A Piece of the Pie: Equity Compensation for Emerging Technology Companies

Transcription

1 A Piece of the Pie: Equity Compensation for Emerging Technology Companies Rick Lucash Special Counsel McCarter & English, LLP Travis Drouin CPA, Partner MFA Moody, Famiglietti & Andronico, LLP Theo Sharp Managing Director Pearl Meyer & Partners Christine Moore Vice President Pearl Meyer & Partners David Hughson Vice Consul British Consulate UK Trade & Investment

2 Twitter Info Tweeters! We are #Cambridge Today s hashtag is #EqComp Presenters from from Moody, Famiglietti & Andronico, LLP Theo Sharp and Christine Moore, Pearl Meyer & Partners 2

3 Equity Allocation - How How Founders Stock Restricted Stock Options ISOs Nonquals Who Key team members Rank and file Advisers 3

4 Restricted Stock Stock that is subject to vesting All or some Forfeit unvested stock if leave the company 4

5 Vesting Vesting usually based on length of service Example: 25% after 12 months Can base on Milestones Then 36 monthly installments Retention Grants additional grants periodically so employee always partly vested Partial Vesting only on Liquidity? 5

6 Accelerated Vesting Avoid for people you want to keep after sale of company Key players may demand Rank and file often do not get, either May accelerate only some of equity Double-trigger change of control + termination 6

7 Restricted Stock Tax Tax on value as it vests BAD 83(b) election Pay tax on value when received Then NO more tax until sell And good shot at (low) long term cap gains rate Do you feel lucky? So works best when value is low 7

8 Options Right to buy stock in future at a price set today Strike Price and 409A Consultants who do 409A valuations for emerging companies Vesting Similar issues as with restricted stock ISOs (no tax on exercise) vs. nonquals More important for companies going public 8

9 Option Conundrum Use it or lose it if leave the company Vested options terminate short time after leaving company Cost to exercise Tax on exercise Unvested options evaporate 9

10 Dilution It will happen Not inherently bad percentage goes down but value can go up Control need not track percentage ownership 10

11 How Much? Target for VCs is 20% for the sweat equity (including founders) Percent of the company What s the denominator Full diluted Use for initial key hires Brackets for the rest target a fraction/multiple of salary (based on current value) 11

12 Dilution Scenario Start: Founders 100% 7.5% to key hires => Founder 92.5% Seed: Angels 10%, Founders 90% x 92.5% = 83.25%; VC: 20% with 10% pool. First apply pool (12.5%) => Founders 83.25x87.5 = 72.8% Then 20% => Founders 72.8 x 80% = 58.3% BUT Board is likely 2 founders, 2 investors and one neutral 12

13 Questions?

14 A Piece of the Pie: Equity Compensation for Emerging Technology Companies Rick Lucash McCarter & English, Travis Drouin CPA, Partner MFA Moody, Famiglietti & Andronico, LLP Theo Sharp Managing Director Pearl Meyer & Partners Christine Moore Vice President Pearl Meyer & Partners David Hughson Vice Consul British Consulate UK Trade & Investment

15 A Piece of the Pie: Equity Compensation For Emerging Technology Companies April 6, 2011 Theo Sharp Managing Director, Pearl Meyer & Partners (508) Christine Moore Vice President Pearl Meyer & Partners (508) Pearl Meyer & Partners

16 Considerations in Determining Equity Compensation Stage of development / round of financing Time horizon for an exit Industry (software versus medical devices) Tolerance of investors for overall equity pool Type of preferences in place for investors, if any Cash flow of the company Culture and philosophy of the company (hierarchical/ egalitarian) Experience / background of management Type of equity instrument (s) Key is to view equity as a component of overall compensation package Pearl Meyer & Partners LLC

17 Old Paradigm Compensation / Exit Exit value typically up to 6 times invested capital Time horizon for exit 3 to 5 years Compensation model designed to draw executives and employees to work in a high risk venture Executives and employees low to modest cash No formal bonus plan to build cash flow Significant equity opportunities throughout Professional level non-exempt receive equity grants Pearl Meyer & Partners LLC

18 What has changed? Exits are typically 3-4 times multiple of capital invested Taking longer to get to an exit. Time horizons are typically 6 10 years Executives being hired to start venture are well seasoned Expectations: Large equity grants for not only Executives but entire employee population Salaries competitive within the market. How much are they giving up to come work for the company? What is the risk, what is the downside? The payouts are not as attractive as they were during the dot.com era or even in Pearl Meyer & Partners LLC

19 Addressing New Dynamics Preserve employee equity allocation: Provide universal equity to all true start-up employees Focus periodic allocations to top executives and key employees as company grows and time horizon lengthens (if the company is thinking it is time for annual grant guidelines, the company should be moving away from universal participation) Design short-term incentive plan to provide incentive to other employees Drains cash but supports the notion that a more stable work force is needed leading up to an IPO Drive appropriate behaviors using compensation elements Pearl Meyer & Partners LLC

