside directors and consultants. NQOs can be granted at or below fair market value. NQOs can be transferable to family members of the optionee. 2. Tax Consequences to Optionee There is no tax consequence to optionee at the time of grant or vesting except in very unusual circumstances. At the time of exercise, the optionee has ordinary income equal to the excess of fair market value of the stock over the exercise price. This amount is also subject to Social Security taxes. Upon sale of the stock, the optionee receives capital gain or loss treatment, which may be long term or short term, depending on the holding period of the stock. The optionee's basis is the exercise price plus the amount included in income upon exercise. 3. Tax Consequences to Employer Subject to Code Section 162(m), the employer has a compensation deduction upon option exercise equal to the amount of ordinary income recognized by the optionee. D. Restricted Stock 1. Availability Restricted stock can be granted to employees, outside directors and consultants. Except for payment of par value (a requirement of most state corporate laws), the employer may grant the stock outright or require a purchase price at less than fair market value. To earn true ownership of the stock, the recipient is usually required to fulfill vesting conditions that may be based on continuing employment over a period of years and/or achievement of preestablished performance goals. Restricted stock can deliver more value to the recipient and therefore is less dilutive to stockholders. During the vesting period, the stock is considered outstanding, and the recipient can receive dividends and exercise voting rights. 2. Tax Consequences to Recipient The recipient is taxed at ordinary income tax rates on the value of the stock at the time of vesting. Alternatively, the recipient may make a Section 83(b) 3

8 election within 30 days of grant to include in income the entire value of the restricted stock at the time of grant. Upon sale of stock, the recipient receives capital gain or loss treatment, which may be long term or short term, depending on the holding period. Any dividends paid while the stock is unvested are taxed as compensation income subject to withholding. Dividends paid with respect to vested stock are taxed as dividends and no tax withholding is required. 3. Tax Consequences to Employer Subject to Section 162(m) of the Code, the employer generally has a compensation deduction equal to the amount of ordinary income recognized by the recipient. The employer also has a compensation deduction equal to the amount of dividends paid with respect to non-vested restricted stock. E. Accounting Treatment of Options 1. General Options are accounted for under either (i) APB 25, which applies to options granted to employees and non-employee directors in their capacity as such or (ii) FAS 123, which applies to options granted to consultants and third parties other than employees and directors. Under APB 25, options receive fixed or variable accounting, with variable accounting based on the intrinsic value of the option, which essentially means the spread. Under FAS 123, options are accounted for using variable accounting based on fair value, which is determined using Black- Scholes or other valuation methodology. 2. Fixed Accounting under APB 25 (a) (b) (c) Generally, there is no compensation expense either at time of grant or upon vesting if the option grant is at fair market value and vesting is time-based (i.e., fixed). If the option grant is below fair market value, the discount is a compensation expense; the discount amount is fixed and determined at grant date and amortized over the fixed vesting period. Options with performance-based vesting will still be subject to fixed accounting if vesting will occur (even if the performance hurdles are not met) at the end of a fixed period, typically five to seven years. 4

9 3. Variable Accounting under APB 25 (a) (b) (c) Variable accounting applies if the award is not fixed in some manner; for example, if the price is not fixed or vesting is performance-based (e.g., only vests if revenue targets are achieved and not on a date certain). Compensation expense is based on intrinsic value as opposed to FAS 123 fair value. Variable accounting always results in compensation expense. This is determined by marking to market every quarter until option is exercised, or in some instances, when award becomes fixed. 4. Special Considerations under APB 25 (a) (b) (c) (d) (e) (f) Option repricing will result in variable accounting until option is exercised under APB 25. Any cancellation/regrant within six months will be deemed repricing. Use of promissory note with below market interest rate to pay exercise price will be deemed option repricing. Use of promissory note without full recourse to pay exercise price may raise similar issues and may be deemed repricing. Any modification to option terms (e.g., change in vesting, extension of post-termination exercise period, extension of term) can be considered a new grant for accounting purposes and will result in a new "measurement date." If on the new measurement date the exercise price is less than fair market value of the stock, the discount will be a charge to earnings under APB 25 fixed accounting. Business Combinations. i. In a purchase accounting transaction when options are exchanged for options issued by the acquiring company: 5

