Part One: Managing Equity Incentive Plans in a Volatile Market

This blog post is part one of two discussing equity incentives and ways for employees to liquidate a portion of their shares while the company remains private. Most companies are in the middle of granting 2020 annual equity awards. This granting of equity awards is happening simultaneously with the COVID-19 outbreak and the larger volatility on business operations and financial markets. The purpose of this blog is to highlight some considerations when granting equity awards in light of recent events.

409A Valuations

The threshold consideration is the overall value of the company, which then flows through to the value of any equity incentives being granted, impacting such matters as the strike price and the number of incentives being issued to eligible recipients (such as, e.g., employees, contractors, advisors, and directors). Although it is not required by law to do so, typically, a company will conduct a 409A valuation to derive the fair market value of the company and its common stock, to provide a base for determination of the value of any equity incentives to be issued (although other factors may be taken into account as well). A 409A valuation is often (but not always) different from a company’s post-money valuation following a financing round because investors typically receive preferred stock. Nonetheless, it is generally good practice to commission a new 409A valuation every 12 months, before the company issues its first common stock options, after raising a round of venture financing, and/or when there is a material event that may impact the value of the company.

Equity Incentives

Equity incentive plans are standard features of startups granting an equity interest in the company to employees and other personnel allowing them to share in the upside potential of the company. A well-crafted omnibus equity incentive plan is going to give the company the optionality to issue (a) Incentive Stock Options (ISO), (b) Non-qualified Stock Options (NQSO), © Restricted Stock and (d) Restricted Stock Units. Within the equity incentive plan, the committee appointed by the board of directors to administer the plan should have the authority, among other matters, to determine when the awards are to be granted under the plan and the applicable grant date; to determine the number of shares of common stock subject to each award; to determine the instrument to grant the employee or personnel; and to amend the awards including the time of vesting.

So, if the 409A valuation returns a lower than expected valuation (especially given the current market) requiring the company to use more shares from the equity incentive pool than anticipated, the company could consider certain alternatives, such as, for example:

• Grant restricted stock units (RSUs), which command a higher value based on how the RSUs are structured, thereby requiring fewer shares to grant to come to an equivalent value;
• Make the equity awards contingent on shareholders approving an increase in the size of the equity incentive pool at the annual meeting;
• Delay the grant until the after the annual meeting of shareholders, if an increase in the size of the equity incentive pool is approved; or
• Provide the option to have the awards cash-settled (which itself does come with some tax and accounting downsides).

It might also be an option to reprice the options if the equity incentive plan permits or pending shareholder approval. If the repricing involves any change in the award other than a reduction in the exercise price, such as exchanging options for RSUs, the company must comply with securities laws and the corresponding tender offer requirements. If a repricing is not an option, the company could also consider granting supplemental awards. However, the granting of supplemental awards does come with accounting difficulties and would adversely affect the company’s dilution levels.

It is also worth mentioning that there could be ‘upside’ to a lower than expected 409A valuation, in light of recent events, as it relates to equity incentive base pricing. With lower base pricing, there is an opportunity for companies to issue equity incentives that are credibly (and, more importantly, tax defensibly) less valuable than they were even one month ago. If one believes that the price of equities and company valuations are, currently, artificially low as a result of the COVID-19 scare, then, by the time they return to normality, the previously issued equity incentives will be more valuable in the hands of key employees and other recipients. An explanation of the company’s theory of the same could be a useful recruiting tool for key employees in these uncertain times.

Our View

Boards and management teams should consult with their legal, tax, and accounting advisors before changing their equity incentive plans as changes can force the company down different paths. As well, the boards and management teams should make decisions based on potential reactions from all stakeholders who are dependent on the future of the company. The next few months are shaping up to be volatile economic times but that also means time for introspection and internal brand strengthening to come out stronger on the other side.

Looking past the issuance of equity and incentive compensation, Part 2 of this blog post is going to cover companies conducting internal tender offers for those seeking to sell a portion of their vested options while the company remains private and weathers this financial volatility.

Written by Stan Sater and Jeff Bekiares

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If you are a business that has questions about equity incentive plans, contact our Founders Legal team at ssater@founderslegal.com and jeff@founderslegal.com.

Originally published at https://www.smartuplegal.com.