Founders and Execs Part 2: Tips for Negotiating Tax Effective Executive Equity Compensation Packages

Following-up on For the Record: Founders and Execs Beware Part 1: The Options for Options Costly Tax Trap, this article will focus on the practical approaches for negotiating and understanding equity-based components of key executive compensation in the context of a company whose value (perhaps despite being relatively new) is high.

Typical Fact Patterns

Valuable Biotech: Founder has a great idea based on exciting science and market opportunity. In fact, this idea is so good investors flock to the financing, giving the company a large initial valuation even before there are employees in the fold. Founder must now build out the team, necessitating some form of equity compensation. However, grants of restricted stock, even after considering a quality 409A valuation, will create taxable income and therefore a cash outlay for the employees.

Valuable Tech Company: In this fact pattern, founder has a highly successful business with solid revenue and profitability. The business is valuable today, but the founder expects the value to increase dramatically in the future. With an IPO or acquisition as possible options, a more senior team needs to be attracted and compensated. Stock options may seem like the best compensation plan as their grant causes no taxation. In addition, as long as the executive exercises and immediately sells, the strike price (out-of-pocket purchase price at the time of grant) and the resulting tax bill on the spread between the strike price and fair market value at exercise can be covered with proceeds. However, the income recognized would be at ordinary tax rates, almost double what the long-term capital gains tax would be.

This company and the founder have a few powerful, but little understood, alternatives to consider. Assume that the objective is to grant an executive $1 million of stock so he or she can participate in value accretion above $1 million. The traditional option approach would grant stock options on $1 million worth of shares and create an obligation to pay $1 million at the time of exercise. If this approach is taken, the executive pays the strike price and an ordinary income tax on any increase in value between the grant date and the exercise value. 

If the executive negotiates for options that can be exercised immediately upon grant and makes a Section 83(b) election, the only out-of-pocket cost is the strike price. Since there is no difference between the value and strike price on date of grant, there is no income tax event. This exercise would also start the holding period on the stock. After one year, the gain on any sale of that stock would be taxed at the more favorable capital gains rates. What is critical in this strategy, however, is that the grant of the options agreement must allow the early exercise and the executive must have the ability to pay the strike price.

It should be noted that private companies may loan executives the money needed to pay for their option exercise, which would not impact company cash-flow as the money loaned immediately comes back to the company as part of the exercise. This loan would however have to be paid back if and when approaching an IPO.  

A Different Approach

In certain circumstances, there is a way for a profitable, tax-paying company to grant its executives stock for free, cover their personal tax bill and be out of pocket zero cash. As above, assume the objective is to grant $1 million of stock to an executive.  For ease of illustration, also assume a 50% tax rate for both the company and the executive. The company would grant the executive $1 million of stock and a $1 million cash bonus, resulting in $2 million of taxable income and $1 million of tax to pay. This tax would be paid with the $1 million cash bonus, essentially making the grant tax-free. From the company’s perspective,  it receives a $2 million deduction for the compensation paid, which then reduces its tax bill by $1 million, the amount of cash bonus paid. As a result, this transaction is cash-neutral for the company as well. 

Although this transaction looks easy on paper, in practicality there are several issues to consider.  First, the company must have taxable income as building a net operating loss inside the company will not help generate the cash needed to pay the bonus. In addition, the stock valuation should not be driven by net income, as the bonus payment would impact the stock value, preventing equalization between stock value and cash paid. From a non-tax/cash-flow perspective, the company must also be willing to agree to this arrangement. Often if an executive is joining an existing company whose team has already grown its value, the  owners (and team) may not want to give what they have invested in and created to a new person without requiring that the stock be paid for.

There is no question that acquiring talented executives is critical for growing companies and that equity compensation remains a key component in that acquisition. However, thought and care must be given when considering the types of compensation packages offered as there is no "one size fits all" plan.