Compensating Your Management Team Presented by: Tim Woods, CPA, MBA, MSF Managing Director and Shareholder CBIZ & Mayer Hoffman McCann April 17, 2014
Today s Presenter Tim Woods, CPA, MBA, MSF Shareholder and Managing Director 720.200.7043 twoods@cbiz.com A member of MHM s Professional Standards Group, Tim is a subject matter expert for derivatives and hedge accounting. He also has extensive experience in leasing transactions, fair value, stock-based compensation, and complex debt and equity transactions. Tim has worked in public accounting, consulting, and private industry for the past 20 years, focusing on outsourced CFO consulting and financial statement audits for small and mid size privately held companies. He has extensive experience in accounting for business combinations and variable interest entities, as well as with issues in leasing, revenue recognition, and foreign exchange.
Today s Agenda 1 2 3 Phantom Equity Questions 5
TYPES OF COMPENSATION
Clearly the manner in which a Company compensates its employees is based on many factors including the experience and skills of the employee as well as market conditions. Today, in the interest of time, we will focus on issues of compensation as they relate to start up companies as well as general issues of compensation.
Risk versus Reward we will assume that the employees and potential employees of the Company understand the risk-reward profile of a start up Company in the BioScience Industry. Bootstrapping early stage companies are typically in the process of raising capital, thus capital is precious and is focused on those areas that are key to the business model of the Company. Accordingly, Form of Cash Compensation: Salary, may need to be initially set at a level that is below the market for established companies, but together with the other facets of the employee s compensation package, bring the overall compensation package to a level consistent with the market. Bonuses are typically set for employees based on specific performance targets and results of the Company. Depending upon the functional area of the employee, these performance targets should be aligned with the business plan and goals of the Company. E.G. R&D results of development, milestones set Finance successful raise of capital Sales targets Commissions given that commissions are sales based, at the time that the Company is generating revenue, commissions will need to be based on a package that is very close to the market; unless other aspects of the compensation package, which we will discuss, make up for the decrease in cash based incentive compensation. To attract top sales professionals, this is a key part of their compensation package with the % of commission increasing with increases in sales.
Profits Interest and Profit Sharing While for start-ups, profits may not be available; however, the Company can compensate its employees in a manner that provides for a certain % of profits, as defined in the related agreement, to be granted to employees. For Profit Sharing, this can be in connection with a qualified retirement plan. Profits interests are granted to specific employees by LLCs and provide for a stated percentage of profits to be paid to the employee.
Other cash aspects of an overall compensation package: Benefits Health, Dental, Vision, Disability insurance (and other) For employee only, or employee, spouse and children Need for consideration of Affordable Care Act ( ACA ) impact Health savings accounts Retirement Plan (401k, Simple IRA, etc ) Employer s contribution (matching) and the vesting term 529 Plan savings for higher education Other perks health club membership, etc Expense account
Equity Based Compensation Regardless if the Company is a corporation (S or C corporation) or an LLC / Partnership, the Company has the ability to provide equity based compensation to its employees. Shares of stock Corporations Membership / partnership units LLCs and partnerships Types of equity based compensation Restricted stock (unit) grants Stock (unit) options Phantom stock (unit)
Equity Based Compensation The Company must understand that before equity compensation can be granted it must first be approved by the Company s Board of Directors, or equivalent. Additionally, we recommend that the Company establish a Stock Incentive Plan which is the document under which the terms of the grants of stock based compensation are governed, in connection with the actual grant agreement. The Company must also understand that its employees are now owners which brings other issues from a management standpoint of the Company (owners may have a sense of entitlement to additional knowledge about the Company, its finances, etc ) That said, when employees are also part owners of the Company, they typically act as such, and behavior shifts toward maximizing the value of the Company can be profound.
Equity Based Compensation Question how much equity does the Company grant and what type of equity? Generally, companies reserve from 10% - 20% of the total equity of the Company for future issuances under the terms of the Stock Incentive Plan. In order to determine the amount of equity based compensation to grant to an employee, the Company must know the value of the underlying stock being granted. The value of a Company s equity can be determined by 3 general approaches: 1) market approach (e.g. price to earnings, EBITDA or sales multiple), or most recent transaction in which capital was raised 2) income approach (e.g. discounted cash flow analysis) and 3) cost approach (how much would it cost to replicate the current state of the Company). Once the value of the underlying equity is determined, the Company can then structure an equity grant properly.
Equity based compensation general terms When a company grants equity based compensation, it wants to ensure that the terms of the grant are aligned with the Company s business plan and goals. Accordingly, the Company can structure the grant in such a manner that the grant vests upon a) the occurrence of a certain milestone (this is called a performance condition), and/or b) the occurrence of a certain metric that is not directly in control of the Company (e.g. stock price, this is called a market condition), and/or c) over the passage of time or stated more accurately, over the requisite service period.
