Decision Vision Episode 42: Should I Issue Equity to Employees? – An Interview with Scott Harris, Friend, Hudak & Harris
Why should I even consider issuing stock to employees? If I do, what form of equity should I use? Business attorney Scott Harris answers these questions and much more as he speaks with host Mike Blake on this edition of “Decision Vision,” presented by Brady Ware & Company.
Scott Harris, Friend, Hudak & Harris
Scott Harris is a Partner with Friend, Hudak & Harris. Scott’s expertise is in business law. He concentrates his practice on corporate, transactional, licensing, intellectual property, merger and acquisition, joint venture, and finance law. By finding the right solutions to challenges and taking advantage of opportunities, Scott ensures that closely-held businesses and their owners grow and succeed.
Scott approaches his work differently. Rather than telling clients what they cannot do, he defines strategies to best accomplish their objectives. Instead of a detached legal assessor, Scott stands shoulder-to-shoulder as a client teammate. Based on solid judgment and decades of experience, he works to understand his clients’ businesses and provides them with successful alternatives.
Scott is admitted in Georgia and California. He has a B.A., cum laude, from Wake Forest University, and graduated from the Emory University School of Law with distinction.
For further information, go to the Friend, Hudak & Harris website or you can email Scott directly.
Michael Blake, Brady Ware & Company
Michael Blake is Host of the “Decision Vision” podcast series and a Director of Brady Ware & Company. Mike specializes in the valuation of intellectual property-driven firms, such as software firms, aerospace firms and professional services firms, most frequently as a transaction advisor, helping clients obtain great outcomes from complex transaction opportunities. Mike is also a specialist in the appraisal of intellectual properties as stand-alone assets, such as software, trade secrets, and patents, and helps clients develop successful commercialization paths for such assets.
He has been a full-time business appraiser for 15 years with public accounting firms, boutique business appraisal firms, and as owner of his own firm. Prior to that, he spent 8 years in venture capital and investment banking, including transactions in the U.S., Israel, Russia, Ukraine, and Belarus.
Mike is very active in the Atlanta startup community. He is the co-founder of StartupLounge, a nonprofit that supports early stage technology entrepreneurs and investors, he teaches the technology valuation module in the Georgia Tech/Emory University TIGER program, and he has coached 6 teams to victory in various business plan competitions for a total of $350,000 in prize money and another entrepreneur who received funding through ABC’s Shark Tank. He continues holding monthly office hours in Chamblee and Alpharetta.
Mike was named to the Atlanta Business Chronicle’s Top 40 Under 40 list in 2009 and is a graduate of the Leadership Atlanta Class of 2014. Mike is also a semi-professional musician, playing keyboards and vocals for a classic rock cover band.
Brady Ware & Company
Brady Ware & Company is a regional full-service accounting and advisory firm which helps businesses and entrepreneurs make visions a reality. Brady Ware services clients nationally from its offices in Alpharetta, GA; Columbus and Dayton, OH; and Richmond, IN. The firm is growth minded, committed to the regions in which they operate, and most importantly, they make significant investments in their people and service offerings to meet the changing financial needs of those they are privileged to serve. The firm is dedicated to providing results that make a difference for its clients.
Decision Vision Podcast Series
“Decision Vision” is a podcast covering topics and issues facing small business owners and connecting them with solutions from leading experts. This series is presented by Brady Ware & Company. If you are a decision maker for a small business, we’d love to hear from you. Contact us at decisionvision@bradyware.com and make sure to listen to every Thursday to the “Decision Vision” podcast. Past episodes of “Decision Vision” can be found here. “Decision Vision” is produced and broadcast by the North Fulton studio of Business RadioX®.
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Show Transcript
Intro: [00:00:01] Welcome to Decision Vision, a podcast series focusing on critical business decisions brought to you by Brady Ware & Company. Brady Ware is a regional full-service accounting and advisory firm that helps businesses and entrepreneurs make visions a reality.
Michael Blake: [00:00:20] And welcome to Decision Vision, a podcast giving you, the listener, a clear vision to make great decisions. In each episode, we discuss the process of decision making on a different topic, rather than making recommendations because everyone’s circumstances are different. We talk to subject matter experts into how they would recommend thinking about that decision. My name is Mike Blake and I am your host for today’s podcast. I’m a director at Brady Ware & Company, a full-service accounting firm based in Dayton, Ohio, with offices in Dayton, Columbus, Ohio, Richmond, Indiana, and Alpharetta, Georgia, which is where we are recording today.
