Chapter 11 - Compensating Your Key Executives - The "Carrot" Approach: Equity Incentives

Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts

McCarter & English LLP

2002-08-02

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Since both start-ups and buyouts depend in large part on extraordinary performance by managers qua proprietors, one principal aim of the planners of new ventures is to put stock or stock equivalents in the hands of senior managers without occasioning tax liability. Indeed, managers may be required to accept stock instead of cash compensation in order to preserve cash flow for the benefit of the lenders. The trick is to use stock as currency without occasioning immediate tax, not a simple exercise since, in the final analysis, stock is being awarded for past or future services, a taxable event in classic terms.

A central planning imperative is to tie equity to the performance of the employee. Thus, if shares (or options or stock equivalents) are awarded, it is important that employee "fat cats" are not thereby created, employees who can relax from and after the date of the award and watch their colleagues make them rich. Accordingly, awards, once made, usually "vest" over time, meaning that the price is fixed as of the date of the grant, but the options or stock can be recaptured for nominal consideration if the employee elects to quit prematurely.

Regardless of how sophisticated the stock or stock option plan may be, it is likely that the employee will have to pay tax at some time on the value he has received. The trick is to match the employee's obligation to pay tax with his receipt of income with which to pay the tax. The most popular securities are the stock option and restricted stocks described in the following sections.