Concerns with Equity-Based Compensation
We’d like to introduce ourselves as the Human Capital Advisory Services arm of this new EisnerAmper Benefits Blog. This is our first blog contribution and we look forward to sharing our observations on a number of interesting and, at times, vexing issues confronting companies, organizations and boards as they wrestle with a host of executive compensation issues.
In this edition we’ll offer Part One of a three-part blog exploration of Compensation Mistakes. We’ll start with one of the most common mistakes made by start-up companies, Equity-Based Compensation.
The Mistake: Promising multiple executives a part of the company.
It’s easy to see how this can come about. A company is newly founded and is ripe with excitement and opportunity. The CEO has assembled a team of eight experienced professionals who recognize the risks of joining a start-up but who also expect to have a piece of the upside. The CEO makes a mistake and offers each executive one percent of the company, along with salaries of $150,000.
The CEO granted significant share ownership of the company without considering the tax burden he was putting on the backs of his executives. Later that year, the company receives a large government research grant. This triggers a taxable event and causes each of the executives to have $1 million in ordinary income in year 1.
The company could give each executive a cash bonus to pay taxes, but that would use up needed cash resources. The CEO is now in a very awkward position. He has to tell all his valued new executives, some of whom were close friends, that he had caused them a huge tax problem. In addition, he gave out all the reserved shares in one grant… leaving no shares to attract other needed executives.
A solution to this problem can be found by taking a number of steps including:
- Reduction in cash compensation
- Cancelling the original promise of fully vested shares
- Adoption of Restricted Stock plan with three years cliff vesting
- Stock options for new executives and a three-year performance unit plan to pay the taxes on the restricted stock when vested in year 3.
This is just one possible solution to this particular problem. In future blogs, we will address other common mistakes and offer solutions.