Michael Blake: [00:00:52] Brady Ware is sponsoring this podcast. If you like this podcast, please subscribe on your favorite podcast aggregator and please also consider leaving a review of the podcast, as well. The topic today is, should I consider issuing equity to employees? And I think there are few decisions in business that are of greater importance and greater depth. And I think many people make that decision with such care. Maybe they even become paralyzed and they don’t do something.
Michael Blake: [00:01:32] And I think, frankly, in other cases, particularly in the tech sphere, but not always that way, you kind of see that decision taken lightly. And, you know, there are people handing out stock and options, you know, more frequently than, you know, handing out replica phases at Comic-Con. And companies can sort of make or break themselves because when you invite someone to become a co-shareholder with you in your company, I think that that is about the most intimate relationship that there is in business.
Michael Blake: [00:02:06] Because once you make that commitment, like a marital divorce, that is not something that is easily done or undone by, you know, hitting control+Z and just trying to undo it. And, you know, I think in some cases, there’s a sense that in some businesses, again, in tech software, biotech, you have to make other people shareholders, you have to issue options or even give them stock or you’re just not going to go any place. There’s an expectation on the part of venture cap blushing and make plans to do that.
Michael Blake: [00:02:41] Others, you know, I think correctly assess this decision with a tremendous amount of caution. Because again, it’s not something that’s easy to do. And when a shareholder, even a relatively minor one kind of goes broken arrow on you, at a minimum, it is spiritually painful. And often, it is legally and financially painful as well. So, you know, a topic of this gravity deserves a guest of the high deal of gravitas.
Michael Blake: [00:03:17] And I can think of nobody better to invite to help us work through this than my pal, Scott Harris, who is a partner at Friend Hudak and Harris here in Atlanta, though he is joining us from their palatial and so far, thank God, safe Napa Valley office. Scott’s expertise is in business law and concentrates his practice on corporate transactional licensing, intellectual property, merger and acquisition, joint venture, and finance law.
Michael Blake: [00:03:45] He helps find the right solutions to challenges and taking advantage of opportunities. He ensures that closely held businesses and their owners grow and succeed, and approaches his work differently in that regard. And like our podcast actually, rather than just telling clients what they can and cannot do, he helps to find strategies to best accomplish their objectives. And as an aside, that’s what a good lawyer tells you.
Michael Blake: [00:04:08] That’s what a good lawyer is when they’re an adviser. They don’t just tell you what you can’t do but they lay out a menu of options of, you know, “Here’s what you could do and here’s what the cost benefits, risks, and potential returns are of doing so.” He stands shoulder-to-shoulder as a client teammate. And based on solid judgment, decades of experience, he works to understand his client’s businesses and provides them with successful alternatives.
Michael Blake: [00:04:35] He holds a bachelor’s degree, cum laude from Wake Forest University and his law degree with distinction from Emory University. During his off hours, Scott enjoys trail running and has a love for working with his hands restoring American muscle cars and making furniture. And, you know, I’ve known and worked with Scott for a long time and he’s a hell of an attorney and hell of a business advisor. Scott, welcome to the program. Thanks so much for coming on.
Scott Harris: [00:05:03] Well, thanks very much for including me, Mike. And thanks for that largely true introduction.
Michael Blake: [00:05:11] It’s the internet, doesn’t have to all be true. The rest, we had filled in by a Russian meme farm. So-
Scott Harris: [00:05:18] Well, thank you very much anyway.
Michael Blake: [00:05:20] Yeah. So, before I get into this, I have to ask you, what is the muscle car douceur?
Scott Harris: [00:05:28] Well, I’m between muscle cars, which is a sad situation. But the last three that I had were all Chrysler products back when Chrysler was American-owned. They were two ’71 Plymouth Cudas and a ’73 Dodge Charger that I really—was owned by my daughter, who followed in my footsteps of spending a lot of time and money underneath cars, as opposed to behind the wheel of cars. So, that’s been the trajectory so far.
Michael Blake: [00:06:12] Well, good for you. I have to come out there and get a ride with whatever the next muscle car is that’s coming down the line.
Scott Harris: [00:06:19] I’ll let you know.
