“Gold without wisdom is but clay.”
– Slovakian Proverb
ACTUAL CASE HISTORY*: Kathy was pleased. After 27 years as a Human Resources executive with a large textbook publisher, she had retired from full-time work about a year earlier, and had become a part-time HR Consultant.
Over the years she had several times been awarded stock options by her employer. Because she had been with the company over 25 years, and because she was over 60 years of age, all of her stock options had vested. Over the years they had grown to represent a sizeable sum of money.
Kathy’s stock options had been awarded to her under two different Company Stock Option Plans. One was established in 2000, and the other established in 2008. When she received each of her stock option grants, Kathy had been provided with copies of the Stock Option Plans, which she put in her financial files.
But now Kathy was puzzled. In response to a recent inquiry she had made regarding her stock options, she had received a letter from a “Third Party Administrator” with a lot of confusing language. She came to us requesting a consultation to figure it all out. To prepare for Kathy’s consultation, we reviewed the Third Party Administrator letter, and the two Stock Option Plans. As we always do, at the start of the consultation we interviewed Kathy, and asked her many questions. It turned out we had bad news for Kathy.
First, 30% of Kathy’s stock options had not been exercised before an applicable deadline in the first Stock Option Plan. Though the stock options had vested, under the Plan’s rules, they had to be exercised within 180 days of leaving employment. When Kathy came to us, it had already been 285 days since her last day of employment. Kathy thought that “vesting” meant “all mine,” to be enjoyed whenever she wanted. She did not know that while the stock options were, indeed, all hers, they had to be exercised – or “taken advantage of” – within a set period of time, or they would become no longer capable of being taken advantage of. Bottom line: they were lost.
Second, another 40% of Kathy’s stock options had been “forfeited,” or taken back from her. Why? Because the second Stock Option Plan provided that, if, during the one-year after separation from employment an employee engages in “competitive conduct,” that employee forfeits all further interests – vested or not – under the Plan. Bottom line: they were also lost.
Frankly, we expected that Kathy, as a Human Resources professional, would have – or should have – known about the basic mechanisms of her long-term incentive compensation. Of course, such presumptions can be wrong quite often. Kathy was crestfallen, and with good reason. This was perhaps the most damaging event ever in her financial life. And at 61 years of age, it was especially troubling.
LESSON TO LEARN: Over many years of counseling and representing executives in matters of their employment, compensation and severance, I have been surprised many times to find that my clients, though fully knowledgeable in their own industries and professions, had little knowledge of the details and intricacies of their compensation, and long-term incentive compensation.
In a very general way, we divide “employee compensation” into three categories: (1) base salary, (2) short term “incentive” compensation, which is usually either in the form of commissions or bonus, and (3) long term “incentive” compensation (or “LTIC”), which is usually in the form of some kind of ownership interest in the company. The idea behind LTIC is to align the interests of the employees with the interests of the company and its other shareholders, and to “incentivize” employees to think about the company’s long-term health and growth.
The problems we see are not often derived from Human Resources failing to provide our clients with all necessary information about their LTIC. Nor are the problems derived from Benefits and Compensation failing to provide our clients with all necessary calculations. Instead, the problems we come upon most often arise from (a) clients not correctly comprehending the basic concepts of LTIC, and/or (b) clients failing to take into account the detailed risks and rewards of LTIC when navigating and negotiating their employment and career issues.
As Kingman Brewster, former President of Yale University, once said, “If you think education is expensive, try ignorance.”
WHAT YOU CAN DO: Educate yourself. First the basics; later the complicated stuff. Let’s take a few minutes to make sure you understand the basic concepts of long-term incentive compensation:
1. “Equity” – “Equity” is a rather broad concept. It can be best understood as “some kind of ownership interest in a company.” Equity may take many different forms, and have many different names. Equity can also be “certain” or “conditional” in nature.
The idea behind offering equity to employees – either at the present moment, or possibly in the future – is to incentivize employees to remain with the company (that is “retention”) for an extended period of time, and to think about their daily efforts as part of the company’s long-term strategy (“team building.”) Some say equity grants to employees are meant primarily to encourage employees to “think and act more as owners, and less as employees.”
There are an unlimited number of kinds of “ownership interests” that employers can offer employees. These would include the more common “stock, restricted stock, and stock options,” each of which will be discussed below. These would also include some uncommon forms of equity, with such names as “phantom shares,” “success units,” and “Class B” shares, derived from what are commonly referred to as “share schemes.”
Incidentally, “equity” can be part of a corporation, a limited liability company, a partnership, or any other legal form in which business is conducted. However, it would not make sense to discuss “equity” in a not-for-profit enterprise. “Equity” can be granted in “public” companies (that is, companies whose shares are traded on open public markets) and “privately held” companies (that is, companies for which there is no open public market for their shares.)
