As a CEO or C-level executive, you may feel that your biggest financial opportunity from your services with a new company may not be your cash compensation, base salary or bonus, but rather your equity package.
There may be one or more of several reasons you feel you have a greater financial upside value in your equity package than from your fairly fixed and limited cash compensation, including the following:
- Appreciation – You feel the stock is undervalued and even if it is fairly valued you feel that during the period of your service the stock price or value might rise significantly.
- Liquidity Event – You feel there may be a liquidity opportunity either an acquisition or an IPO that might also significantly increase the stock price.
- Favorable Taxation – You feel that with the right structuring, equity appreciation and cash out may be taxed at a much lower rate than cash compensation giving you much more take home pay.
There is no certainty that you will achieve these favorable financial outcomes with your equity, even if you receive a significant equity position in the company. If, despite your efforts, the company fails and the stock price declines or, worse still, the company goes bankrupt, regardless of the terms, you are unlikely to benefit.
However, if the company does succeed, there are different ways you might be denied the benefits you earned. This article discusses several of the key protections you should seek to assure that if the company does succeed and investors reap a reward, you, as a key executive who had a significant role in this success, are rewarded as well.
Meaningful Level of Equity
You want to be sure that the level of equity issued to you is appropriate. If you succeed in your mission, perhaps over four years, the value of your equity might double, triple or even see 4x growth. More than that might be possible, but the amount of equity you are issued needs to provide you a meaningful pay back within that growth.
So for example, if your base pay is 400k, your bonus 50% target, then if you achieve 3x growth over the 4 year vesting period, a $3 million equity pay out would seem to be a meaningful one.
To achieve that payout, you would need equity valued at $1.5 million that appreciates 3x to $4.5 million to net $3 million. So, if the company issued you equity of $100,000 or even $500,000 that just won’t do it for you. 3x growth on $100,000 to $300,000 would only net you $200,000. Netting just $200,000 after the 4-year vest and 3x growth, it means you achieve just $50,000 of value per year over the 4 years. That would make the equity by far the smallest component of you executive comp package. Even you cash bonus with a 50% target is 4x greater than annual equity. Even with $500,000 in equity, 3x growth to $1.5 million will only net $1 million. That would mean $250,000 per year. A little more than your bonus but still much lees than your base pay. Over 4 years the stock might not appreciate, but if you do bring success to the company and big success – 3x growth, you ought to share in it. I would want to see a big hit where your efforts made millions for the owners and investors.
Tax Favorable Structure
The best possible structures would be to achieve long term capital gains treatment to be taxed at half the rate of ordinary income, with no withholding and no pay roll tax.
Even better, if possible, is to have your equity issued as QSBS – qualified small business stock -which is held for five years and could potentially have zero Federal taxation. The higher of $10 million or 10x growth can be shielded from Federal taxation – not even capital gains taxes are paid.
To achieve that low level of taxation you would need to own the share – either restricted stock or RSUs – restricted stock units. If the value is too high for you to acquire, the company can loan you the money to acquire the shares or to pay the taxes if the shares are issued without cost to you. The tax law offers potentially highly favorable terms for such loans at 120AFR (that is 120% of the Applicable Federal Rate) which is currently 2% per annum lower than the Wall Street Journal prime rate.
If the Company does succeed, a major concern is that at some point there may be a “changing of the guard” and a new CEO may want to bring in his or her own people.
So, if you have delivered for the company and perhaps gave up a good amount to join, but are just 18 months into your vesting and see significant upside ahead, it would be a shame to then be replaced and thus see your replacement reap the rewards you earned.
How do you protect yourself against this sort of premature, unjustified termination that deprives you of what you were building toward? The answer is termination and severance provisions in your job offer or employment contract, that create a barrier to premature termination. You cannot stop this conduct, but you can deter it by making the company buy you out.
True Up Adjustment
Angel and VC investors receive anti-dilution protections for their investment. These protect them against a down round.
What about the CEO, CTO, CFO or other critical C-level officer? Shouldn’t you get protections too?
For the C-level officer, I typically try for a “true-up adjustment.” This works like anti-dilution protection that investors get. My goal is typically to preserve your equity position through a certain level.
Thus, for example, if you join an early stage company and take a 4% equity position and will have a key role in helping that company achieve its next round of equity, a true-up adjustment could maintain your 4% position through that next round. Because this would be an adjustment and not a new stock grant, there would be no taxation to you just as there is no taxation for the implementation of investor anti-dilution protections.
If the Company achieves success and rises in value, that does not guarantee you will be able to monetize the success you achieved. If the Company is a public company, this is not an issue because after any black-out periods you can sell shares on the public market.
But what if the company is private? What if there is no market for your shares? How do you monetize the value in your equity?
If this is an important concern, then I seek cash out protections, which provide that if liquidity is not achieved within a reasonable time frame, your offer or contract would provide for a put option that enable you to sell all or part of your shares back to the company at an appraised fair market value price.
In addition, the contract should provide “tag along” rights so that when any founder or investor sells shares, you are notified of the sale and permitted to sell up to the same proportion of your shares for the same price and terms.
There are other protections you can also seek, such as information rights in the company, but the five protections set out above are the most important. In this area, it is wise to utilize the services of a tax-trained executive employment attorney to review the documents and assure there are sufficient protections so that if you do achieve success for the company, you have reasonable assurance going in that you will in the end be able to reap the rewards of the success you achieved for the company.
Written by Robert A. Adelson, Esq.
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