Michael Blake: [00:06:20] Good. So, you know, you’ve worked with a lot of technology companies. I’ll bet you, there’s not a lot that you haven’t seen yet. But let’s start off with a very basic discussion here, because we want to help our listeners work through this question. You know, why do companies even consider issuing equity at all? I mean, it’s an enormous pain the neck. There’s some risk. Why would a company even want to approach that discussion at all?
Scott Harris: [00:06:49] Well, that is the threshold question and a good place for us to start. So, imagine yourself running a company and potential employees number 1, 2 and 3 come to you as we’ve experience out here as a bit of an archetype for technology companies. They’re very qualified people. They have long resumes and you need to make yourself stand out among other people vying for their skills. Your choices are, you could pay them a lot of money or being a startup, you may be a little bit cash-strapped, you may be self funding at this point, but you still would like to engage these people and attract them and retain them.
Scott Harris: [00:07:36] You know, how else do you do that if you can’t do it with money? Well, that’s when stock and what we call synthetic stock alternatives come in for employers. And the most and easiest to understand examples of stock are, “Hey, employee number 1, love you to come to work for me. I don’t have enough money to pay you your full salary. I’ll pay you some salary and I’ll just outright grant you X in equity of my company.” And X is a percentage or it could be a number of shares, but it’s a “chunk”. That’s an outright grant.
Scott Harris: [00:08:20] And you don’t have to do this inconsistently between them, but I’m just giving other illustrations. To employee B, you might say, “Look, in lieu of giving you a chunk of stock right now, I’d like to give you stock options or equity options to buy a set number of units of equity at a given time based on certain circumstances over a period.” The most obvious examples of those or just a typical example of those would be four-year options, vesting 25 percent of the total grant of exerciseable equity units, a quarter a year on each anniversary of the grant date.
Scott Harris: [00:09:15] So, you come to work for me today, that’s the same day that I give you these options. A year from now, you can buy 25 percent of the stock at a given price. Another year from now, you buy another 25 percent, et cetera, all the way to the fourth year. And the last example I’ll give you is something called synthetic equity. We’ll make that our third example of employee. And to that employee, we tell them, “Hey, look, I’d like you to come to work for me. I can’t afford to pay you the entire salary that you should demand somebody of your qualifications, but I’d like to give you”, let’s call them, “stock appreciation rights.”.
Scott Harris: [00:09:59] We could also call them phantom stock, but we’ll just use the general description of both of those. It’s not stock. You’re not going to end up with stock in my company, but you’re going to end up with the economic benefits of having that stock like the appreciation that you would see in stock price from today’s grant until when you exercise these or in the event the company is sold, we’re going to calculate what you get as compensation as a bonus based on the sale price of equity as if you own that equity.
Scott Harris: [00:10:38] And the benefit there to the company is you don’t actually have to deal with the headaches of issuing stock in the terms upon which it is held and having shareholder and/or member agreements, but the employee has a lot of the same economic benefits as if they were a shareholder without some of the downsides including a voting stake in the company. So, there are many ways to do it. I’ve just explained three different ways to do it.
Scott Harris: [00:11:07] What are the benefits of doing that? Well, to the employer, one of the primary benefits is in lieu of paying somebody cash, you’re giving them these bonuses that are basically in the form of stock or options or synthetic equity. You save cash. That’s a major benefit particularly to startup companies. There are other incentives as well. It causes employees often to think of their contributions to companies in terms of what does this do to entity valuation.
Scott Harris: [00:11:47] Is my contribution making the company more valuable or am I just getting a paycheck at the end of the day? Sometimes, the alignment in economic incentives between employers and employees is crucial for those companies getting off the ground. And it puts everybody largely on the same side of the company benefits and may benefit to part of the ledger as opposed to the tension between, you know, management, just labor.
Scott Harris: [00:12:20] Another plus for employers in using equity and equity-like compensation is the ability to attract people you might not otherwise be able to secure. Especially in today’s environment with 3 percent unemployment, it sure helps to have equity and equity kicker attraction to people that you’re looking to hire and/or maybe, you know, hire away from other engagements. At least, in the tech and in many other industries, it’s pretty much a standard.
Scott Harris: [00:12:59] And particularly with early stage companies and initial key employees, there are very few that operate without some sort of an equity incentive. And then, of course, the last—and I wouldn’t say it’s the last, but it’s the last one I’ll cover today. The last reason companies doing this is as compared with just giving somebody a paycheck twice a month or at the end of each month, when you have that equity compensation vests over a period of time, the ability to enjoy more of that benefit vests over a longer period of time, you tend to incentivize retention of employees.
