Six Share-Based Payment Strategies for Private Companies
At Equity Methods, we have a substantial focus on equity design and accounting for public companies. Lately, though, we’ve been having more conversations with executives and founders of private companies looking to install best-in-class long-term incentive programs.
Private companies are increasingly seeking ways to create liquidity on share-based payment awards issued to key employees. Some, of course, are trying to attract and retain talent in an environment where newly public companies are handing out buckets of liquid entity. But even private companies outside of very tight labor markets are struggling with how to strengthen the perceived value of their equity and drive growth through high-powered incentives. In fact, some private companies create liquidity only at termination, which leads to the strange outcome of terminated employees being the only ones to monetize their holdings.
We have some ideas.
1. Offer Redemption Vehicles for Employees
In the most extreme cases, redemption is only permitted upon a change in control when there’s an observed market price and corresponding liquidity. But if there isn’t a liquidity event, the perceived value of the equity can start to crumble. As a solution and if cash positions permit, offer redemption vehicles for employees. The most basic form is to offer set windows during which the company will repurchase vested equity (or phantom equity) for cash. The redemption price is generally tied to a recurring business valuation that is being performed by an outside valuation specialist.
If providing interim liquidity is considered too generous or will excessively burn cash, impose caps on how much can be redeemed at once or consider using discounted redemption prices. A discounted redemption price could be the most current 409A business valuation discounted by 20%.
2. Add a Performance Condition
While the most current business valuation will normally form a good basis for setting a redemption price, business valuations can be largely driven by far-into-the-future “terminal values.” As a result, it’s possible to have a high business valuation when, in the present day, the company is struggling or cash tight. One solution is to add a performance condition to the option in order to more closely synchronize how many options vest or are exercisable at any given time with how the company is performing. For example, an option’s vesting might be made contingent on achieving some measure of free cash flow. Even better, the number of options exercisable could be inflated or deflated according to a tiering of cash flow hurdles.
3. Avoid Immediate Cash Settlement
Cash-settlement features trigger liability accounting under ASC 718. Any effort to create liquidity by the company creates an obligation for the company to pay cash, which is the classic definition of a liability. Consider whether the corresponding mark-to-market accounting poses a problem. For many companies, earnings volatility from stock compensation is a non-cash expense that can be carved out of non-GAAP financials.
Truly immediate cash-settlement is also impractical, since there are not daily valuations of the underlying equity. As mentioned earlier, it’s more common to provide discrete windows during which redemption may occur.
We are aware of some companies that have sought to avoid liability accounting by finding third parties that will create a market for the company’s shares (akin to what public companies have by default since their equity is publicly traded). If structured correctly, the company is not on the hook to redeem the equity award for cash, which could allow for equity accounting to be preserved.
Another way of providing liquidity for shares without becoming subject to liability accounting is to only pay cash for shares that have been held for at least six months following exercise. ASC 718-10-25-9 provides a safe harbor of six months being a “reasonable period of time” for an employee to bear the risks and rewards of share ownership, which prevents liability classification. Administering these more complex terms can be tricky, but this middle ground approach can offer the simultaneous benefits of liquidity to the participant and fixed value equity accounting to the company.
4. Consider Sweeteners
Other features might sweeten the appeal of such an award. One is an extended post-termination exercise window of six to nine months. Why is this important? Companies (mostly in Silicon Valley) are facing extreme difficulty in the labor market when newly public companies are handing out what are normally perceived as much more valuable instruments.
Another sweetener is to set a minimum, but not maximum, price at which the employee can settle the award—equivalent to a put right. However, only in very extreme and unusual cases do we think this makes sense.
5. Establish a Policy for Terminations
Any business valuation in a private company is a theoretical value. Of course, that value is adjusted for risk and uncertainty, but the value is merely an average of a wide dispersion of potential future events. In reality, only one of those potential future events will transpire, and it might not transpire for many years.
This risk is especially acute in a private company where liquidity opportunities are given at termination. To manage it, consider the following options:
- Don’t allow for liquidity at termination—plain and simple.
- Use cliff vesting awards instead of graded vesting awards so that more is forfeited at termination. With a four-year cliff vesting award, multiple grants will be forfeited at the time of termination. To the extent the employee was not a short-termer, cliff vesting still allows upside to be captured on earlier grants.
- Impose a payout cap. For example, specify that the payout cannot exceed 180% of the grant price if the award is exercised in conjunction with a termination event. This may strike a balance that serves the interests of both parties.
6. Plan for a Change in Control
In addition to dealing with the termination case, private companies also struggle more generally with paying out on an award that is mostly intended to drive an IPO or purchase event. Let’s step back and think it through. Many private companies issue options to motivate employees toward a specific milestone: going public or getting purchased by a strategic buyer. As a result, some companies simply don’t offer interim liquidity opportunities because the only thing that matters is that future IPO/acquisition. But others, for all the reasons in this paper, want to enhance the appeal of their equity awards by offering interim liquidity while keeping employees focused on the real goal—IPO or acquisition. If you’re in this boat, consider the following ideas:
- Cap the payout on awards settled prior to IPO or acquisition. For example, structure the award to pay out at no more than 200% of the grant price if/when exercised prior to a change in control. Perhaps specify that if there isn’t a change in control after seven years, only then is the cap removed or lessened.
- Issue two separate grants, whereby one type can only be exercised after a change in control. Similarly, this provides windows for interim liquidity while sending the clear signal that the main prize is a future change in control.
All in all, the right answer depends on each company’s own circumstances. And while we’ve focused on the higher-level strategy considerations, there are a host of important tax and accounting issues triggered by each approach that need to be understood. We look forward to discussing these ideas further with you.
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