Different types of equity awards carry different pros and cons. When designing an equity plan for your company, it is essential to consider what equity vehicles are right for your corporate structure and level of resources. In this post, we explores a few of the more popular equity types including stock options, restricted awards, and performance-based awards.
A stock option gives the employee the right to purchase a designated number of shares at a fixed exercise price at the end of a specified vesting period. If the market value of the stock rises after the stock option is granted, the holder may purchase the stock at the price set at grant and reflected in the stock option agreement.
Stock options are generally recognized and understood by employees and do not require a significant investment in employee education. Companies also have the option of including performance conditions to guide participants towards achieving particular performance goals.
On the flip side, there are a few reasons companies might shy away from granting stock options. Private company option programs require a fair market valuation to determine the minimum exercise price (409A valuation) which implies a valuation by an outside consultant and adds extra cost. Additionally, because most employees hold options until the liquidity event, perversely, it is often only ex-employees (who would otherwise forfeit the options) that tend to take advantage of capital gains treatment by exercising prior to liquidity. For both private and public companies, dilution can be a greater concern with stock options, as opposed to restricted stock, since companies will typically need to grant a greater number of stock options than restricted stock awards to reach the same value for employees. Also, the idea of motivating employee performance by virtue of a rising stock price is not all true. Stock price can be affected by a number of outside factors not related to employee performance, and therefore many companies have chosen to move away from stock options.
Restricted stock is stock that is subject to certain contractual restrictions on ownership, such as restrictions on transfer or resale. These restrictions remain in place until the restricted stock vests, based on the employee’s continuous employment, thus creating a strong incentive for an employee to remain with the company.
Unlike options which require appreciation in the stock price in order to realize any value, restricted shares are typically worth something, even if the stock value goes down. The lack of an exercise price also yields a higher perceived value to the employee, due to a more tangible sense of ownership, and as we mentioned above, allows the company to deliver the same dollar value with less actual shares issued than an option award.
When choosing restricted stock, remember the Section 83(b) election. By filing an 83(b) election, employees can pay taxes up front, in hopes that the value goes up and they will avoid a higher tax at vest. If no 83(b) election is made, employees will be taxed upon the vesting of the shares. Restricted stock also requires private companies to obtain a 409A valuation.
Performance-based awards can be any equity vehicle with attached performance conditions. These conditions can be market-based or operations-based and are usually defined by performance metrics.
Performance awards allow for better alignment of executive compensation with shareholder interests. However, they can be challenging to administer. First, companies are required to disclose these conditions in proxy statements, along with compensation policies and criteria for evaluating the results. (Read more about the role of performance awards in executive compensation in this post.)
In addition, the variability of conditions attached to performance awards creates a significant amount of additional work for the administrative, finance, and accounting functions. In general, ASC 718 requires companies to modulate expenses over time on these awards or units based on a subjective probability assessment of whether the performance metrics can be achieved. This can be a challenging task depending on the size of your stock plan team.
Determining the right types of awards that will closely align with your company’s performance and goals is an important step to developing a successful equity compensation program. For more information about designing and implementing a private company equity compensation program, download The Complete Private Company Equity Plan Blueprint, and for public company guidance on proper accounting for award types, be sure to get your copy of Accounting for Equity Compensation: A Primer.