Scott Harris: [00:13:41] “I’m not going to leave this week because at the end of the year, I’ve got a 25 percent vesting of my options that I would like to be entitled to. I’m going to hang out for a little bit longer.” And then, at the end of that year, somebody might say, “You know, I’ll stay on in another year because at the end of that year, I’ve got another chunk of this equity that’s going to vest with me”, as opposed to the paycheck that you just cashed and spent on your muscle car that week. So, those are some of the incentives for the employers.
Michael Blake: [00:14:19] Now, you know, the question I’m asked a lot and I’m sure you got a lot to when you’re talking about this is a concern about giving up control. You know, you mentioned three different approaches, equity, options, and synthetic equity. What are the different implications in terms of having to share control with the people to whom you are making those grants?
Scott Harris: [00:14:48] Well, let me try to be a little bit more concise in this answer than the previous answer that I gave. The difference between equity and non-equity or synthetic equity is technically speaking, the synthetic equity, it’s more of a bonus and it does not involve the issuing of stock or rights to purchase stock or equity. It’s really just a bonus that is tracked based on equity value. That’s the yardstick for it.
Scott Harris: [00:15:22] So, when you give it out, you’re not giving up voting control and there is no voting aspect to it. On the other hand, equity grants or options, those are either just the outright giving of stock or the outright giving of a right to buy stock in a future date based on certain conditions in any given price. If you give away too much of that, you could give away voting control of the company, but I’ve hardly ever seen that happen.
Scott Harris: [00:15:52] And that’s because there are many ways to deal with the loss of control as a result of granting equity-based options to employees. One is you just make sure you don’t give out enough of it to constitute a considerable percentage of voting equity. Another option is to give away non-voting equity, non-voting stock, or membership interest if you’re in an LLC. So, it can be done both ways. But generally speaking, it’s not a concern that you’re going to be giving up control in a properly constructed equity compensation plan.
Michael Blake: [00:16:37] Now, for purposes of our discussion, because I think that’s the nature of our listener base, companies that we’re covering are privately held probably on the smaller side. So, you know, if I’m an employee, why do I find these grants attractive? You know, it’s not like I can go on my E-Trade account and sell them. In fact, even if I could do that, in many cases, the grant agreements themselves put, you know, pretty heavy restrictions on the opportunity to sell. Why do employees find these instruments attractive in lieu of cash?
Scott Harris: [00:17:22] Well, the bottom line answer is economic upside. Nobody ever, at least that I’m aware, became a billionaire at Microsoft, Google, or Facebook based on salary alone. It was mostly because of the ability to process pay and the increase in value of the entity, AKA stock or options or synthetic equity. So, it has a quality all unto itself even though at the end of the day, it’s all dollars. Equity often is a multiple potential upside, rather than just typical bonuses or compensation. They can also have different—and I will caution this by saying you shouldn’t take any tax advice in the aggregate that is not based on a specific analysis of individual facts.
Scott Harris: [00:18:25] So, I will throw that out there as a caveat to anybody running off and doing something without proper advice. But generally speaking, equity can be taxed. But the upside of equity compensation is taxed at times differently than just straight cash compensation. Sometimes, it’s subject to capital gains, taxes which are at least federally and it’s generally a lower rate than in some states as well. So, it has a tax advantage to some employees over and above the same amount of just the general cash compensation. Those are just a couple of reasons.
Michael Blake: [00:19:11] Now, I associate these kinds of grants with some sort of technology company, though that just may be the myopic world in which I live. Do you see grants of this nature in other industries the same frequency, more frequency, less frequency? And if it’s more or less than tech, why do you think—or if a tech does indeed sort of lead in this regard, why do you think that is?
Scott Harris: [00:19:41] I guess I would say that, you know, these types of compensation arrangements can exist virtually in any company, in any field. They do tend to be—you know, they become so popularized as a result of tech that I think a lot of people think that they’re perhaps more prevalent in tech than other industries. I’ve seen them across, you know, many industries. But I think they have just become a standard particularly in tech, biotech, healthcare, you know, healthcare startup industries. And we tend to associate them as maybe being more prevalent, although I don’t have statistics on it.
