Selected Issues in Equity Compensation

Excerpts

From Chapter 1, "Administering an Employee Stock Option Plan"

Companies generally document equity compensation grants by preparing formal grant agreements (commonly referred to as “award agreements”). The grant agreement is a written or electronic document that specifies the terms and conditions of the grant. The grant agreement typically contains the following:

• name of the grant recipient
• effective date of the grant
• type of grant (e.g., ISO, NSO, SAR, RSA, RSU)
• number of shares of stock covered by the award
• exercise price if the grant is a stock option or SAR
• applicable dividend and voting rights if the grant is in the form of restricted stock
• vesting schedule and acceleration and forfeiture events
• expiration and termination provisions

In addition, if the grant is a stock option or SAR, the agreement usually sets out the procedures the optionee must follow to exercise it, the permissible forms of payment of the exercise price, and other related matters. If the grant is restricted stock, the agreement may set forth the procedures for making an 83(b) election to accelerate taxation on RSAs or for making an election to defer issuance of the shares for RSUs. Alternatively, the agreement may simply make reference to the provisions within the plan document that are not specific to any particular grant.

For private companies, the agreement may set forth the liquidation rights, including a right of first refusal clause that provides the company with the first chance to buy the shares at the same price and terms as another offer; a put option that gives the recipient the right to sell the shares to the company; a call option that gives the company the right to buy the shares back from the holder; a tag-along clause that requires the majority shareholder to allow the minor shareholders to join in on a sale of the company; or a drag-along clause that requires the minor shareholders to sell their shares in a sale of the company. If the grant is for “qualified stock” of an NSO or an RSU under a broad-based plan of a private company, the agreement sets forth the procedures for making a fairly new “83(i) election” to defer taxation of the shares for up to five years if the company allows these elections.

An equity grant represents a contract between the company and the recipient. For this reason, requiring recipients to formally acknowledge and accept the terms and conditions governing an award will help eliminate possible contract disputes during its term. Since the grant agreement sets out the obligations of the recipient in connection with the receipt of the grant and acquisition of the shares, most companies require that the recipient sign (or acknowledge receipt of) the grant agreement. When acceptance is required to effectuate an award, companies may put an expiration date on the acceptance. A company should set a time limit within which a recipient must sign and return the grant agreement (or acknowledge acceptance of the grant conditions). The company should address whether there is to be a penalty for failure to return an executed agreement (or make the required acknowledgement). In addition, the company should provide a formal method for a recipient to actively decline the grant. The plan administrator should ensure that records of grant acceptances and rejections are retained.

However, some companies do not require an affirmative acceptance of the award, taking the position that a grant agreement is legally binding with or without a signature—particularly in the case of stock options, which require action on the part of the employee to purchase the shares. Before taking such a position, it is important to discuss the consequences with the company’s legal counsel.

From Chapter 11, "Designing and Implementing an Employee Stock Purchase Plan"

A common misperception is that the $25,000 limit can be administered by limiting contributions to a percentage of $25,000 commensurate with the discount offered under the plan (e.g., where a plan offers a 15% discount, by limiting contributions to $21,250 per year, or 85% of $25,000). Generally, this is not the case because the value of the shares for purposes of the $25,000 limit is based on the fair market value of the stock at the grant date (typically the employee’s entry date into the offering), and the purchase price may be based on the fair market value on the grant date or the purchase date. To effectively administer the $25,000 limit by capping employees’ yearly contributions, both the $25,000 limit and the purchase price must be based on the same fair market value.

For example, assume that an employee enrolls in an ESPP when the fair market value is $25 per share. The plan offers a look-back and a 15% discount. The employee purchases stock under the offering later that same year, when the fair market value is $20 per share. If the employee is allowed to apply contributions of $21,250 (85% of $25,000) to the purchase, the employee will purchase 1,250 shares ($21,250 divided by 85% of $20 per share purchase date fair market value). This would exceed the 1,000 shares ($25,000 divided by $25 per share grant date fair market value) that the employee is limited to under the $25,000 limitation.

While it is true that where a plan has a look-back and the stock appreciates in value over the offering, both the purchase price and the $25,000 limitation will be based on the grant date fair market value, there is no way to predict that this will occur at the time the employee is making contributions to the plan, making this an unreliable method by which to administer the $25,000 limitation.