10 (A) (B) The fair value (i.e., Black-Scholes value) of vested options (including options that vest on the change in control) is included as part of the purchase price of the target. Unvested options also become part of the purchase price in an amount equal to their fair value. However, if continued service is required for vesting after the date of the acquisition, then the "intrinsic value" of the unvested options, i.e., the spread at the acquisition date, is allocated to unearned compensation cost and expenses over the remaining vesting period. Any compensation cost determined by its intrinsic value is deducted from the fair value of the unvested options in determining the allocation to the purchase price. ii. In a pooling of interests transaction, if the exchange of options does not increase the intrinsic value or the ratio of exercise price to market value, then no new measurement date will be required. 5. FAS 123 Applies to Options Granted to Consultants Fair value of options (determined on each vesting date) with respect to those options vesting as of such date will result in a charge to earnings. (a) (b) Fair value is determined using Black-Scholes or other binomial valuation method. Directors' grants can be subject to FAS 123 if granted for consulting services. F. Accounting of Restricted Stock 1. General As with options, APB 25 applies only to restricted stock granted to employees and non-employee directors. 6

11 2. Fixed Accounting under APB 25 If vesting is time-based and grantee pays full value, there is no compensation charge. (a) (b) If vesting is time-based, but grantee pays less than full value, the discount is a compensation expense; this amount is fixed and amortized over vesting period. Restricted stock with performance-based vesting will be subject to fixed accounting if vesting will occur at the end of a fixed period, typically five to seven years, even if performance goals are not met. This form of restricted stock is commonly known as TARSAPs. 3. Variable Accounting under APB 25 If vesting is performance-based, fair market value of stock at time of vesting, less purchase price, must be charged to earnings; interim estimates will likely be required. 4. FAS 123 Applies to Restricted Stock Granted to Consultants (a) The fair market value of the stock, at each vesting date, less purchase price, will be a charge to earnings. (b) Directors' grants can be subject to FAS 123 if granted for consulting service. II. RECENT DEVELOPMENTS IN EXECUTIVE COMPENSATION A. Vesting Trend The trend is towards faster vesting, over a period of three to four years, with vesting occurring initially at the end of 12 months from the date of grant, and then pro rata vesting on a monthly or quarterly basis thereafter. 7

12 B. Broader Option Participation and Larger Equity Pools 1. Broad-Based Plans Increasingly, option plans are no longer reserved just for executives. In a recent survey prepared by Wordatwork, 80 percent of the companies that reported having a stock-based compensation plan offer stock options to a broad-based group of employees. Options are becoming the currency of choice and a large majority of employees in new economy companies expect equity grants to be part of the compensation package. In some instances, companies grant options to every employee, including contract and part-time employees. 2. Equity Pools The rate at which companies grant stock continues to increase. This can be attributed to the cash-to-equity shift prevalent among new economy companies, as well as the increased use of equity grants as a key recruitment and retention tool across a wide variety of industries for both executives and professionals. According to a 1999 study of equity plans in the 200 largest U.S. corporations prepared by Pearl Meyer & Partners Inc., while the average equity pool for executive and employee incentive pools stabilized at 13.2 percent in 1998, a number of companies have equity pools well in excess of the average. In fact, 15 companies set aside more than 25 percent of their outstanding shares for their employee stock plans. Of these, nine have allocations exceeding 30 percent, with five companies higher than 40 percent and two of these higher than 50 percent. The diversified financial/brokerage sector, with an average equity pool of percent, was by far the leader, followed by the technology sector at percent. With new economy and start-up companies, which tend to be cash-poor, one should expect an even higher level of equity reserved in employee stock option pools. C. Stock Purchase Loans Another trend is the increased use of stock purchase loans. Both old economy companies, such as Kodak and Monsanto, and new economy companies, such as ebay and Excite@Home, have extended loans to key employees for use towards stock purchases. In some instances, the underlying stock may be subject to risk of forfeiture. To encourage retention, sometimes these loans are forgiven if the employee remains employed for a certain period of time. By owning stock outright instead of just options, the key employees enjoy both voting and dividend rights and are more aligned with the interest of stockholders. There is also the added and not insignificant benefit of receiving capital 8