Scott Harris: [00:20:30] So, the question is, do they fit with your business plan and what you want to do to incentivize your employees regardless of what company you’re in? I have clients in distribution businesses that have employee equity participation, got a lot of clients obviously in the tech and biotech sectors that do this almost all the time, invariably. But I can’t say that it is—I don’t have any specifics, although I would think that it is a practice that has become so standard in the tech industry and it had more of an effect on other industries as a result of that. I don’t have the numbers to back it up.
Michael Blake: [00:21:24] Okay. So, is there a relationship between companies issuing some form of equity to their employees and their later on capacity to raise money? For example, I’ve actually heard some time in some cases, there’s some VCs that require an option pull to be put in place that they just don’t believe they’ll ever be able to retain talent. Maybe there are instances where VCs don’t like a lot of options out there because they don’t want to have a big shareholder base. Do you think there’s a connection between sort of the capacity or attractiveness as a company to raise money and their activity or their propensity to issue equity in this regard?
Scott Harris: [00:22:16] I do. And I think it’s a direct and positive correlation, meaning that for the most part in my experience for my clients that I’ve dealt with and have had an exit in terms of a purchase by another entity, as you know, they’ve sold out, so to speak, in one form or another, either partially or wholly, I think acquirers like to retain the attributes of the business that have caused it to be successful in the past. One of the largest contributors of which is the employees. They tend to see equity compensation as the glue that holds a lot of, you know, talented people together and tends to make them loyal to giving it a single given entity.
Scott Harris: [00:23:04] So, I think it’s an attraction for a lot of companies that are acquired especially, you know, through venture funds. And of course, you see that because a lot of those funds give an incentive to employees that has previously held options in the company to either roll those existing options into the acquired company and/or to also be participants in stock plans with the employees in the acquired firm. So, it’s good as a retention pool and targets for acquirer owners and so much so that they use them themselves often once they’ve acquired those entities.
Michael Blake: [00:23:55] So, have you found that one format or another seems to be more popular with employees? And to remind, we’re talking about the choices between direct equity, synthetic, and options. Does one seem to be more popular than the others?
Scott Harris: [00:24:17] I think options are more prevalent and they have some attractions to employees. Employees tend to like to think they have some sort of voting control, if it is options for voting equity. It’s generally not enough to sway control one way or the other. Sometimes, they like it, but you can have options in both voting and unvoting shares. But I would say the advantage that options have is if done a certain way, they’re not taxable at the time of grant.
Scott Harris: [00:24:59] And imagine if you’re an employee not getting what you think you should be—the market might bear if you were just getting paid in cash alone, the last thing you want to do is get an option award and have to come out of pocket cash to pay the taxes on it when you’re really not getting that cash in this compensation anyway. It provides a cash flow pitch for the employee. So, options and some synthetic equity as well can provide upon grant a non-taxable event to the employee. They don’t have to come out of pocket money. And they can time when they exercise their option and when there might be a subsequent taxable event.
Scott Harris: [00:25:47] So, a grant of stock on the other hand while nice, they’re a little bit less prevalent. It’s nice to get a chunk of stock. The difficulty for the employee is that’s going to trigger a taxable event to them if the stock has value at the time it’s granted, which we would hope it does. And again, sometimes, that means—well, in all instances, that generally means that that’s going to come with a tax bill. That tends to be a disincentive for a lot of employees as I’ve seen it. Hence, the preference for options or synthetic equity that doesn’t have that tax bill that comes with receiving the grant before you’ve actually exercised everything.
Michael Blake: [00:26:37] Yeah, direct equity grant reminds me of the scenario in which somebody wins a car on a game show, right? You’re not really winning a car, you’re winning a discount to buy the car from the US government basically depending on what your tax rate is.
Scott Harris: [00:26:55] Exactly the same situation here. It’s the white elephant that you won but now, you have to pay taxes on.
Michael Blake: [00:27:03] Right. So, let’s say now that somebody is listening to this program and they’re thinking, “Okay. Well, I understand at a high level, you know, why it’s desirable to sort of spread some of the equity around and, you know, maybe we’ll do it in one format or another.” What do the administrative steps at a high level look like in order to actually execute an equity or equity-like instrument grant?
