Consulting Services Issuing Equity-Based Compensation
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In the current climate of economic uncertainty and depressed equity valuations, many companies experiencing reduced levels of cash flow may want to consider a shift in the way employees and key personnel are compensated. There are many advantages to replacing a portion of cash compensation with equity-based compensation, including:

  • Relieving strain on cash flows as cash payments are reduced;
  • Aligning the interests of the employee with the performance of the company;
  • Improving employee retention; and
  • Providing potential tax benefits for employer.

Employers can weigh several topics in selecting the form of equity award to find the best fit for both the company and its employees. There is also wide latitude in determining the underlying provisions of the selected award (e.g., restriction periods, performance targets, forfeiture clauses, etc.). Several commonly-used forms of equity compensation include:

Types of equity awards

Award Type

Description

Stock Options

Grants the right to purchase company stock at a defined exercise price over a certain period of time.

Restricted Stock

Grants a restricted share of company stock, which may become issued and unrestricted after a defined period of time. May have certain conditions, such as continued employment or achieving certain financial targets.

Profits Interest Units

Grants the right to receive a percentage of profits upon the achievement of certain conditions or common stock value.

Stock Purchase Plans

Grants employees the right to purchase company stock, typically at a discount to fair market value.

Stock Appreciation Rights (SARs)

Grants the right to receive cash or stock in an amount equal to the appreciation of the company’s stock value at the time of grant through the end of the defined term.

Phantom Stock Units

Grants the right to receive cash or stock in an amount equal to the value of an equivalent number of shares of stock, or the appreciation in value of an equivalent number of shares of stock since the date that the units were granted, upon the occurrence of one or more predetermined events (e.g., a change in control of the company, retirement at or after age 65, etc.).

Valuation considerations

When issuing equity-based compensation, companies need to perform certain valuation analyses to help ensure compliance with tax and financial reporting rules and regulations.

Tax - Internal Revenue Code (IRC) 409A

  • Requires determination of the Fair Market Value (FMV) of common stock.
  • Certain forms of equity-based compensation require a 409A analysis to ensure option exercise prices or profits interest thresholds are set at Fair Market Value for equity awards to be considered “at-the-money” and avoid tax consequences.
  • Many companies issuing equity-based compensation elect to perform 409A analyses on an annual or semi-annual basis for grants made throughout a year, however, interim analyses may be required if there have been significant changes to company value between valuation dates.
  • 409A analyses provide an additional benefit in allowing companies to periodically assess the FMV of their stock.

Financial Reporting - Accounting Standard Codification (ASC) 718

  • Requires determination of the Fair Value (FV) of issued equity awards.
  • In order to determine the non-cash expense amount for the company’s income statement, a valuation must be performed under the guidance of ASC 718. The FV of the equity-based award issued will be amortized over the life of award to determine the expense amount.

Help is available

Understanding the tax and financial reporting considerations and performing the required valuation analyses associated with issuing equity based compensation can be a complicated undertaking. Whether considering a new equity compensation plan or if one is already in place, contact a P&N advisor for assistance in navigating these issues.

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