13 gains treatment on the stock price appreciation upon subsequent sale of the stock. The differences in tax rates are quite significant (39.6 percent vs. 20 percent for federal taxes). In instances where the underlying stock is restricted, executives often file a Section 83(b) election to avoid recognition of income upon vesting of the restricted stock. Where the restricted stock is purchased for fair market value, albeit with the proceeds of a stock purchase loan, no income would be recognized by the executives upon making the Section 83(b) election. Stock purchase loans should be structured very carefully to avoid tax and accounting concerns. State corporate law and the Company's by-laws must also be examined to ensure that stock purchase loans are properly authorized. In some instances, stock purchase loans that are secured by the stock may result in filings with the Federal Reserve Bank. D. Forfeitable Stock Deferral Premium Another way that companies may encourage stock retention by executives is by offering a deferred compensation program pursuant to which an executive could defer a portion of his cash bonus into deferred stock units that are credited to his account with a premium. This premium is forfeitable if the employee terminates employment prior to the vesting date for the premium. To illustrate this approach, assume an employee deferred $10,000 of cash bonuses into deferred stock units at a time when the stock price was $10 and the company credited a 15 percent stock deferral premium. The employee would be credited with 1,000 units ($10,000/$10) plus 150 units (1,000 x 15%) for the premium. If the employee subsequently terminates before the vesting date, the 1,000 units would be distributed in shares and the 150 premium units would be forfeited. Such a program enables executives to acquire more stock on a tax-deferred basis. E. Transferable Options 1. Overview Transferring stock options to family members is a valuable estateplanning device for high net worth executives. Only non-qualified stock options can be transferred since incentive stock options are not transferable under the tax laws. If the executive makes a completed gift of a stock option to a family member, the gift will be subject to federal gift taxes at the time of the gift based on the fair market value of the option at that time, subject to the potential availability of the $10,000 annual exclusion and/or the unified credit. Since the value of the option could be less than the value of the shares at the time of exercise, the individual could have transferred the future increase in value to family members free of estate and gift taxes. 9

14 2. Gift Tax Consideration In order to achieve the desirable tax consequences, it is important that the executive makes a completed gift of the stock options. For some time, there had been some uncertainty as to whether a completed gift could be made with an option that was not currently exercisable. The Internal Revenue Service, in a recent revenue ruling, concluded that one cannot make a competed gift of a stock option until it becomes exercisable. In the event the option were to become exercisable in stages, each portion of the option that becomes exercisable can be gifted on a separate basis. Rev. Rul In a recent revenue procedure, the Service also provided guidance on the valuation of stock options for gift tax purposes. In Rev. Proc , the Service stated that stock options must be valued by using a generally recognized option pricing model, such as the Black-Scholes method, that takes into account the following factors: the option exercise price; the expected life of the option; the current market price of the stock; the expected volatility of the stock; the expected dividends on the stock; and the risk-free interest rate over the remaining option term. Further, a taxpayer that wishes to rely on Rev. Proc may not apply a discount to the valuation produced by the option pricing model to take into account factors such as the lack of transferability and risk of early termination of the option upon termination of employment. It should be noted, however, that the methodology provided by a revenue procedure is simply a safe harbor. 3. Income Tax Consequences At the time of option exercise by the family member, the executive (not the family member) will recognize ordinary income in an amount equal to the excess of the fair market value of the stock over the exercise price of the option (i.e., the option spread). The family member nevertheless receives a basis in the shares received upon exercise equal to the exercise price paid plus the amount of income recognized by the executive. The income tax consequences of option exercises again result in transfer of wealth to family members without the payment of gift or estate taxes. F. Repricing Underwater Options 1. Overview When a company's stock price drops below the exercise prices of options, the options become "underwater" and have no perceived current value to the employees. Many companies try to address employees' 10

