A Practical Guide to Equity Incentive Plans

January 1, 2010

Author: John A. Leonard

A. Introduction

Equity (a Company’s stock if it is a corporation or membership interests if the company is a limited liability Company) may be a Company’s best method to reward long time performance and retain employees. At the heart of a Company’s program is the “Equity Incentive Plan”. This article discusses the types of Equity Incentives common to many Equity Incentive Plans (the “Plan”).

B. General Plan Description

Most Plans are established for certain key employees of the Company, certain consultants and advisors to the Company, and certain non-employee directors of the Company. The Plan document describes the term of the Plan (typically 10 years), as well as how the Plan is administered (typically by the Board and typically the Plan gives the Board wide latitude to make decisions). Most Plans permit the grant of Incentive Stock Options, Non-Qualified Stock Options, Restricted Stock Awards, and other stock grants.

C. Incentive Stock Options versus Non-Qualified Stock Options.

It is important to understand the differences between Incentive Stock Options and Non-Qualified Stock Options. The principal differences between the two types of options are eligibility and tax benefits. With respect to eligibility, Incentive Stock Options are limited to the Company’s W-2 employees. Independent contractor consultants and others that are not W-2 employees are ineligible for Incentive Stock Options. Non-Qualified Stock Options can be offered to both W-2 employees and other individuals or consultants that do not otherwise qualify as a W-2 employee. In both cases, the holder of the option pays a pre-determined amount of money to purchase common stock of the Company – with the expectation that the payment is less than the market value at the time the option is exercised. The tax differences are summarized in the table, below. When the Company grants an Incentive Stock Option or Non-Qualified Option it will need to: (a) take a Board Action; (b) enter into a Stock Option Agreement; (c) enter into a Stock Purchase Agreement; and (d) provide a sample Notice of Stock Option Grant.

D. Restricted Stock

The other type of equity incentive common under Plans is Restricted Stock. Unlike an option, stock is issued all at once – but subject to forfeiture if the recipient ceases to be employed by the company for a certain amount time. Unlike options, the recipient usually pays nothing for the stock. The tax issues related to Restricted Stock are summarized, below. When the Company grants a Restricted Stock Award (discussed below) it will need to: (a) take a Board Action; (b) enter into a Restricted Stock Agreement and (c) provide a Notice of Restricted Stock Grant. In many instances the recipient will want to make a Internal Revenue Code Section 83 election. This election typically reduces the amount of tax the recipient would otherwise pay if he or she failed to make the election and instead was taxed when the Restricted Stock vests. There is a 30 day time limit in which to make the election, the stock will need to be valued and the valuation is reported by the Company and the recipient, thus, the values need to be the same.

E. Other Grants

Many Plans permit “Other Grants” of common stock. For example, a Plan might provide: “From time to time during the duration of this Plan, the Board may, in its sole discretion, adopt one or more incentive compensation arrangements for participants pursuant to which the participants may acquire shares, whether by purchase, outright grant, or otherwise.” Generally, this contemplates some sort of “Stock Bonus” – usually upon achieving a significant goal or sometimes in lieu of cash bonuses at the end of the year if the Company is cash-poor. A grant covered under this provision would require a Board action and a Stock Purchase or Shareholder Agreement.

F. Summary of Taxation Issues

The chart below summarizes important tax differences between Incentive Stock Options, Non-Qualified Stock Options, Restricted Stock and a Stock Bonus:

Types of compensation and tax consequences

Type of compensation Effect on employee at:      
  Grant Exercise (Assume at time of Vesting) Sale of Shares Tax deduction for employer?
Incentive Stock Option No income No income Long-term capital gain* No
Nonqualified stock option Ordinary income** Ordinary income*** Long-term capital gain* Yes
Restricted Stock No Income or Ordinary Income if IRC Section 83 Election**** Ordinary income if no IRC Section 83 Election Long-term capital gain* Yes
Stock Bonus Ordinary income Not applicable Long-term capital gain* Yes

* If shares held more than one year.   ** If value of shares can be determined.   *** If income not recognized at date of grant.   **** If recipient elects to recognize at time of grant, income is recognized, but typically at a substantially lower amount than if recognized at time of vesting.