Restricted Stock Grants Example: the Company grants 10,000 shares of restricted stock to an employee, for which the value per share on the date of grant has been determined to be $10; therefore, the aggregate value of the stock is $100,000 on the date of grant. The terms of the grant are such that the stock will vest 25% a year on the anniversary date of the grant over a period of 4 years, or 2,500 shares per year. For purposes of the income tax of the employee, absent an 83b election, which we will discuss, the fair value of the stock is included in income, only when a substantial risk of forfeiture no longer exists. Accordingly, the employee will include in their income as salary, the fair value of the stock on the date that the stock vests (so as the value of the stock increases, the salary increases). Note that the employee does not have to recognize the amount that the Company determines to be the fair value of the stock for financial reporting purposes, as the employee can determine the fair value taking into account the lack of marketability, the size of the Company, etc Of course we always recommend that both the Company and the employee consult with their tax advisor prior to entering into a stock based compensation transaction.
Restricted Stock Grants 83b election Rather than recognize the fair value of the stock in income as it vests, the employee can elect to include the full fair value of the stock in income at its initial grant date by completing the 83b election form. In this case, the employee recognizes the full $100,000 income (provided that this is the fair value of the stock for IRS purposes) and any ultimate increase in the fair value of the stock is only recognized as a capital gain upon the sale of the stock. If the 83b election is not made, then the employee recognizes the fair value of the stock in income on the date that it vests. For example if the 83b election is not made, and the fair value of the stock has increased to $200,000 over the 4 year period, the employee will have recognized an additional $100,000 in income, versus only recognizing the $100,000 as a capital gain upon the sale of the stock. The Company receives a tax deduction for the value of the stock as it vests.
Stock options There are 2 types of stock options that can be granted for IRS purposes: Incentive Stock Option ( ISO ) can only be granted to EEs Non-qualified Stock Option ( NSO ) Stock options provide the right to the employee to purchase stock of the Company at a predetermined price, but not the obligation to exercise the option. Stock options are generally granted with an exercise price that is equivalent to the fair value of the stock on the grant date; in our example this would be $10 per share. The vesting terms for stock options can be structured in exactly the same way as for restricted stock.
Stock options The fair value of stock options for financial reporting purposes are generally determined by use of the Black-Scholes option pricing model which ascribes a value to the time component of the option. However, for purposes of the IRS, the only value that is subject to taxation is the intrinsic value of the option which is the difference between the fair value of the underlying stock and the exercise price. In general, neither the value of an ISO nor the value of a NSO is included in the option recipient s income at the time of grant unless, in the case of a NSO, the stock option has a readily ascertainable fair market value at the date of grant, which would only be the case if the value of the option is readily ascertainable (e.g. traded on an exchange).
Stock options With a NSO, upon exercise, the corporation receives a tax deduction (and the employee reports taxable income) for the difference between the option price and the quoted market price of the stock at the date of exercise (intrinsic value). With an ISO, unless the employee disposes of the stock within one year of exercise or two years from the date the option was granted, the employer does not receive a tax deduction. Should the employee make such a disqualifying disposition as defined in the federal income tax law, the corporation receives a tax benefit that should be accounted for in the same manner as the tax effects of a nonqualified stock option.
Stock options Incentive Stock Options ISOs allow the holder to receive special tax treatment upon their exercise that is not available to the holder of a NSO, provided the ISO meets rigid statutory qualifications. For example, under Section 422(b) the option must: Be granted to an employee pursuant to a plan approved by the shareholders; The exercise price must equal the stock s fair market value at the date of grant; The option may not, by its terms, have more than a 10-year exercise period after it is granted and the option must be granted within 10 years from the date the plan is adopted; The option contains transferability restrictions; and, The holder of the option at the time of grant does not own more than 10% of the combined total voting power of all corporate stock. (This restriction will not apply if the option price is at least 110% of the stock s fair market value at the date of grant.)
Unlike a NSO, an ISO may only be granted to an employee of the company. A stock option plan that allows non employees to participate in the plan will not qualify as an ISO and the grantee will not receive the favorable tax treatment afforded such options on date of exercise. If the requirements are met, the holder may generally exercise the options free of tax, postponing the taxable event until such time as the stock received as a result of the exercise is sold. There is one exception to this rule, however. For alternative minimum tax purposes, the exercise of an ISO is treated as if the ISO were a nonqualified stock option. As a result, the spread between the stock s value and its exercise price (intrinsic value) is treated as an AMT adjustment. The employee s tax basis in the shares received upon exercise of an ISO is equal to the exercise price for such ISO. Additionally, the Company receives no deduction when an ISO is granted or when it is exercised. The employee reports capital gain or loss, (long-term if he meets the holding rules described below) upon the sale of ISO shares in an amount greater or less than his tax basis. The Company receives no deduction when the employee sells ISO shares.
Phantom Stock If the Company determines that it would rather compensate the employee with cash instead of stock, buts wants the compensation to be tied to the increase in value of the Company s equity, the Company can grant phantom stock to the employee. Phantom stock allows the employee to receive in cash the difference between the fair value of the Company s stock on the date of grant and the fair value on the date that phantom stock vests (typically based on an event, e.g. sale of the Company). Phantom stock is not equity so the employee does not own any part of the Company. Vesting can be treated just as with the restricted stock and stock options; however, the Company will ultimately be required to pay cash to the employee. Such cash is treated as ordinary income for tax purposes.
CBIZ & Mayer Hoffman McCann P.C. We are available to consult with you with developing your compensation plans and specific issues with regard to stock based compensation. Tim Woods, CPA, MBA, MSF Shareholder and Managing Director 720.200.7043 twoods@cbiz.com
Questions?