15 dissatisfaction with "underwater" options by repricing the stock options. Repricing of stock options often results in increased scrutiny and criticism by institutional shareholders of a company's compensation program and policies. Shareholders may question whether repricing defeats the purposes of providing long-term incentive to employees by removing the risk to such employees of downward price movements in the company's stock. Some critics compare repricing to changing the scoreboard or moving the goal posts halfway through a game. Institutional Shareholder Services, a proxy advisory service in Bethesda, Maryland, that advises institutional investors, proclaims a zero tolerance for option repricing. Institutional Shareholder Services advises its institutional clients to vote against stock plan proposals for any company that has repriced stock options without shareholder approval. Recently, the State of Wisconsin Investment Board has taken steps to persuade a number of companies in which it has a stake to seek shareholder approval of all option repricings, although such approval is not typically required under state laws or stock exchanges rules. These policies may ignore the business realities faced by many companies; namely that underwater options do not have retention value to employees. Since December 1998 when FASB announced that stock option repricing would result in variable accounting, the use of option repricing has slowed down significantly. Instead of re-pricing when stock price drops below the option strike price, some companies, like Microsoft, who have a large pool of reserved shares in their option plans, have made additional option grants to employees to address morale and retention issues. 2. Corporate Governance Shareholder approval is typically not required for option repricing, so long as the stock plan document gives the board, or the compensation committee, discretion to determine the option price, and there is no prohibition in the company's by-laws or the stock plan itself. Nevertheless, repricing of stock options has been the subject of shareholder litigation. Grounds for such lawsuits have included corporate waste, conflict of interest and breach of fiduciary duty. To avoid shareholder litigation over this issue, compensation committees asked to approve repricing should carefully deliberate and consider any proposed option program in order to avail themselves of the business judgment rule. In particular, compensation committees should consult legal, accounting and other professional advice and should demonstrate their careful consideration of the issues through well-documented minutes, including well-reasoned justification for the repricing program, such as the need to keep the company's compensation programs competitive and to avoid cherry picking by competitors. To mitigate the risks of shareholder litigation, the compensation committee should also consider prohibiting outside directors and executives from 11

16 participating in the program and requiring additional consideration from the option holders, such as restarting the vesting period over again. 3. Designing the Option Repricing Program One way to reprice options is to simply amend the existing stock options to reduce the exercise price. Another method is through an option exchange program. Under this method, employees are given an opportunity to surrender underwater options for new options at a lower exercise price, but for fewer shares. Very often, the exchange is made on a true economic basis, by valuing the old and new options under an option-pricing model. Some companies require additional consideration such as extending the vesting period and/or imposing a "black-out" on option exercises for a reasonable period following the repricing. 4. Proxy Disclosure If option repricing benefits any of the named executive officers, then the company is required to disclose additional information in its proxy statement for the fiscal year in which the repricing occurs. This includes an explanation by the compensation committee of the repricing program and the basis therefor, as well as a repricing table that shows all option repricing (as well as exchanges) with respect to options held by executive officers (not just the named executive officers) in the last ten years. 5. Accounting Considerations (a) (b) Expense Charge. Companies that reprice options will be subject to variable accounting under APB 25 and are required to recognize as a compensation expense an amount equal to the difference between the new lower exercise price and any future increase in stock price through the date the option is exercised. This applies to both vested and unvested options. Any option cancellation and re-grant within six months is deemed to be option repricing for this purpose. Pooling of Interest Accounting. Option repricing within two years of a business combination could adversely affect the parties' ability to use the pooling of interest method to account for the combination. 12

