As an executive, you know that compensation negotiations are serious business. Failure to exercise due care when establishing your executive compensation package may result in leaving money on the table, both presently and in the future.
Generally speaking, when it comes to salary and bonus, you want to be paid the market rate for your position. Other compensation and related benefits such as vacation, personal time and health insurance coverage are usually fairly straightforward.
For most CEOs and C-suite executives, however, the major area of negotiation often concerns equity compensation.
This article discusses key things to look for in your equity package, the four main choices for structure of equity and the different consequences of each. Finally, the article discusses how Restricted Stock is the best choice for senior executives joining high growth companies and in turn-around situations.
Equity Is Not Always Important
Equity compensation is usually important to CEOs and senior executives, but not always. Non-profit corporations, for example, don’t offer equity. Generally, family businesses don’t either (See my article on phantom stock, which is an attractive alternative to equity in a family business.
Other businesses do have equity, but the opportunity for equity appreciation or for liquidity may be limited. In these circumstances, the executive’s interest should be more focused on his or her base salary and bonus package.
Barring the above exceptions, most incoming CEOs and C-suite executives join the company with a positive view of its prospects. They believe that they can make a contribution to the company’s growth, and the goal of equity compensation is to afford the executive a share in the growth he or she contributes to. Executive equity further aligns the goal of the executive with that of the company. The executive has some “skin in the game” for the growth of the company.
Where Equity Has Its Greatest Value
Equity compensation takes on its greatest potential value in companies, often technology-based, that are pre-IPO and with high growth potential. Another opportunity would be in turn-around situations where the equity began with a low base price and a considerable increase in value would result if the CEO can bring about a successful change to the company.
For example, consider a CEO who is brought into a turnaround situation or to scale a pre-IPO company with high growth potential over a 4-year horizon. His or her base salary is $400,000, and the current value of equity vesting over 4 years is $2 million. If that executive succeeds in leading the company to significant growth or an IPO or other liquidity event and in 4 years, his or her equity triples in value, that would be $4 million of appreciation – more than double the executive’s base salary over that period. In high growth situations, the potential increase in equity value may be even greater than the 3x in this example. It could be 4x, 5x, 10x or more.
Another very important consideration is that the executive’s salary is taxed at ordinary income tax rates and is subject to payroll taxes. The equity appreciation has the potential to not subject to payroll taxes and be taxable at capital gains rates, which is generally only one half that of ordinary income tax rates. So, the after-tax income generated by the sale of the equity has the potential to far exceed the after tax income of salary and bonus.
Key Ways to Assure Value in Your Equity Compensation
The example above illustrates how important equity can be as a component of executive compensation. And there are several other takeaways.
- What will be the strike price? Is there opportunity for considerable appreciation within the given time horizon.
- Did you receive enough equity to make this worth it? Because the executive started with equity whose aggregate strike price was $2 million, 3x appreciation translated to an appreciation of $4 million. Had the aggregate strike price been $200,000, then even with 3x growth, the potential gain for 4 years would only have been $400,000.
- Type of equity and its tax treatment is important. There are many choices in how to structure equity. The executive in a high potential growth or turnaround situation should seek the structure for his or her equity that offers the best prospect for capital gains on the appreciation.
Equity Structures in Executive Compensation
There are four main choices for equity structure:
- Incentive stock options, qualified under the tax code (ISOs)
- Non-qualified stock options (Non-quals)
- Restricted Stock
- Restricted Stock Units (RSUs).
The most popular choice of equity structure, especially for employees and lower level executives, are stock options, either ISOs or Non-quals. The advantage of stock options is that they cost nothing when they are issued. At the same time, they are also worth nothing on issuance. The recipient must pay the strike price on exercise. The stock options disappear on or shortly after employment termination, and the opportunity for a favorable tax outcome on appreciation is limited.
For Non-quals, when the options are exercised, the strike price must be paid. In addition, all appreciation at the point of exercise (whether or not the stock is liquid at the time of exercise) is taxable at ordinary income tax rates and subject to payroll taxes.
