“Employee-Friendly” Equity Compensation

6a0134836082f8970c01b7c82ab74a970b-200wiIn this sixth installment of my “Stock Options on the Precipice” series (other articles: 1, 2,3, 4, 5), I will cover some common concerns employees have about equity compensation. The term “employee-friendly” equity compensation has become popular over the past couple of years. What does this mean and do the people using the term actually understand the purposes and technical issues surrounding equity compensation? More importantly, is there equity compensation that isn’t employee-friendly? Lastly, what should you be doing about it?

Part of the inspiration for this post is the article, “Loyalty Pays Off for Snapchat Employees” from The Information. A journalist contacted me to ask if I thought a vesting schedule of 10% in year 1, 20% in year 2, 30% in year and 40% in year 4 was unfriendly to employees. People who were upset with this arrangement had contacted him. An additional concern was based on a built-in expiration of shares if the company did not have a liquidity event within 2.5 years of the date of 100% vesting. This all sounds a bit odd and uncommon, but digging a bit deeper provides a different story.

Equity compensation has a few key purposes. 1) It’s a way for companies to save cash that can then be used for more urgent issues. 2) It’s a way to align employees to the long-term success of the companies and investors. 3) It’s a way to promise pay today with the resulting pay being based on the success or failure of the company. 4) It’s a way to delay the recognition of income and taxes. There are other reasons for equity, but let’s start with these. So, truly employee-friendly equity balances the success of the company, investors and employees in ways that benefit all three parties.

  1. Saving cash is important. Delaying vesting events until the company has money from operations or a liquidity event is pretty employee-friendly. Paying money you need to grow, or simply don’t have, is not friendly to anyone. Failure is seldom friendly.
  2. Aligning employees to the success of investors and the company can seem unfriendly and sometimes it is. If the company is not willing to share enough value to make up for the risk, or the investors’ protections are so heavily weighted that it makes employee value a near impossibility, equity compensation is being used incorrectly. If employees have to stick around several years in order to get a real payout, then the complaints are probably misplaced.
  3. Equity compensation is a commitment to pay in the future. It is important to note that the future is not forever. Most plans guarantee payment or cancel unpaid equity awards in 7 -10 years. If you have been at a company that long and they still love you, they will usually provide new awards to fill in the hole left by those expiring. If you are no longer an employee, please refer to #2.
  4. Different types of equity have wildly different income and tax events. Stock options allow the individual to elect when to have ordinary income, capital gains or losses and the associated taxes. Restricted Stock Units (RSUs) automatically trigger ordinary income and taxes upon vest. Some types of restricted stock and stock options allow for non-traditional decisions such as 83(b) elections. RSUs do not offer this possibility.

It should be noted that Snapchat awards RSUs. When RSUs vest, the individual has income and the company must withhold taxes. As quoted from my comments to The Information’s article:

RSUs at the time of vest automatically result in ordinary income and associated tax withholding. This can be expensive for both the employee and company. The taxes must either be paid by the employee via check, or covered by the company by holding back some of the shares (or cash value). The taxes must be delivered rather quickly to the various tax agencies.

Having a tax event on illiquid stock, while you live in an area with a high cost of living and while your salary may (or more often may not) be below the industry norm, can be troublesome for many employees. Thus, a vesting event on RSUs may be viewed as particularly unfriendly, especially as compared to stock options.”

It turns out that Snapchat’s “vesting” requires both the trigger of time (4 years for 100%) AND trigger of an exit or liquidity event. While this may require employees to stick around for a long time, guaranteeing a payout of cash or shares prior may prohibit the achievement of key goals and, in the end, prove to be unfriendly to everyone involved.

Yes, there are many forms of equity compensation that are unfriendly. Among these: A) Equity that has no value unless the company reaches some nearly unachievable value. B) Equity that can be transacted by an individual, then cancelled or purchased back with no additional consideration to the individual. C) Equity that is in such small amounts that it results in being little more than lip service. D) Equity that is designed in way that it essentially results in tax penalties to the individuals. E) Any equity plan that inhibits the long-term success of the company. All of these are fairly rare.

Yes, equity can have terms that are more employee-friendly, but the key is in the details. Stock options that vest earlier can be very good as long as that vesting does not get in the way of company success. RSUs that vest early are not in the same boat. Annual grants can be great, but only if the program leaves enough shares to hire key staff during the run-up to IPO or exit. Early exercise can be great, but when a down market may be on the horizon it may just be a good way to punish your employees.

Before you run out and amend or defend your plan, be sure you know exactly how it works and WHY it works that way. Even the most seemingly unfriendly provisions may exist to protect employees. Even the most generous provisions can ultimately destroy employees. As I continue this series I will discuss key features such as vesting schedules, termination rules and change in control provisions in more detail. Never hesitate to jump into the comments section and provide your input or contact me directly.

Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and has been deeply involved in equity compensation for a long, long time. Dan has written several inustry respurces including the recent Performance-Based Equity Compensation. He has co-authored “The Decision Makers Guide to Equity Compensation”and “Equity Alternatives” and a few other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.