G. Valuation Issues

Valuation is an important issue for the Company and a Company must make e arrangements to have the options or restricted stock valued at least annually. Generally, options are valued both at the time of grant and at the time of exercise. Restricted Stock is valued at the time of grant if the employee makes an election under Internal Revenue Code Section 83 or at the time of vesting if no Section 83 election is made. Timing of the valuation is important. Depending upon what is happening at the Company, it may need annual valuations or more frequent valuations. In other words, the Company does not need a valuation each time a grant is made – it can use an existing valuation if it is recent enough based upon the facts and circumstances of the Company’s business. A valuation that is recent, but prior to winning a major contract, may be too low. Similarly, a valuation that is recent, but prior to a negative event that affects the Company may be too high.

H. Securities Issues

There are two issues a Company needs to be aware of when in connection with offering and granting options and restricted stock: (1) every offer or sale of securities needs to be registered with the Securities and Exchange Commission (SEC) unless there is an exemption; and (2) in every offer or sale of a security, there must be no material omission of fact or material misstatement of fact (this is called “Adequate Disclosure”). With respect to the first issue, Companies usually rely on the Rule 701 exemption to registration found in the Securities Act of 1933. Important Aspects of Rule 701 are the following:

  • The offer and sale must be in connection with a written “Compensatory Benefit Plan.”
  • The offering must be limited to employees, directors, general partners, trustees, officers or consultants and advisors, and their family members who acquire such securities from such person through gifts or domestic relations orders.
  • With respect to Consultants, they need to be natural persons (not entities), they must provide bona fide services to the company, and the service cannot be in connection with the offer or sale of securities in a capital raising transaction.

With respect to the second issue, Adequate Disclosure, Rule 701 states that if the Company does not issue more than $5,000,000 of Securities in its Compensatory Benefit Plan in a 12 month period, then the Company does not need to give an Offering Circular to participants in the Plan. An Offering Circular is a long and detailed stock offering document most typically used when a company is raising money from investors. Many Companies never cross that dollar threshold and thus, the need for a detailed Offering Circular will not be mandated by law. Although an Offering Circular may not be mandated, the Company still must give Adequate Disclosure. Many Companies elect to include, at the time of the option grant and again at the time any option is exercised, a full and updated set of risk factors, and a statement regarding any activities, issues or items that management would consider material to an individual considering the purchase or sale of the issuer’s securities. Many Companies include as an exhibit to the Option or Restricted Stock agreement (to be signed by the employee upon grant of the stock or option under the plan) a set of risk factors and a statement about any material information. This requires comparatively minimal legal investment and the risk factors and basic disclosures should be able to eliminate a majority of the risk.

I. Other Equity or “Equity-Like” Incentives

The Plan and the documents and discussion discussed above relate only to Equity Incentives. However, a Company can choose from a wide range of incentives and benefits that relate to the Company’s equity without actually issuing any equity. For example, some Companies use “phantom stock” agreements or “stock appreciation rights.” Phantom stock is helpful when a Company does not want to issue equity to recipients, but desires to reward recipients as if the recipient owned stock. Thus, a Company can enter into an agreement with a recipient that it will compensate him or her as if the recipient held a certain amount of stock. This way, a recipient can receive cash amounts whenever dividends are paid to other holders of common stock or, more importantly, receive a certain portion of the sales proceeds should the Company be sold during a specified period of time. These agreements are very flexible and can be drafted to provide for vesting, incentive goals, and other incentives based upon particular metrics. A significant benefit to the Company on these types of arrangements is that the recipient does not have the power to vote as other shareholders would on mergers, significant sales, etc. The recipient also does not have “dissenter’s rights” upon a sale, as a shareholder would. One significant drawback to the recipient is that the amounts received are taxed as ordinary income, rather than long-term capital gains.


This Article is published for general information, not to provide specific legal advice. The application of any matter discussed in this article to anyone's particular situation requires knowledge and analysis of the specific facts involved.

Copyright © 2010 Fairfield and Woods, P.C., ALL RIGHTS RESERVED.

Comments or inquiries may be directed to:

John A. Leonard.