VOICES FROM THE INDUSTRY: New rules could change equity-compensation planning

May 1, 2006

Equity compensation has long been a topic of great interest to company managers and private equity investors alike.

Recent changes in tax laws, accounting rules and securities laws may lead to new ways of thinking about this type of compensation.

Stock options tra er, with a grant of restricted stock, the holding period for which begins on the date of grant (if an election is made) or at the time of lapsing of the restriction (if no election is made).

However, the downside to the receipt of restricted stock is that executives must either risk capital up front or incur ordinary income tax at the time of the grant (if an election is made) or at the time of lapsing of the restriction (if no election is made) on an amount equal to the value of such stock on the date of the grant or the date of lapse, as the case may be, less any consideration paid.

More LLCs

As a result, increasingly, companies are organizing themselves, or their holding companies, as limited liability companies that offer "profits interests" to top management. If properly structured, profits interests do not result in ordinary income (or any related income tax) at the time of the grant and also begin their capital-gain holding period at the time of the grant. These interests then are typically rolled into stock upon an initial public offering of the company.

Under FAS 123R, an accounting rule that took effect on Jan. 1, the accounting treatment for stock options also generally will be less favorable than the accounting treatment for restricted stock or profits interests.

Public issuers will need to value options (under either a Black-Scholes or binomial formula) and will have to expense the value ditionally were a favored form of equity compensation because there generally was no charge against earnings for the value of the option under previous generally accepted accounting principles. In addition, the employee could defer income recognition, and any cash outlay, until a point when a return on investment was more certain.

Nevertheless, restricted stock and profits interests have always offered some advantages over stock options from an employee's income-tax perspective.

Most employees receiving equity compensation desire long-term capital-gain treatment rather than ordinary income treatment. Stock options usually do not result in long-term capital gains because they aren't typically exercised by the holder until an exit opportunity arises and the capital gains holding period does not begin until exercise. This is not the case, howev in excess of the exercise or strike price over the applicable option vesting period, even if the option has a strike price that is equal to fair market value as of the date of the grant.

And, while private issuers can still use the intrinsic value method for valuation, they must mark the options to market on a quarterly basis under variable accounting rules.

Therefore, the longer the term of the option and the more volatile the stock price, the greater the charge to the issuer. Restricted stock, on the other hand, will continue to be treated as it is under current rules (i.e., there is an expense to the company only to the extent the purchase price for the stock is less than its fair market value and this expense is taken over the period during which the stock is subject to forfeiture).

Under these rules, restricted stock grants made for nominal or no consideration, which is frequently the case, can provide both greater upside potential and downside protection as compared to stock options with a fair-market-value exercise price on the same number of shares of stock.

As a result, companies can grant fewer shares of restricted stock to provide a similar equity incentive, which means less dilution to the company's shareholders.

FAS 123R will also likely result in a broader use of performance-based vesting (whether a company is granting restricted stock or options), which is generally viewed as a desirable way to align company and management interests.

Under the prior accounting rules, if an issuer wanted to avoid quarterly market-to market-accounting rules (as most did), it was required to include a fixed date for vesting of any performance-based awards, which could result in vesting of the grant even if performance hurdles were not met.

FAS 123R now requires fixed accounting treatment for performance-based options and restricted stock, thus eliminating the need for a cliff-vesting date.

Fair market values

While fair-market value determinations have always been important, given that grants of equity below market value result in earnings charges under GAAP and, in the case of stock options, prevent qualification as incentive stock options, the new deferred compensation tax rules under Rule 409A of the Internal Revenue Code have made these determinations even more important.

Under these rules, if an option is granted with a strike price below fair market value, the option not only will be taxed as it vests, thus, resulting in phantom income, but also will be subject to an additional 20-percent tax to the recipient. This is expected to result in an increase in the use of third-party appraisals to support value determinations and an increase in board deliberations and care in documentation concerning strike/purchase prices for grants.

Rhodes is a partner at Indianapolis-based law firm Ice Miller LLP. Her primary area of concentration is in venture capital and private equity financings, mergers and acquisitions. Views expressed here are the writer's.
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