Scott Harris: [00:27:31] Okay. Well, they’re very similar for stock grants and options. Generally speaking, the company adopts an option plan or a grant plan. Then secondly, they issue individual option grants to individual employees, like employee A, B, and C in our previous example. And that allows those people the right to purchase a given number of units at a set price at a time in the future under certain conditions. And then, once those conditions are met, there’s an eligibility of vesting, so to speak, of ability to purchase those options.
Scott Harris: [00:28:20] And then, they may or may not be purchased, you know, at that time or later. But that’s kind of the way that the equity side of it works. The synthetic equity side of it, very similar. The company adopts a plan. It issues individual grants. They wait for the conditions for those grant’s exercise to occur. And then, the employee is entitled to a bonus typically without the need to pay for purchasing stock or equity, they’re entitled to that bonus payout when those conditions are met.
Michael Blake: [00:29:05] So, you know, another question that I see come up a lot is, in particular, if I was in issuing options or some sort of synthetic instrument, does that mean that my company has to have a certain corporate form, whether it’s a C corp, S corp, LLC, something else? You know, does that drive even whether it’s possible or does it change the mechanics of how such instruments might be issued?
Scott Harris: [00:29:36] No, it really doesn’t. We can make—the basic three flavors of entities that you see these days, especially small entities, when they’re starting out are corporations, whether they’re taxed as corporations or whether they’re taxed as partnerships. We separate those into the categories of C corps, taxed as corporations or sub-chapter S corporations that are more taxed like partnerships. And then, the other one is limited liability companies, LLCs. And long story short is both equity and synthetic equity grants can be done the same in each entity regardless of which one a company has at that time.
Michael Blake: [00:30:34] Okay.
Scott Harris: [00:30:34] So, the good news is we’re company form-agnostic.
Michael Blake: [00:30:40] So, certainly, Silicon Valley will appreciate that. So, I’m going to bring back a term that we don’t hear as much anymore interestingly of late, at least, I don’t, maybe you do, which is options backdating. And what is exactly options backdating and is it a bad thing? And if so, why?
Scott Harris: [00:31:04] Well, first of all, let’s get a little bit of background on what we’re talking about, so we can consider this question with a little bit more understanding of how it comes about. As I said before, an option grant is the ability to purchase equity at a later date at a specified price. Generally speaking, in order for those options not to be taxable to the employee at the time they’re granted, the specified purchase price has to be equal to or greater than the prevailing price of the same equity at the time of the option grant.
Scott Harris: [00:31:48] Now, let’s unpack that. That’s a whole lot of terms. Let’s look at it this way, if I grant you the right to buy for $50 a unit of equity that is on the day that I grant you that right worth $100, it’s really like me handing you a lot in 50-dollar per equity benefit. And that’s generally compensation to the employee and granting those types of options can also have tax consequences to the employer.
Scott Harris: [00:32:23] So, let’s talk about backdating an option. So, same situation, but I’m going to grant you this option to buy equities for $50. Today, let’s say the stock is worth $100. But six months ago, the stock was worth $50. If I backdate this option to you and date it six months ago and give you the right to buy stock that at that time of the backdated grant is worth $50 or $50, those tax situations that we talked about both for their employer and the employee do not exist in theory.
Scott Harris: [00:33:12] And therefore, the grants can be issued to you without those tax consequences. Well, that’s mostly true except for the parts that the backdating brings up other issues. And while backdating options is not, per se, illegal, it can be very problematic and it can bring taxes and other legal considerations and complications to this situation when it’s done. So, is it good? Is it bad? Well, people have different opinions on that.
Scott Harris: [00:33:48] Obviously, the executives receiving grants kind of like having that locked-in benefit to effectively have the right to buy something that is more valuable today for a price at a time when it was less valuable. The flip side of that is other shareholders say, “Hey, that’s kind of like taking money away from us”, the other shareholder, by giving somebody else the right to buy what today is more valuable. So, opinions vary. If it’s done, it needs to be done very carefully or it can raise a whole host of problems that you wouldn’t want to have.
Michael Blake: [00:34:27] Now, a term you and I both hear a lot and it’s a term that nobody likes, except for maybe some people like me, is the notion of what’s called a 409A valuation. And so, can you explain to my listeners what 409A kind of is and means in the context of a stock option or potentially, even a stock appreciation rights grant?