17 III. TREATMENT OF EQUITY UPON SALE OF COMPANY A. Overview In designing stock option plans, it is important to consider whether the vesting of unvested options will be accelerated upon a sale of the company. There is no one correct approach that serves the needs of every company. B. Full Acceleration vs. Partial Acceleration Some stock option plans provide for full acceleration of unvested stock options upon a sale of the company. This is particularly prevalent among large public companies. Other stock option plans provide that if the options will be assumed by the acquiring company, the vesting of 50 percent of the unvested options will be accelerated upon the sale of the company. The remaining 50 percent will vest in their normal course, but in the event the optionee is terminated by the acquiring company without "cause" within a period of time after closing (typically varies from 12 to 18 months), the vesting of the remaining unvested options will be accelerated as well. A third approach provides for no acceleration upon sale, but full or partial acceleration of vesting if the optionee is terminated without "cause" within a certain period after closing. The second and third approaches are sometimes referred to as "double-trigger" approaches. C. Business Concerns Investors are generally not in favor of full acceleration because of concerns that it might lower the value of their investment. Further, there is the added concern that the employees who receive a "windfall" upon the sale of the company will have no incentive to stay with the acquiring company post-acquisition. This could increase the cost of the acquisition as the acquiring company may be required to put in place additional incentives to retain the key employees. The double-trigger approaches discussed above are viewed by some investors as a more balanced approach which also provides protection for employees who are terminated without "cause" before the end of the vesting period. Employees, on the other hand, for obvious reasons prefer full acceleration of stock options upon the sale of the company. Some companies may permit full acceleration in specific grants in order to attract and retain high quality employees in a competitive market. D. Accounting Considerations 1. Purchase Accounting In a purchase accounting transaction when options are exchanged for options issued by the acquiring company, vested options (including options that vest on the sale of company) are treated as they have been in the past. The "fair value" (i.e., Black-Scholes) of the substitute options is 13

18 included as part of the purchase price of the target. Unvested options also become part of the purchase price in an amount equal to their "fair value." However, if continued service is required for vesting after the date of the acquisition, then the "intrinsic value" of the unvested options, i.e., the spread at the acquisition date, is allocated to unearned compensation cost and expenses over the remaining vesting period. Any compensation cost determined by its "intrinsic value" is deducted from the "fair value" of the unvested options in determining the allocation to the purchase price. 2. Pooling of Interests Accounting If the exchange of options does not increase the intrinsic value or the ratio of exercise price to market value, then the exchange of options will not result in compensation expenses. In a transaction that is accounted for as a pooling of interests, it is impermissible to change the vesting of options at the time the transaction is negotiated or contemplated as that would be considered a change in equity position that would disqualify the use of pooling. E. Tax Considerations Stock options or stock grants that vest upon a sale of the company are considered parachute payments potentially subject to the golden parachute tax. In the case of a private company, the golden parachute tax concerns can be avoided completely if the shareholders, upon full disclosure, approve the acceleration in vesting in connection with the sale transaction. See Section V. IV. EMPLOYER PROTECTIVE PROVISIONS IN EQUITY COMPENSATION There are a number of protection provisions that a properly represented employer should seek to have in their employee equity documentation. As indicated below, not all of these provisions are appropriate for public employers. A. Limited Window to Exercise Post-Termination If the employment is terminated with cause, stock options should provide that the option held by an executive terminates immediately, and is no longer exercisable. Similarly, with respect to restricted stock, vesting should cease and a repurchase right should arise (See IVB). In all other cases, the option agreement should specify the posttermination exercise period. Typically, post-termination periods are 12 months in the case of death or disability, and 90 days in the case of termination without cause. Some executives will try to negotiate extended post-termination exercise periods as long as the remaining exercise period in the original ten-year term. 14

