1 BUILDING THE MANAGEMENT TEAM: TERMS OF EMPLOYMENT, STOCK AND INCENTIVE OPTIONS Daniel A. Pepper, Esq. Pepper Legal Consulting Group, LLC Stevens Institute of Technology Law & Entrepreneurship Program How to Advise Entrepreneurial Clients: What Every Counsel Should Know Hilton Hotel, Newark Penn Station Newark, NY

2 The Terms of the Executive Employment Contract THE TOP 9 TERMS EXECUTIVE EMPLOYEES ASK FOR… … AND HOW YOUR ENTREPRENEUR CLIENT SHOULD NEGOTIATE THEM.

3 1. The Signing Bonus Returning in popularity after the dot-com bust To be made whole on the loss of vesting options, bonus, and other benefits in switching jobs What the Employee wants: What is the company’s need? What is the perceived immediate value? Corporate Response:

4 1. The Signing Bonus What is common: 15-25% of annual cash pay 20-35% vesting of options Below-market stock Retirement annuity Repayment of cash if employee leaves company early

2. Equity What the Employee Wants: Reward for management and achievement with a stake in the enterprise he or she helps to build Corporate Response: Restricted Stock vs. Stock Options vs. Phantom Stock Financial Accounting Standard Board (FASB) recommendation 5

2. Equity A stock option is the opportunity, given by the employer to an employee, to purchase a certain number of shares of the company's common stock at a pre-established price, known as the grant price, over a specific period of time, known as the vesting period Exercising a stock option means purchasing the company's common stock at the grant price, regardless of the stock's price at the time you exercise the option What is a stock option? 6

2. Equity Two types of stock options: Nonqualified Stock Options (NSOs) are more traditional stock options that do not meet certain IRS requirements that allow special tax treatment. Taxed at time of exercise. IRS levies ordinary income tax, social security tax, and Medicare taxes on the difference between the fair market value when you exercise the stock options and the grant price 7

2. Equity Incentive Stock Options (ISOs) do meet the IRS requirements for special tax treatment. Do not have to pay regular income taxes at the time of exercise But must hold shares at least one year from the date of exercise and two years from the grant date in order to receive special tax treatment If shares sold after the waiting period, subject to a capital gains tax (unlike income tax with NSOs) on the difference between the sale price and the grant price. \ If shares sold prior to the waiting period, these sold shares are subject to a disqualifying disposition which means income taxes generally due on the difference between the fair market value at exercise and the grant price. 8

2. Equity What is Restricted Stock? A grant of company stock in which recipient's rights in the stock are restricted until the shares vest (or lapse in restrictions). Once the vesting requirements are met, an employee owns the shares outright and may treat them as she would any other share of stock in her account Vesting periods for Restricted Stock Awards may be time-based (a stated period from the grant date), or performance-based (often tied to achievement of corporate goals.) 9

2. Equity Restricted Stock Income Tax Treatment Under normal federal income tax rules, employee is not taxed at the time of the grant (assuming no election under Section 83(b) has been made. The amount of income subject to tax is the difference between the fair market value of the grant at the time of vesting minus the amount paid for the grant, if any. 10

2. Equity Restricted Stock Income Tax Treatment For grants that pay in actual shares, the employee's tax holding period begins at the time of vesting, and the employee's tax basis is equal to the amount paid for the stock plus the amount included as ordinary compensation income Upon a later sale of the shares, assuming the employee holds the shares as a capital asset, the employee would recognize capital gain income or loss; whether such capital gain would be a short- or long- term gain would depend on the time between the beginning of the holding period at vesting and the date of the subsequent sale. 11

2. Equity Restricted Stock Income Tax Treatment – Special Tax 83(b) Election Under Section 83(b) of the Internal Revenue Code, employees can elect to change the tax treatment of their Restricted Stock Awards. Election includes the fair market value of the stock at the time of the grant minus the amount paid for the shares (if any) as part of their income (without regard to the restrictions). Employees will be subject to required tax withholding at the time the restricted stock award shares are received. The stock's holding period now begins immediately after the award is granted 12