Scott Harris: [00:34:57] Well, I’m not sure I can, but I’ll do my best. It’s a very complicated concept. You need to figure out what it means to each individual based on the particulars of that person’s situation. But let’s try the 40,000 flip view. Section 409A is the section of the Internal Revenue Code that covers non-qualified deferred comp arrangements. So, those would be both options and synthetic equity or stock appreciation rights as an example, okay?
Scott Harris: [00:35:32] You either have a non-qualified deferred compensation plan under 409A that complies with 409A or it doesn’t comply. If it complies with 409A, you can avoid a lot of unfavorable tax consequences. If you don’t comply with 409A, you can be hit with a lot of punitive taxes that are really intended to be a disincentive to not qualify. So, what does it take to qualify or not qualify, generally speaking?
Scott Harris: [00:36:13] Well, one of these has to do with one of the factors that we talked about before, which was whether or not, whatever the exercise price is equal to or higher than the value of the equity on the date of grant. So, in other words, is there that locked-in gain or is there no locked-in gains? And therefore, no incentive to exercise the options on the day of grant even if you could. So, in situations where somebody issues their stock, their options, or their synthetic equity grant not in compliance with 409A as we talked about before, there could be a pretty considerable tax burden given to the company. So, you know, sure, the company-
Michael Blake: [00:37:17] And it’s the recipient too.
Scott Harris: [00:37:20] Well, into the recipient as well. That’s right. It’s a double whammy, it hits on both sides. So, the question, you know, may be, well, should we still issue these in spite of those disincentives? And all I can say is it’s the question that you need to deal with specifically under the conditions of your situation and those of the grantee, the party, the employee holding the option right because you wouldn’t want to step in anything. It could be expensive.
Michael Blake: [00:37:57] So, let’s say we’ve gone through the process of setting these things up administratively, we’ve got the tax aspect handled, we’re working with a good CPA firm and good law firm to get this thing handled. You know, what happens if an employee in spite of my best efforts to keep them and I’ve given them precious shares and options, you know, has the temerity to leave the company? What happens then, typically?
Scott Harris: [00:38:25] Well, again, it depends on the terms of their grants or their options or their synthetic equity. Some require that those be redeemed or exercised, the ones that are vested at the time of termination. Some give a period of time after termination for them to be exercised. Some would cause those rights to go away. So, it just depends on how the rights are constructed.
Michael Blake: [00:39:04] So the key there, I think the key takeaway is, you know, think of this problem at the start, don’t think of it when it actually happens because at the outset, you can and should kind of dictate what the outcome is if an employee leaves. In other words, there should really be no uncertainty if those agreements are drawn up and structured correctly.
Scott Harris: [00:39:29] Yes. And that’s why one of the first things that is done in constructing these plans is to draft and adopt the plan at the corporate level. And then, all of the awards granted under that plan or subject to it. And then, one of the terms that’s typical in those plans is what happens upon termination and the ability to exercise and whether those rights go away or not. Absolutely.
Michael Blake: [00:39:56] And it is at least 10 times harder and more expensive to change things afterwards than it is to do it the way you need it to be done at the outset, right?
Scott Harris: [00:40:07] You don’t even want to go there.
Michael Blake: [00:40:09] Right. You don’t even want to go there. Right. Exactly.
Scott Harris: [00:40:11] Yeah. Have a plan and follow your plan.
Michael Blake: [00:40:12] The only people benefit from that is you and me.
Scott Harris: [00:40:16] Well, as I say, have a plan and follow your plan.
Michael Blake: [00:40:21] There you go. So, you touched upon this before but I don’t think we gave a name to it. It’s an important concept that I think we make sure that the listener understands. And that is, you know, what is vesting and why is the notion of vesting typically part of the equity grant equation?
Scott Harris: [00:40:43] Retention is the one-word answer. The example of that was like the example I gave earlier, where somebody had one quarter of their entire grant able to be exercised at the end of each one year anniversary of their grant date, which may be their initial employee, the date or may be a different date. That gives me as an employee the incentive to keep chasing after that carrot to stay employed, to stay eligible to exercise those grants in the chunks that become vested, as opposed to just leaving the company, which typically terminates the ability for having any options to grant. So, it’s the carrot on the end of the ever extending stick. I get the first bite. After a year, maybe the second bite. After two years, three, and four or whatever the term of the vesting is.