19 B. Repurchase Rights With respect to restricted stock, private companies should always consider having repurchase rights for unvested as well as vested stock. Unvested stock should always be subject to repurchase either at cost or fair market value, or the lower of cost or fair market value. With respect to vested stock and stock issued upon exercise of vested options, some employers retain a repurchase right at fair market value upon termination under all circumstances until the employer goes public; other employers only retain a repurchase right under limited circumstances, such as termination without cause or bankruptcy. In general, public companies should only retain the repurchase right with respect to unvested stock, as the need to ensure that an employer s securities remain only in a limited number of friendly hands is no longer present. C. Right of First Refusal As another means to ensure that securities remain only in relatively few friendly hands, private company employers often have a right of first refusal or first offer with respect to any proposed transfers by an executive. Generally, these provide that prior to transferring equity securities to an unaffiliated third party, an executive must first offer the securities for sale to the employer-issuer and/or perhaps other shareholders of the employer on the same terms as offered to the unaffiliated third party. Only after the executive has complied with the right of first refusal can the executive sell the securities to such a third party. Even if an employer was not contemplating a right of first refusal, outside venture capital investors are likely to insist on these types of provisions. 1 Rights of first refusal (and co-sale rights) typically terminate once the employer has successfully completed an IPO. D. Drag Along Rights Private companies should also consider having a so-called drag-along or takealong right, which generally provides that a holder of the employer s equity securities will be contractually required to go along with major corporate transactions such as a sale of the company, regardless of the structure thereof, so long as the holders of a stated percentage of the employer s equity securities is in favor of the deal. This will prevent individual employee shareholders from interfering with a major corporate transaction by, for example, voting against the deal or exercising dissenters rights. Again, venture capital investors typically insist on this type of provision. 1 It would not be unusual for venture capital investors to insist on a co-sale right as well. 15

20 E. Non-Voting Securities Another technique private employers should consider is issuing non-voting common stock to their employees. Generally, except as required by law, holders of nonvoting common stock have very limited voting rights and, hence, will be less likely to interfere with a major corporate transaction that has the backing of a stated percentage of security holders. F. Option Clawbacks To protect themselves from an employee who seeks to engage in post-termination competition, employers may consider a claw back provision under which an employee who violates a noncompetition agreement (see Section II.B. below) forfeits not only his or her stock and stock options but also any profit derived therefrom. At least one Federal Circuit court has recognized such a provision. International Business Machines Corp. v. Bajorek, 191 F.3d 1033 (9th Cir. 1999) (option agreement enforces where it included a promise that employee would return any profit (here, $928, ) made from his or her stock option if he worked for a competitor within six months of their exercise). But see Lucente v. International Business Machines Corp., 99 Civ (CM) (S.D.N.Y. October 19, 2000) (stock forfeiture provision invoked when former executive joined competitor two years after his retirement was unreasonable as a matter of law). V. GOLDEN PARACHUTE RULES A. Overview Sections 280G and 4999 of the Internal Revenue Service Code disallow a federal income tax deduction to the employer corporation of an "excess parachute payment" and impose a non-deductible excise tax equal to 20 percent of the "excess parachute payment" on the recipient of the payment. The parachute tax rules generally apply to compensation payments to a disqualified individual if the payments are contingent on a change in the ownership or effective control of the employer corporation or in the change in ownership of a substantial portion of the assets of the employer corporation. The parachute tax rules do not apply to payments by S corporations, or payments by closely-held corporations, if the shareholder approval requirements have been satisfied. 16