ISOs are more favorable. No tax is imposed on option exercise, but rather on sale of the stock itself. If the stock is held after exercise for less than a year, the appreciation at the time of exercise is taxed at ordinary income tax rates and subject to payroll taxes. If the stock is held longer than a year, the appreciation is a preference item for the Alternative Minimum Tax, potentially triggering AMT taxation. The later sale of the stock will be taxed at capital gains rates, with no credit for any earlier AMT paid.
Restricted Stock: Best Choice for Senior Executives in High Growth and Turnaround Situations
In the high growth and turnaround situations, the much better choice is to get all or a significant part of your equity structured as restricted stock. This is often negotiable for CEOs and senior executives.
Restricted stock offers the CEO or senior executive the following significant advantages:
- Avoiding the strike price. CEO and executive restrictive stock grants often grant the stock at zero cost so there is no payment of the strike price.
- Retention of value on termination. ISOs must expire within 90 days of employment termination, and though the tax code does not require that for Non-quals, those options are typically written the same way. With restricted stock, once you vest, you own and retain it. The company cannot cancel your stock on termination unless there is a buy-back provision.
- Capital Gains Tax Treatment. Typically, an IRC Section 83(b) election is made within 30 days of the grant of restricted stock. This is accompanied by payment of the value of the stock issued (For true startups, the stock may be worth little at founding and a nominal payment is made which is fair market value at the time). After that, if the stock is held more than a year, all appreciation will be taxed at capital gains rates and that tax will fall only on sale of the shares.
There is no down side to restricted stock if issued to a founder of a startup company. There is a downside if the CEO or senior executive is issued restricted stock in an established company. Assuming the stock is issued without charge, ordinary income tax will be due on issuance of stock for all shares then vested and for any shares for which the 83(b) election has been made. Typically, the CEO or senior executive receives a loan from the company to help pay his or her taxes. The loan terms often provide for forgiveness if the executive is terminated without cause before vesting of the shares, and re-payment of the loan on sale of the shares.
Restricted Stock’s Potential Economic Benefit: An Illustration
In our example, let’s say the CEO was issued $2 million in restricted stock and timely made the 83(b) election, he or she would be taxed about 40% (ordinary income and payroll taxes). That would be $800,000, paid with the proceeds of a loan by the company secured by the stock. The CEO would then have a $2 million tax basis in the stock. When the shares are sold for $6 million, the CEO has a $4 million capital gain. At 20% tax rate, that would result in $800,000 in capital gain taxes. After the CEO pays back the loan with interest accrued, e.g. $900,000, he or she nets $4,300,000. (That is – $6 million, less $800,000 +$900,000)
In contrast, if the CEO were issued Non-qual options of $2 million aggregate strike price, and then exercised and sold on the same 4-year date, he or she would pay a $2 million strike price, and pay 40% tax (ordinary income and payroll taxes) on the $4 million in appreciation, i.e., $1,600,000. As a result, the CEO nets only $2,400,000 (That is – $6 million, less $2 million + $1.6 million).
As illustrated in the above example, both the grant of restricted stock, use of the 83(b) election and its favorable tax structure can make an enormous economic difference to the executive. In this example, netting the executive almost twice the net income.
RSUs: Hybrid Equity That Also Delivers Value
Another equity structure is RSUs – restricted stock units. This approach is a bit of a hybrid. The RSU is a contract of the company to issue stock in the future. Thus, like restricted stock, the executive is receiving something of value with no strike price and where vested, not terminable on employment termination. On the other hand, like options, there is no 83(b) election and ordinary income taxes will be due as it vests. The RSUs structure is quite desirable in companies where high growth is not expected and the executive wants to be assured of equity that will have value. For more information on RSUs, see my CEOWORLD magazine article on RSUs.
In structuring your executive equity compensation, there are other important issues in the terms of stock grant agreements, stock option agreements, equity plans and other key documents that govern the terms of your equity. Given the potential importance of equity in the overall value of your executive compensation package, it is wise to have an experienced executive employment lawyer review and advise you on those contract terms.