20 New Pay Paradigm Time Horizon to an Exit Event Up to Three Years Three to Five Years Five Plus Years Executives and Key Employees Hire seasoned executives Competitive base salaries Significant equity grants Other Employees Modest to competitive base salaries Modest universal equity grants Executives and Key Employees Competitive base salaries Formal short-term incentive plan At-Hire and annual equity grants Other Employees Competitive base salaries Formal short-term incentive plan Limit equity grants Executives and Key Employees Competitive base salaries Formal Short Term Incentive Plan At-Hire and annual equity grants May consider carve-out plan for top executives Other Employees Competitive base salaries. Formal short-term incentive plan Pearl Meyer & Partners LLC

21 Competitive Equity Holdings General Guidelines Total Equity Participation at various Stages of Development (Fully Diluted) Level Early Stage (Post First Round Financing) 25 th 75 th percentiles Mid-Stage (Post Second Round Financing) 25 th 75 th percentiles Later Stage 25 th 75 th percentiles Founders 2.00% % 2.00% % 1.75% % CEOs 4.00% % 3.50% % % Executives 0.65% % 0.50% % 0.50% % Directors 0.20% % 0.10% % 0.10% % Managers 0.50% % % % Data from Dow Jones Compensation Pro Pearl Meyer & Partners LLC

22 Stock-Based Compensation Travis M. Drouin, CPA, CIA Partner MFA Moody, Famiglietti & Andronico, LLP 1 Highwood Drive Tewksbury, MA Copyright Moody, Famiglietti & Andronico, LLP. All Rights Reserved. Direct Travis@mfa-cpa.com On

23 MFA Moody, Famiglietti & Andronico LLP 100+ Professionals and 15 Partners Ideal Alternative to the Big 4 Highly Focused on Early Stage Companies Significant Venture and Angel-backed Client Base Expertise in: Audit Assurance Tax strategy and compliance Mergers and Acquisitions and Financial Due Diligence Valuation (MFA Cornerstone) Wealth Planning and Management (New Wealth Advisors) Talent Acquisition (Strategic Talent) Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

24 General Corporate Structures Corporation (S-corp versus C-corp) Limited Liability Company (generally taxed as a partnership) Profits Interests simple to implement but conversion to C-corps must be managed closely 3 Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

25 STOCK OPTIONS Incentive Stock Options, aka ISOs (ISO) No tax consequences to employer and no taxable income to employee at grant or exercise dates Nonqualified Stock Options, aka Nonquals (NSO) Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

26 ISO Requirements Plan must be in writing Options must be issued to employees and the plan must specify eligibility Plan must specify number of shares and be approved by shareholders within 12 months before or after plan adoption Options must be granted within 10 years of the earlier of either the adoption or approval of the plan Options limited to a maximum 10-year life Exercise price may not be less than fair market value (FMV) at the date of grant Options must be nontransferable other than at death and must be exercisable during the executive s lifetime only by the executive Additional restrictions on 10% shareholders (i.e., exercise price at 110% of FMV, and exercise period is capped at 5 years from grant date) Limit on vesting of $100,000 of FMV (measured when granted) per year Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

27 ISOs Realized Any gain on the sale of the stock is realized as long-term capital gain, PROVIDED the employee does not dispose of the stock either: within two years from the date of grant, or within one year from the date of exercise Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

28 Basic Tax Implications of ISOs $20 $10 APPRECIATION } } Tax Preference Item All appreciation taxed as capital gains (if stock is held at least one year after exercise and two years after grant) Purchase Price Date of Grant Date of Exercise Date of Sale Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

29 Non-qualified Stock Options Stock options NOT meeting the definition of an ISO Exercise price can be above, below or at fair market value Options do not need to be issued under a plan Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

30 Basic Tax Implications of NSOs $20 } Capital gain at date of sale $10 } Ordinary Income at Date of Exercise Purchase Price Date of Grant Date of Exercise Date of Sale Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

31 Restricted Stock Stock that cannot be transferred is awarded or sold subject to forfeiture or repurchase by employer, generally at the same price paid by the employee Once the employee vests, the restrictions lapse and the stock becomes unrestricted Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

32 Basic Tax Implications of Restricted Stock $20 } Capital gain at date of sale $10 Ordinary Income at Date Restrictions Lapse Date of Grant Date Restrictions Lapse Date of Sale Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

33 Tax Considerations Restricted Stock 83(b) Election - employee elects to recognize compensation income currently at grant date Must be made within 30 days of actual transfer of stock FMV is not reduced for transfer or other restrictions that lapse (only for those that never lapse) Income equal to FMV less cost at grant date Involves: Upfront cash outlay Sometimes employer loans to fund cash outlay As compared to ISO, which involves: No cash outlay No tax implications until exercise and sale Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

34 Establishing Fair Market Value Hire an expert! It is your tax audit insurance policy and will save you time and money when you engage a financial statement auditor Copyright MFA - Moody, Famiglietti & Andronico, LLP. All Rights Reserved.

35 Stock-Based Compensation Thank you IRC Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Copyright Moody, Famiglietti & Andronico, LLP. All Rights Reserved.