21 B. Parachute Payment and Excise Tax 1. Three-Times Rule Code Section 280G(b)(2)(A) defines a "parachute payment" as any payment in the nature of compensation that is made to a "disqualified individual" (i.e., officer, shareholder or highly compensated employee), is contingent on a change in control of the employer corporation, and, together with all other payments, has a present value that equals or exceeds three times the individual's "base amount" (i.e., the average annual taxable compensation received by the disqualified individual over the most recent five years ending before the change in control). Compensation paid pursuant to agreements entered into one year before a change in control is presumed to be contingent on the change. If the present value of the parachute payment equals or exceeds three times the individual's base amount, then the individual must pay an excise tax equal to 20 percent of the excess of parachute payment over the base amount. (Note, not three times the base amount.) For example, if an individual's base amount is $300,000 and the individual is entitled to receive parachute payments with a present value of $1,000,000, he is liable for an excise tax of $140,000 [.2 x ($1,000,000 - $300,000)]. The corporation's tax deduction is limited to $300, Types of Parachute Payment (a) (b) (c) Severance payments which become payable because of a termination of employment in connection with a change in control are generally considered parachute payments. Stock grants that vest or stock options that become exercisable as a result of a change in control are also considered parachute payments. However, if the payment is certain (i.e., would have been paid sometime in the future if the individual had remained employed) but the timing of receipt is accelerated due to the change in control, only a portion of the payment is treated as contingent on the change. The proposed regulations include a formula for determining the value of the portion to be treated as contingent. Prop. Reg G, Q/A - 24(c). If a disqualified individual receives benefits continuation following a termination of employment in connection with a change in control, the value of the benefits continuation are likely to be considered parachute payments. 17

22 (d) (e) Any amount that one can establish as reasonable compensation for personal services to be rendered on or after the change in control is not considered a parachute payment. Payments to a disqualified person for not competing against the employer corporation after the change in control may come under this exception if the amounts are reasonable. Payments from tax-qualified plans are not considered parachute payments. C. Strategies Regarding Excise Tax 1. General There are three approaches that corporations generally take with regard to the golden parachute tax: (a) tax gross-up; (b) safe harbor cap; and (c) payment of highest amount with or without cap. 2. Tax Gross-Up In order to protect the executive from the punitive nature of the excise tax, many corporations provide the executive with a "gross-up" payment to ensure that the executive receives the after-tax benefits he or she would have received had the payments not been subject to the excise tax. In particular, the gross-up payment would be equal to the sum of (a) the excise tax on the parachute payments, and (b) the federal, state, local, employment tax and excise tax on the gross-up payment. The gross-up payment can be very costly to the employer. At today's tax rates, the gross-up payment can be close to three times the amount of the excise tax. In addition, the corporation would not be entitled to a tax deduction with respect to the excess of the parachute payments, including the gross-up payment, over the executive's base amount. 3. Safe Harbor Cap Under this approach, the corporation and executive agree in advance that the parachute payments (including severance payments) payable upon a change in control would be limited to three times the executive's base amount less $1.00. For example, assume that the executive's base amount is $200,000, and that the parachute value of the executive's options that accelerated upon the change in control is $150,000. Under the safe harbor cap approach, the maximum severance payments cannot exceed $449,999 [(3 x $200, $150,000 - $1)]. This safe harbor cap could lead to disappointment to the executive because in many instances, given the magnitude of today's equity grants for executives, the 18

23 acceleration of vesting may cause all or a substantial portion of the executive's safe harbor to be used up prior to the payment of any severance benefits. 4. Payment of Highest Amount With or Without Cap Another approach that some corporations take is to impose the safe harbor cap only if the executive's net after-tax benefit is greater by applying the cap than if the cap is not applied. A variation of this approach is to impose the cap only if the amount to be eliminated as a result of the cap is less than a certain percentage (e.g., 110 percent) of the present value of all taxes imposed on the eliminated amount. These approaches are less costly to the corporation than the gross-up approach and will provide for larger after-tax dollars to the executive. For example, assume that the executive's safe harbor is $900,000 and that the contractual payments would have been $1,500,000 prior to any cutback. Further assume a maximum combined tax bracket of 65 percent (including the excise tax) and 45 percent (excluding the excise tax). With the cap, the executive would have received $495,000 on an aftertax basis ($900,000 x.55). Without the cap, the executive would have received $585,000 on an after-tax basis ($1,200,000 (i.e., the amount of the payment in excess of the base amount) x.35 + $300,000 (i.e., the base amount) x.55). In this instance, the executive would be better off without the cap than if the cap had applied. VI. COMPENSATION DEDUCTION CAP UNDER CODE SECTION 162(m) A. General Under Code Section 162(m), subject to certain exceptions, a "publicly held corporation" is denied a deduction for remuneration paid to a "covered employee" for services performed by such employee to the extent the remuneration exceeds $1 million for the taxable year. 1. Publicly Held Corporation A "publicly held corporation" is defined as "any corporation issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934." Code 162(m)(2). 2. Covered Employees Under Code Section 162(m), an individual is a "covered employee" if the individual is employed on the last day of the company's tax year and he or she is either the chief executive officer or any other individual whose compensation must be reported to shareholders under the Securities 19

