Paying with Equity Linda Knobbe, CPA

By Mukund Mohan bestengagingcommunities.com/2012/07/29/should-i-pay-my- lawyer-or-advisor-in-stock/ Pros Doesn’t use up company cash to pay salaries. Can encourage loyalty Gives recipients a potential share in future success Cons Can be costly to set up and manage Reduces founders’ share of equity Complex to value

Jeremy Stoppelman Yelp Cash Compensation: $340,657 Yelp holdings worth $250.6 million Joe Mansueto Morningstar Cash Compensation: $105,295 Morningstar holdings worth $1.9 billion Kosta Kartsotis Fossil Group Cash Compensation: $0 Fossil holdings worth $716 million Examples of Equity Compensation Success

Restricted Stock The simplest way to grant equity ownership in exchange for services. No income or tax until vested. Taxable as ordinary income upon completion of vesting schedule. Then capital gain tax applies upon sale of stock. May qualify for 83b election and allow recipient to "prepay" taxes based on stock value at grant date. This election reduces overall taxes if stock appreciates between grant date and vested date. Tax deduction when restrictions met, or at date of 83b election. Immediate ownership, but subject to later forfeiture (typically time or performance-based) Complex issues regarding determination of grant date and vesting date. Complex valuation. Compensation value is Intrinsic value (difference between FMV and strike price) on award date. Grant of company stock that may be subject to forfeiture if certain future conditions are not met Equity ownership granted without a purchase price paid by employee.

Phantom Stock OR Stock Appreciation Rights Taxable as ordinary income on amount of bonus. Tax deduction upon bonus paid Does not give away company equity, unless settled in stock Possible ERISA (Employee Retirement Income Security Act) issues if it resembles a qualified plan (ESOPs or 401(k)). If the plan is designed for a limited number of employees, or as a bonus for a broader group of employees that pays out annually based on a measure of equity, would most likely avoid these problems. Valuation can be complex. Contractual bonus tied to company stock value or appreciation of its value Can be settled in cash or stock.

Incentive Stock Option (ISO) Limits on use, must be designed within ISO rules to qualify. Pays only if stock price increases. Taxable at Capital Gains rate when stock is sold. Ordinary taxable income if stock not held for 1 year after exercise and for at least 2 years after the grant of the option. Possible AMT consequences No tax deduction unless employee disposes of stock prior to meeting holding requirements Ownership is effective when option exercised Limits on Exercise Price, Value of Grant, Term of Grant and Term of Plan. Complex plan documentation Complex valuation and amortization. Option to purchase company stock Preferential tax treatment.

Nonqualfied Stock Option (NQSO) Pays only if stock price increases. Taxable as ordinary income on exercise (for spread between strike and FMV of shares); Then, capital gain tax on growth after the exercise. Tax deduction upon exercise When option exercised Possible 409A considerations, if exercise price is less than FMV. Complex plan documentation Complex valuation and amortization. Option to purchase company stock Corporate tax deduction when exercised.

Partnership Profits Interest May need valuation to determined company value. Taxable at Capital Gains rate when disposed (exit or sale). No taxation at grant if "safe harbor" met. Allocated profits from partnership are taxable when reported on Schedule K-1. No tax deduction Immediate, but only to the extent of increased value after grant Annual capital account maintenance required. Multiple valuation dates creates additional complexity. Maintenance of capital table and accumulated earnings/profits. Holders of Profits Interest granted share of increase in value of company over stated period of time Shares in profits only, not an equity stake. Can only be utilized for LLCs or partnerships.

Final Thoughts Pay careful attention to your cap table and keep it updated at all times Monitor fully diluted ownership Check in with your tax advisor frequently to stay on top of tax consequences Check in with your legal advisor to make sure you don’t grant what you haven’t authorized.

Linda A. W. Knobbe, CPA Senior Manager (314) Questions?