In Praise of Alternative Equity Compensation –

Equity compensation structures at venture-backed startups and other private companies have followed a standard pattern for many years-restricted common stock or time-vested common stock options. The traditional principal structuring considerations for employee equity compensation have been business incentives, accounting impact and tax minimization. Although significant accounting changes have occurred over the last couple of years and perceptions have changed with respect to non-cash compensation, little has changed in equity compensation structures. That is unlikely to continue to be the case, with increasing awareness among sophisticated entrepreneurs and managers of the potential adverse impact on their equity from down-round pricing and deal structures such as multiple liquidation preferences.

Companies and their employees are beginning to explore alternative structures that afford some protection from these events. Among these structures are (a) performance-based option vesting tied to achievement of individual or company-wide goals, (b) options in which the number of shares varies depending on the return outside investors receive in a liquidity event, (c) “make-whole” guarantees entitling the employee to a cash payment on a liquidity event hypothetically linked to a deemed conversion of preferred equity, with or without a minimum percentage equity guarantee, (d) options on preferred stock, and (e) acquisition/IPO cash bonus pools.

Startups typically issue restricted stock to founders and to early stage employees until the stock becomes too expensive for an employee to purchase because of valuations established by venture financings. Restricted stock is preferable to options from an employee’s point of view since the employee will receive long-term capital gain treatment on a liquidity event if holding period requirements are met. In order to align the employee’s incentives to the needs of the business, restricted stock typically has “golden handcuff” vesting provisions, meaning unvested stock is forfeited to the company at cost upon termination, with vesting occurring in increments over three or four years. Because the stock is purchased at “fair market value,” there is no charge to earnings if vesting is solely time-based and the number of shares is fixed.

After the company receives its first round of convertible preferred stock financing, the common stock typically is valued at a steep discount to the preferred stock price. Even so, the purchase price for restricted stock may be too high. The employee might be permitted to purchase the stock with a promissory note, but there are undesirable consequences to that structure, including the repayment risk in a down-round (or worse) scenario. Because of these complications, post-financing incentive equity often takes the form of stock options that qualify for “fixed accounting.”

Stock options can be structured for favorable accounting treatment (that is, no compensation expense) if they meet two criteria: One, they are for a fixed number of shares with a fixed exercise price equal to fair market value of the underlying common stock at grant, and, two, they are solely time-vested, as opposed to performance-vested. One structure called a TARSAP mixes performance and time vesting, but it is rarely used due to accounting uncertainties. For tax purposes, if the options are at fair market value and meet certain other requirements of the tax code, they can also be granted as incentive stock options (ISOs). With an ISO, there is no tax or withholding on exercise, and if a sufficient holding period is met after exercise, the spread is converted into long-term capital gain.

So what’s wrong with this picture?

This question can be put a different way: If accounting and tax considerations were completely irrelevant, how would equity compensation be structured? We suggest that the structures would look a lot different. Further, although tax and accounting considerations are still relevant, we suggest they may be increasingly less relevant in the post-Enron environment, allowing a fresh look at equity structures.

We suggest that the fixed-number-of-shares, time-vested structure for restricted stock and stock options is not optimal from a business point of view. Certainly, it is not optimal in all cases. The business purpose of equity grants is to align the interests of the employee with those of other shareholders. Current accounting rules favor companies that grant options that vest with tenure over companies that grant options that vest based on performance. The employee should be incentivized to be as productive as possible as quickly as possible, not just productive enough to not be fired. Structures that vary the amount of equity or the price of the grant based on performance or external equity indexes are also treated adversely

Structures with a fixed exercise price below market at the date of the grant and with time vesting are accounted for with a fixed charge to earnings over the vesting period. Structures in which the price varies, or the number of shares varies other than by time vesting, result in a variable charge to earnings measured by changes in the value of the employer’s equity over the vesting period. This treatment is particularly troublesome given that there is an open-ended charge to earnings.