2. Equity Employees are not subject to income tax when the shares vest (regardless of the fair market value at the time of vesting. Employees are not subject to further tax until the shares are sold. Subsequent gains or losses of the stock would be capital gains or losses (assuming the stock is held as a capital asset). However, if an employee were to leave the company prior to vesting, he would not be entitled to any refund of taxes previously paid or a tax loss with respect to the stock forfeited. Restricted Stock Income Tax Treatment – Special Tax 83(b) Election 13

2. Equity Corporate Response: Are Restricted Stock Awards favorable to Stock Options? While stock options can give an employee a "home run" from a compensation standpoint, the employee runs the risk that the options will have no value, due to the possibility that the exercise price will be greater than the value of the stock. In contrast, restricted stock gives an employee immediate value, is less likely to become worthless, and entitles the employee to all the rights of a shareholder Stigma of Enron and WorldCom 14

2. Equity Phantom Stock Confers benefits similar to restricted stock Employee does not receive actual stock Contractual right to payment based upon the value of company stock No taxable event for company or employee until payment is made to employee (ordinary income to employee, compensation deduction for company) 15

3. Relocation Assistance Remove the cost of moving family, and don’t want to incur more taxes on relocation reimbursement What the Employee Wants: Common to pick up cost of family and professional relocations, including temporary living, storage, moving, and sometimes dual mortgages and cost of home sale/purchase Relocation assistance to move back to original area Company can avoid employee taxable income by allowing tax gross-up Corporate Response: 16

4. Position, Duties, Support What the Employee Wants: Clear responsibilities, sufficient resources, industry visibility Corporate Response: Interests of both parties to confirm officer and/or board positions, responsibilities, performance targets, authority, and reporting structures Discuss staff, facilities, budgets, and D&O insurance Permit outside board and advisory positions that don’t present conflict of interest 17

5. Expense Payments What the Employee wants: Company support in development of professional status and skills Corporate Response: Typical to pick up costs for trade organization memberships, publication subscriptions, speaking engagements, national meetings, trade shows, continuing education 18

6. Non-Competition and Non- Disclosure The least amount of restrictions on the employee’s ability to find employment after separation from the company. What the Employee Wants: NDAs need to protect existing and future trade secrets, including customer information NDAs need not reach into employee’s prior knowledge or generally known information Non-disparagement Corporate Response: 19

6. Non-Competition and Non- Disclosure Non-Compete agreements should address three concerns: Employee working with a customer or direct competitor Soliciting customers or prospects Raiding employees after moving to another company Timeframe restrictions should be commensurate with: Normal shelf-life of confidential information Time needed for company to re-establish itself and to integrate a successor into company’s relationships Corporate Response (cont’d) 20

7. Term and Termination Predictability of employment term and consequences upon termination What the Employee Wants: Should provide a fixed-term contract and mutual early termination clauses, with and without cause With-cause termination clauses based on matters under control of offending party Without-cause termination should include mutual notice periods and which rights are forfeited Corporate Response: 21

8. Severance What the Employee Wants: A financial safety net in the event of termination Corporate Response: Protects the employee against the company’s right to terminate without cause 6 months to 1 year is common, phased in based on service with company Disputes settled by binding arbitrationPrevailing party attorneys’ feesBenefitsPublicity surrounding terminationRelease and settlement 22

9. Change in Control What the Employee Wants: Full severance and full vesting of restricted stock and/or options in the event the company is sold or merged (the “Golden Parachute”). Corporate Response: Section 280G of the IRC prohibits company’s from taking deductions on any “excess parachute payments” if the aggregate present value of the payments or distributions exceed 3 times the employee’s base amount. 280G contains exemptions for small business corporations that satisfy certain shareholder disclosure and approval requirements Full or Accelerated vesting is typical Severance payable on phased-in approach Be wary of the termination being “for cause.” 23

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