By understanding the basics of Compensation Plans, Packages and Structures, a company can effectively lay plans to help incentivize employees toward achieving company goals. A well designed and implemented Compensation Program will pay for itself in increased company profits. Here are the significant areas of the business to consider and the applicable compensation strategies to consider.
A. Ownership
1. Founders Stock Strategy
a. Issue convertible preferred stock to outside investors and reserve common stock for founders and key employees.
i. Convertible Stock should have a liquidation preference large enough to eliminate the book value of the Company, and in subsequent funding rounds the liquidation preference of each stock class should be increased to cover the current book value.
ii. The Convertible Preferred Stock should have Senior Dividend, Preemptive and Redemptive Rights; registration rights and rights of co-sale.
iii. Holders of Common Stock own only the remaining Shareholders' Equity after the convertible stock preferences has been satisfied.
iv. The Goal: The superior rights of the Convertible Stock, when combined with the probable profit loss of a new venture, will substantially reduce the taxable fair market value of the Common Stock. Founders and Key Employees can obtain Common Stock at significantly reduced prices and tax liabilities than paid by outside investors.
2. Stock Options Incentives
a. An Incentive Stock Option Plan (ISO) provides employees with tax preferable stock acquisition.
b. There are many rules, conditions and tax implications for an ISO, so the ISO Designer should be knowledgeable with factors the IRS considers instrumental to a fair market stock valuation. Penalties can be severe for miscalculations.
c. A Qualified Stock Plan is a fantastic way to attract and keep talent, as long as, the design and use of the program understands potential issues, such as the Alternative Minimum Tax, Sequential Exercise Rule, Loans, Holding Period Requirements, ISO Exercise Conditions, Stock Exchange and Fair Market Valuation.
3. Non-Qualified Stock Options
a. Maybe good to mix with ISO plans for certain employees to balance tax implications.
b. Excellent vehicle if want to grant an option to an Outside Director, Consultant, Adviser, or Supplier.
c. Issues to consider when utilizing a Non-Qualified Stock Option Plan include Inadvertent ISO Qualification; Institute withholding, Shareholder's Grants, Loans and Valuation Methods.
d. Considerations: In some situations a Non-Qualified Option can be more advantageous over an ISO; however, an ISO has a lower tax burden at exercise, and the time value of money is superior. Also, long-term capital gain implications are often better tempered through an ISO. Again, it is very important to hire experts in this area to fully explore Qualified and Non-Qualified Stock Option Plans.
4. Subordinated Common Stock
a. Junior Stock can allow key employees of startup firms or high growth companies to acquire a subordinate class of Common Stock at a fraction of the value of regular class Common Stock.
b. Have an option to possibly convert into the regular Common Stock.
c. This stock structure awards key employees from substantial improvements in the Company's Sales and Earnings.
d. The associated rights of Junior Stock conveys inferior rights to those of regular Common Stock, such as, reduced voting and dividend rights, and inferior liquidation preferences.
e. However, if the Company achieves specified Strategic Goals in Sales and Net Income, the Junior shares convert to regular shares on a one to one basis.
f. Junior Stock Plans should restrict ownership of shares to continuing company employees and include transfer limitations, repurchase provisions and rights of first refusal.
g. Junior Stock can be offered through an ISO or Non-Qualified Stock Options. There can be certain tax preferences to a Junior Stock Option Employee when purchased through a Qualified Plan, yet issues of Valuation, Lapsing Restrictions and Conversion should be considered by a tax professional.
h. Goal: Junior Common Stock Plans is a very economical compensation structure for a Key Employee; yet clearly incentivizes Employees to contribute to the overall success of the Company. While Convertible Preferred Stock and Junior Common Stock have many common features, the goals of each are opposite:
i. Convertible Preferred goal is to depress value of regular class stock into which a secondary class will convert.
ii. Junior Common Stock's goal is to depress value of the secondary stock class which will be converted to regular class.
B. Harvesting Value: Rule 144 Implications
1. Founder's Stock is subject to Rule 144 Restrictions, which sets standards and procedures by which restricted and control stock can be sold. The rule specifies when, how and how much restricted stock and control stock may be sold in the public market place by private company owners and is subject to the SEC's Securities Act registration rules.
2. Restricted Stock is stock acquired from a Company which has not been registered with the SEC through a Private Placement.
3. Control Stock is stock owned by Company Principals who control the business affairs of the stock issuing company, which would include Officers, Directors, Major Shareholders and individuals who influence Management Decision Making.
4. Changes: There have been substantial changes in Restricted Stock Transactions whereby Small Cap Venture Funds have incentives to buy into small companies. The holding and sales periods have been significantly shortened. Please confer with a Tax Professional to measure any Rule 144 implications to your Company's Stock Structure and Plans. These changes to restricted stock holding periods have made this type of stock a lot more marketable, as a result, much easier to determine fair market value.
5. Implications: Expert counsel should be utilized when designing your Company's Compensation Structure and Package to fully understand the extent of Rule 144 regulations, penalties and implications.
C. Returning Ownership: Termination Considerations
1. A Company needs to be protected against founders, key personnel and major shareholders departing, to include disability, termination and death.
2. Buy/ Sell Agreements help a company retain the ability to recapture the value of stock and ownership, normally through the use of insurance policies to fund the Buy/ Sell Agreement.
3. A Buy/ Sell Agreement will protect the entrepreneur's return on his or her efforts.
4. Other forms of protection are utilized through Vesting Programs for Stock Options and profit-sharing plans. As a Company matures and achieves success, vesting plans can secure key employee loyalty while maintaining adequate incentives to excel and increase company profits.
D. Conclusions
1. A company's choice of Compensation Structures and Programs should reflect both its ability to reward and incentivize employees and affect the company's future growth.
2. Typically, Founder's Stock, an ISO and Non-Qualified Stock Option Plans are often best suited for early stage companies, while Junior Common Stock Plans may be more appropriate for recent IPO companies or later stage private companies.
3. Experts in tax, accounting and compensation structure, regulations and laws should be sought as laws governing compensation structure and package design and implementation change constantly.
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