As for taxes, if the employee is granted an option that is not an ISO (or non-qualified option), the employee recognizes taxable income on the spread at the time the options are exercised. In the case of a private company, that is not mitigated by the ability to do a simultaneous exercise and sale into the public markets. In reality, even employees who hold ISOs rarely time their exercises and sales for long-term capital gain treatment. In addition, ISOs may create alternative minimum tax problems.

ISOs do have one significant advantage: There is no tax due on exercise, which is particularly useful to a departing employee, who typically must exercise vested options within a short window of time after termination. The limited exercise period is not a requirement for an option to be an ISO at grant. However, if the option permits exercise beyond the specified tax-mandated post-termination exercise period, the option is automatically converted into a non-qualified option after that period.

Our assertion about the new relevance of unconventional structures is based on several factors: One, ISOs rarely result in long-term capital gain; two, non-cash accounting charges are irrelevant to a private company; three, changes in accounting principles have significantly reduced the impact of non-cash compensation charges in an acquisition; and four, non-cash compensation charges increasingly are becoming irrelevant even for public companies. Therefore, why not structure employee equity to maximize business incentives?

For private companies, accounting measures of performance do not drive valuations. Cash flow and the promise of future financial performance are the real performance measures. Why then are equity grants structured around accounting considerations and not business incentives in private companies? The reason is the anticipated relevance of GAAP performance in an IPO or an acquisition. That is, even if non-cash earnings charges are unimportant for a private company, the impact that the historical financial statements will have on valuations in an acquisition or an IPO is relevant.

For the vast majority of startups, the exit strategy is a sale to a strategic buyer rather than an IPO. This trend is being reinforced in our public markets, where the economics, market mechanisms and the diminished interests of bankers, analysts and institutional investors render all but a handful of small public companies almost invisible. It is in the rarefied atmosphere of public equity that the highest sensitivity to the accounting for option grants exists-where the word “dilution” refers to a reduction in earnings per share rather than a shift in economic value of equity rights. Even there, the sensitivity is diminishing.

If this has always been the case, what has changed?

On the accounting side, there has been one dramatic change: the demise of pooling-of-interests accounting. Perhaps more importantly, the financial community is increasingly beginning to ignore or discount non-cash equity compensation expense in measuring a company’s performance.

In poolings, the financial statements of the acquired company were combined with those of the acquirer going backward and forward. Compensation expense from “non-qualifying” options decreased the acquirer’s historical and future earnings. Under currently mandated purchase accounting, the acquired company’s historical financial statements are not combined with the acquirer’s financials other than in possible pro forma disclosures in footnotes. This suggests that one important cornerstone of the existing compensation structures no longer applies: to optimize the accounting treatment of the private company’s equity compensation in order to minimize any adverse effects on the acquirer’s “pooled” historical financial statements.

Adverse accounting treatment of compensation at a private company may have an adverse impact on the acquirer’s financial statements post-acquisition in the case of unvested options. Under purchase accounting, the cost of assuming vested options is treated as part of the purchase price with no negative effects on earnings.

Similarly, variable expense related to performance-based options does not affect the acquirer’s income statement to the extent that the performance milestones have been achieved or, as often happens, at least for management, the vesting of the options accelerates on the acquisition under the terms of the original option grant. An expense issue remains, however, with respect to unvested, non-accelerated options. The “intrinsic value” of these options at the date of acquisition would be amortized into the acquirer’s financial statements as compensation expense over the remaining vesting period.

We suggest that the impact of this one circumstance is likely to be minimal because, in addition to the acceleration of many options at acquisition, the successful private company on acquisition most likely would have achieved the performance measures specified in any performance-based option grants. Also, the intrinsic value for “qualifying options” may not be significantly less than for more creative structures.

There has also been a change in the perception of the relevance of non-cash compensation expense for “non-qualifying” options. Post-Enron, incentive-based equity, or at least the favorable accounting for it, has taken on something of a public taint. A number of prominent public companies are electing to treat options under an alternative accounting treatment, in which the fair value of the option at the date of grant is amortized to earnings over the vesting or performance period.