Michael Blake: [00:41:51] Now, in my experience, typically—maybe typically is not the right word. But in my experience, much more often than not, the agreements that govern these equity grants have a provision that says something to the effect that if the employee leaves the company that, you know, they’ll either forfeit what they’ve got or they’ve got a sell back to the company in a fairly punitive rate. And in some cases, I think there’s a good term basis, if we fire you for cause, you do something, you know, really ass-headed, you get yourself put in jail or do something that’s going to hurt the company, right, then you might just forfeit them outright. Do you see things that are similar in your world as well?
Scott Harris: [00:42:38] Yes. Usually, the purpose of equity and equity-related compensation is to incentivize the behavior that you wanted in an employee that is valuable to the company. In the same respect, you’d like to disincentivize behavior that is harmful. One of the best ways to do that is to deal with the repurchase of either stock that’s already been bought as a result of the exercise of options or in the alternative, to terminate those options and the ability to participate and to exercise that behavior is not what the company wants to incentivize. So, yes.
Michael Blake: [00:43:26] Okay.
Scott Harris: [00:43:27] We see those and we see differences in prices depending on how parties might separate at the end of an employment term.
Michael Blake: [00:43:36] All right. We are getting close to our time limit and I know you’ve still got an afternoon of stuff you’ve got to do as we’re wrapping up here on the East Coast. But one of the last questions I have is what happens to these grants when the company is sold?
Scott Harris: [00:43:54] Okay. Well, we touched on this before.
Michael Blake: [00:43:57] Yeah.
Scott Harris: [00:44:00] And the answer is it depends on the plan. But typically speaking, one aspect of option grants vesting is pretty interesting and let’s cover that. Imagine the situation where, you know, you’re a four-year employee and you’re, you know, two years into your employment and in your vesting of your option, and they turn around and they sell the company. Well, generally speaking, absent any other provisions in the plan, you only got half of the stock that you were hoping to get and they sold a little “too early” for you to maximize your benefit.
Scott Harris: [00:44:44] And, you know, that may always weigh on you if you’re an employee when you’re worried about the company being sold. The way to alleviate that concern and something that many companies do is allow accelerated vesting of options in the event of certain dispositions of the company “selling out”. And the reason they do that obviously is to align the interests of the employee no matter where they are in their vesting schedule with the control group of shareholders. I get paid, you get paid, and you don’t have to continue to serve out your employment term.
Scott Harris: [00:45:31] Now, there could be exceptions to that. Some people that acquire companies would like options rolled in. They don’t want them to necessarily accelerate and allow an employee to, you know, cash out and walk away, and start, you know, buying their next yacht, and they want them to stick around. But generally speaking, the disposition of a company accelerates vesting so that an employee gets treated the same way with their full grants and ability to exercise those at the same time the company is part and essentially, participate in a shareholder in that disposition event just like the rest of the shareholders do.
Michael Blake: [00:46:15] All right. So, we’re running out the clock here. We’ve covered a lot of ground. There’s so much more to cover. We can’t do it justice, the scope of a 45-minute program. Maybe a 45-credit hour program, we could. But I think that this is going to give the listeners a pretty good idea at least of how to frame this discussion. If somebody would like to reach out to you to talk about this more, maybe they’re thinking about doing this with their own company and would like your help, what’s the best way for them to contact you?
Scott Harris: [00:46:49] Probably, the best way to contact me is email. My email address is sharris, no punctuation between that, spaces, underscores, dashes, anything, just sharris, all smooshed together, H-A-double R-I-S, @fh2, the letter F like Frank, the letter H like Harry, then Arabic number 2, looks like FH-squared, .com.
Michael Blake: [00:47:14] I love that domain name, by the way. I mean, I don’t think I know anybody else with a three-character domain name. That’s awesome. I got to hear the story of how you did that at some point. But, Scott, thank you so much for doing this. And, you know, I learned something and I know our listeners did too. It’s a very complex issue, but at least, this will give people a head start. That’s going to wrap it up for today’s program. I’d like to thank Scott Harris again so much for joining us and sharing his expertise with us today.
Michael Blake: [00:47:46] We’ll be exploring a new topic each week. So, please tune in so that when you’re faced with your next business decision, you have clear vision when making it. If you enjoy these podcasts, please consider leaving a review with your favorite podcasts aggregator. It helps people find us so that we can help them. Once again, this is Mike Blake. Our sponsor is Brady Ware & Company. And this has been the Decision Vision podcast.
