Equity Compensation in Private Companies – Still Full of Landmines

Fred WhittleseyEffective Equity: The Equity Compensation Blog, Pay and Performance: The Compensation Blog

 

A new report by Proskauer Rose LLP summarizes IPO activity in 2016 and includes some of the equity compensation problems that continue to dog these new companies.  For example, “66% of health care issuers received a cheap stock comment” from the SEC.  (Proskauer includes biotech and biopharma companies in the “health care” sector.)

What the SEC calls “cheap stock” – equity compensation issued to employees at a price (i.e., option strike price) below fair market value – opens up the same issue on the tax front.  To the IRS, the “cheap stock” problem is manifested as “discounted stock options” which are legal if the equity plan allows it (most don’t) and creates the 409A taxation problem for employees.  If those employees are in California, there is a double tax whammy.

This is a continuing saga, as documented by Latham & Watkins in 2010 and my friend Mike Melbinger at Winston & Strawn in 2014 with roots going back to the 1980s.

I work with many startups, including those in our conscious company incubator/accelerator Fledge and with more established private companies.  While many private companies would love to believe they are “pre-IPO” that is in fact a rare exit for them.  The most common exit for them, of course, is failure.  The next most common is being acquired by a larger company.  And a few make it independently to the public markets. I just finished an article for InvestorJunkie that presents another problem for employee equity holders of IPO companies (a topic for another blog).

Along this path, the use of equity compensation is nearly ubiquitous.  For most companies that means granting stock options.  But more companies are forming as LLCs taking them into the complex world of “member interests” as the form of equity (a topic for another blog).

Even the simplest equity compensation arrangement – grants of stock options with time-based vesting for shares in a C corporation – are filled with potential landmines, and both the SEC and IRS have highly effective minesweepers.

I continually find equity compensation mistakes being made early in the lives of these companies.  Even though they’ll say “we got the plan from our lawyers” or “our CPA said it was OK” they manage to find ways to mess up their equity grants to employees. There are so many examples, the National Center for Employee Ownership created an entire book, “If Only I’d Known That – Common Mistakes in Equity Compensation and What to Do About Them” (2011) for which I authored multiple descriptions of horror stories.

Because I do a lot of expert witness work, I get to see these mistakes on the back end when they become the source of litigation.  The smallest case I was involved in over the past few years was arguing over only a couple of million dollars.  The largest was arguing over $40 million against a large entertainment company that inherited an equity compensation problem from a company it acquired.  Sometimes equity compensation can be as complex as making a movie like Star Wars.