The advantage of this model for venture-backed companies is that such values exclude a volatility factor and so result in a lower valuation of the options than would be the case for a public company. This treatment also minimizes the compensation cost volatility associated with variable option grants under the existing prevalent accounting model that arises from changes in the value of the issuer’s equity prior to the vesting of such variable options. These considerations make the granting of performance-based options an attractive alternative for companies electing this accounting treatment.

The new accounting regime and new perceptions of the decreasing relevance of non-cash compensation expense, as well as the real-world impracticalities of ISOs, have created an opportunity-particularly for private companies-to revisit the desirability of equity structures that maximize business objectives, but are less sensitive to accounting and tax considerations.

There is another factor at work here in the current financing “depression” in the private venture-backed technology company market. Dilutive or down-round financings have become more prevalent. Moreover, new deal structures, such as preferred stock with multiple liquidation preferences, have significantly dimmed the prospect of common equity holders ever realizing a significant gain. In other words, as a result of greatly reduced enterprise valuations, the required payouts to preferred stock investors resulting from large prior investments and/or multiple liquidation preferences renders unlikely that the common equity will ever acquire significant value. Astute entrepreneurs and professional managers are increasingly seeking different forms of protection from these troubling scenarios. For these economic reasons, accounting and tax considerations increasingly are taking a back seat in structuring equity compensation, at least for senior managers.

Among the structures that are beginning to emerge are the following:

Performance-based common stock options . Companies are granting common stock options in which the options vest based on the achievement of individual or broader-based performance goals. A portion of the option vests if the goal is achieved by a certain date. If the goal is not reached by a specified date, a portion of the option is forfeited. An alternative approach is the non-qualified option, in which the number of shares varies depending on the return outside investors receive on their investment in a liquidity event. In this case, the option might have time-based vesting milestones. But once it is vested, the option could be exercised post-termination and only on a liquidity event, like an IPO. Lastly, vesting schedules can be made dependent on achievement of company-wide milestones or a combination of individual and company milestones.

Equity-based incentives with dilution protection devices . In the case of negotiated equity grants, the employee could be given a deeply discounted option that vests on performance milestones, so that the employee may be rewarded for individual performance even though the equity has not increased in value due to market conditions or other factors unrelated to individual performance. Employees can be given contractual “make-whole” guarantees, such that on an acquisition the employee would be entitled to a cash (or stock) payment equal to the difference between the amount actually realized by the employee and the amount that would have been received on the hypothetical basis that all convertible senior securities had been converted into common stock. Alternatively, or in addition, an option might specify that the number of shares subject to the option could not go below a specified percentage of the fully diluted equity compensation.

Cash incentive payments . Structures that do not utilize restricted stock or stock options are even more flexible and avoid the risk of the dilution of equity-based compensation. A bonus pool may be established that is payable in cash on an acquisition equal to a specified percentage of the amount payable to investors in an acquisition or after the investors have received their original investment plus a specified return. An IPO may be treated as a deemed acquisition of the company at its pre-money valuation, with the employee being paid in stock valued at the IPO price. Such a payout would be a taxable event and some liquidity for the equity would be necessary. A similar structure would be for the employee to be contractually entitled to a cash payment equivalent to a “carried interest” on the investors’ returns. To the extent that such models are contingent upon a specific contingent event outside of the employee’s control, they may not have any current accounting implications until such time as the contingency is resolved. This charge would be “washed” in the purchase accounting for the acquisition.

Each of the previous strategies has advantages and disadvantages. We expect, however, that given the trend away from rigid adherence to historical structures with favorable accounting consequences or perceived tax benefits, a number of these structures will become increasingly commonplace.

Edwin Miller is a partner at law firm Morse, Barnes-Brown & Pendleton, P.C., in Waltham, Mass. Christopher Lindop is a partner at Ernst & Young LLP in Boston.