24 Exchange Act of 1934 Act by reason of being among the four highest paid officers. 3. Exception for Performance-Based Compensation Code Section 162(m) excludes performance-based compensation from the $1 million deduction limit. Such compensation must satisfy the following four requirements: (a) Performance Goals. The compensation is paid solely on account of the attainment of one or more pre-established objective performance goals. See Treas. Reg (e)(2)(i)-(ii). i. The goal must be established by the compensation committee not later than 90 days after the commencement of the performance period (or within the first 25 percent of the period if the period is less than one year). ii. iii. iv. The performance goal must be objective such that a third party having knowledge of the relevant facts could determine whether the goal is met. The compensation committee does not have the discretion to increase the compensation due upon attainment of the goal, but may retain negative discretion to reduce the compensation. The performance goal can be based on one or more business criteria that apply to the business unit, or corporation as a whole. Examples of business criteria include stock price, earnings per share, return on equity, market share, sales, etc. v. If the executive would receive part or all of the compensation even if the performance goal is not attained, the compensation does not qualify for the performance-based exception. (b) Goals Must Be Determined by Compensation Committee. The performance goals must be established by a compensation committee comprised solely of two or more "outside directors." See Treas. Reg (e)(3). 20

25 i. To qualify as an "outside director," a director (A) (B) (C) (D) must not be a current employee of the public company; must not be a former employee of the public company who receives compensation for prior services (other than benefits under a taxqualified retirement plan); must not have served as an officer of the public company; and must not receive remuneration from the public company, directly or indirectly, in any capacity other than as a director. For this purpose, "remuneration" includes: i) any amount paid to an entity in which the director has more than a 50 percent beneficial interest; ii) iii) amounts, other than de minimis remuneration, paid by the public company to an entity in which the director has more than 5 percent beneficial interest; and amounts, other than de minimis remuneration, paid by the public company to an entity by which the director is employed or self-employed. To qualify under the de minimis exception, the remuneration must be $60,000 or less if paid for personal services and may not exceed 5 percent of the gross revenues of the entity for the taxable year ending with or within the preceding taxable year of the public company. ii. Although the regulations provide that the compensation committee must be comprised solely of two or more outside directors, the Service has ruled 21

26 that a compensation committee with directors who do not so qualify as outside directors can still qualify as a committee of outside directors under Code Section 162(m) so long as all the directors who do not so qualify abstain or recuse themselves, and there are at least two remaining directors who qualify as outside directors. PLR (c) Shareholder Approval Required. The material terms of the performance goal under which the compensation is to be paid must be disclosed to and approved by the shareholders before the compensation is paid. Treas. Reg (e)(4). i. The shareholders must be made aware of the material terms of the compensation, including the class of eligible employees, the description of the business criteria on which the performance goal is based and either the maximum amount of the compensation that would be paid or the formula used to calculate the amount. ii. iii. iv. The specific targets do not have to be disclosed to the shareholders. If the compensation committee has authority to change the targets under a performance goal, the shareholders must reapprove the performance goals every five years. The shareholder approval requirement is satisfied only if the material terms of the performance goal are approved by the shareholders, in a separate vote in which a majority of the votes cast (including abstentions, to the extent abstentions are counted as voting under applicable state laws) on the issue are cast in favor of approval. (d) Certification. Prior to payment, the compensation committee must certify in writing that the performance goals were in fact satisfied. Code Section 162(m)(4)(C)(iii). For this purpose, the approved minutes of the compensation committee are satisfactory. 22