- Careful consideration of challenges. Private companies often successfully implement equity-based long-term incentive plans, but doing so requires careful consideration of the many issues that such plans present, both from a design, administration and funding perspective.
- Valuation is beneficial. Valuation is important for any award types that are tied to the value of company equity, either at grant, vesting or payment.
- Company-funded award payments. Because there is no public market to facilitate the sale of equity, recipients of awards of private company equity would be looking to the company to fund the payment of any awards — whether or not specifically tied to the value of the company’s equity.
In a previous Workspan Daily article, we explored the various design and planning challenges associated with establishing an equity-based long-term incentive plan in the private company. I analyzed various alternatives for the design of equity compensation plans, discussed the pros and cons of each, described the general tax impact and underscored other issues that might affect a private company’s decision to implement one alternative over another, or whether to even offer a long-term equity compensation plan at all.
With that as a backdrop, let’s turn to highlight some of the issues that should be considered when designing an equity-based long-term incentive plan for a private company.
Because private companies have no ready market for their shares, valuation of the company’s equity is an issue that must be addressed. Valuation is important for any award types that are tied to the value of company equity, either at grant, vesting or payment. Stock options, which should generally be granted with a strike price not less than the FMV of the company’s shares on the date of grant, depend on a company valuation to establish the strike price.
The value of awards upon vesting (in the case of restricted shares for which no section 83(b) election was made) and payment, in the case of RSUs, phantom stock, and SARs, must be established in order to determine the income realized in respect of the awards. While a number of valuation methods exist, a private company considering a long-term equity-based incentive plan should be aware that company valuations can be costly and must generally be completed annually to ensure compliance with the various tax laws, including section 409A.
Cash Flow Impact
Because there is no public market to facilitate the sale of equity, recipients of awards of private company equity would be looking to the company to fund the payment of any awards — whether or not specifically tied to the value of the company’s equity. In the absence of a projected exit timeline or some other monetization technique, the company could experience a significant drain on cash, especially if a significant number of awards that have gained significant value become payable simultaneously.
Some companies address this cash flow issue by spreading out payments over a number of months or years; however, this can have a negative impact on the participants’ perceived value of the awards.
In the absence of a public market or some plan to monetize its equity, a company considering an equity-based long-term incentive program should be cognizant of the fact that payments under the plan will need to come out of cash flow from operations. This alone often will cause private companies considering an equity-based plan to scrap the idea, or at least search for other alternatives.
Payroll Tax Issues
A third and final issue for consideration concerns the income tax withholding and payroll tax issues that these types of plans present. For stock-settled awards, most often the taxable event does not involve a cash payment.
For example, when RSUs vest and stock is transferred to the participant, or nonqualified stock options are exercised, or shares are transferred to a holder of stock-settled SARs, ordinary income must be recognized, and the company will have a corresponding obligation to withhold for income tax and remit payroll taxes on the value of the shares transferred.
The main question is how this tax deposit obligation will be funded. One alternative would be to require that participants make a cash payment to the company in the amount of the company’s tax deposit obligation. For obvious reasons, this is almost never the approach that companies take, as it would be very unfavorably received by award recipients.
Another alternative would be “net settlement,” where the company will withhold a number of shares equal in value to the tax deposit requirements. However, the question still remains: Where will the cash to make the deposits come from? The company will have to fund the deposit, in effect “buying back” the withheld shares. In determining how to fund tax deposit obligations, therefore, the company should consider the impact to its cash flow.
For cash-settled awards, there are no significant payroll issues, because all income and employment taxes may simply be withheld from the cash payment.
In many cases, private companies successfully implement equity-based long-term incentive plans. However, to do so requires careful consideration of the many issues that such plans present, both from a design, administration and funding perspective.