Granting equity, or promising to do so in the future, is especially popular among smaller and start-up companies, who cannot offer the same salaries that can be offered by larger, more established employers, but who seek to attract and retain the same high-quality employees.
2. The (Equity) “Plan” – Almost without exception, when employees are granted long-term incentive compensation, there is prepared a formal “Plan” which sets down, in effect, all of the rules, regulations and procedures applicable to that “share scheme.” It is essential that you acquire a copy of the Plan, and read it carefully. Sometimes employers offer employees a Summary Plan Description (or “SPD”) of the Plan; while helpful, the actual Plan, itself, contains all of the details that govern all matters related to the equity grant.
3. “Stock” – “Stock” is the most common name given to equity in a company, and the form most people are familiar with. Those who own “stock” in a corporation have an ownership claim to a proportionate share of the corporation’s assets and profits. Generally, this ownership interest is subordinate to the claims of the company’s creditors. “Stock” in a corporation is equivalent to “membership units” in a limited liability company (often called an “LLC”) or partnership units in a partnership or limited liability partnership (or “LLP”).
Stock may be awarded to employees upon hiring (often called a “hiring grant”), upon certain events, such as achievement of company goals, or in order to encourage an employee to remain with the company (“retention grants.”) In general, the receipt of stock by an employee is considered taxable compensation to the extent that the stock is of higher value than the purchase price, if any.
Sometimes, a “hiring grant” of stock is awarded to a new employee to replace the value of stock (or other equity) the new employee has lost by his or her leaving his or her former employer. (See “forfeiture,” below.) By law, there may be certain periods of time (called “black out periods”) during which employees cannot sell stock in their company, to make sure that “inside information” is not taken advantage of, either intentionally or accidentally.
4. “RSU” – (An acronym for “Restricted Stock Unit”). RSU’s are simply stock units that carry with them certain restrictions. They are generally acquired by means other than on an open market, such as a stock exchange. Examples of such restrictions may include (a) a limitation as to whom the stock can be sold, (b) a period of time before the stock can be sold, (c) the markets on which the stock may be sold, (d) restrictions set out in SEC regulations, among others. (Though not as common, RSU’s may also have vesting restrictions.) As a general rule, RSU’s are not registered with the SEC, and so cannot be sold on open markets. One restriction seen with increasing frequency is a requirement that the stock may only be sold back to the employer at a price determined by a formula.
RSU’s are being offered to employees with greater frequency, and may be granted outright, or sold at a discount. RSU’s are commonly granted before or during corporate mergers and acquisitions, private placements, and during securities underwritings, such as prior to an initial public offering (“IPO”). When RSU’s are given to an employee, the employee is typically prohibited from selling or otherwise disposing of stock for a defined period of time.
Generally, with certain exceptions, the recipient of an RSU award may elect to treat the value of the RSU as taxable income either (a) when granted, or (b) when the restriction lapses. Generally, the fair market value of an RSU is not reduced as a result of the restriction, unless there is a permanent restriction upon the sale of the RSU.
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5. “Stock Option” – A “stock option” is simply a right, sometimes granted by an employer to an employee, to purchase a specified amount of stock (or other equity) at a certain price, during a certain time period.
Stock Options are perhaps the most common form of long term incentive compensation offered to employees. They offer great versatility and flexibility to employers, and for employees can represent an opportunity to develop significant wealth with little investment.
First, the employer generally sets a purchase price per share (the “grant” or “strike” price), which is often – but not always – discounted to the then-market price.
Second, the employer generally sets a certain period of time before the employee can elect to make the purchase (called “exercise” of the option; see below.) The hope is that, between the “grant date” and the “exercise” date, the price of the stock will increase, so that the employee can then “buy low” and “sell high,” and take the difference in those prices as profit.
Of course, the price of the stock may not increase, and could even decrease. If the price of the stock is, for example, $10 per share, and the price the employee can pay for the shares is, for example, $15 per share, then this would be called “under water options,” which would be, at the moment, worthless. While “under water,” if time still remains for the employee to elect to purchase the stock, it is always possible that the share price will increase over the “exercise” or “strike” price, and in this way again become valuable.
Third, so long as all terms of the stock option are complied with, the employee can decide if and when to (a) convert the options to stock by “exercising” the option, (b) sell the stock, and (c) retain the difference as profit.
6. “Vesting” – “Vesting” is what happens when the employee becomes free to elect to take advantage of the stock option (or other form of equity.) For example, if a stock option grant says that 1/3 of the grant “vests” after one year, then on the one-year anniversary, 1/3 of the stock option grant “vests” and can thus be considered yours to take advantage of. Vesting may be viewed as removal of all conditions to ownership. Though many people think that “vesting” and “non-forfeitable” are synonymous, under the terms of many equity plans, there exist some circumstances in which employees can become “de-vested,” or “divested” of ownership of formerly “vested” equity. (See “forfeiture,” below.)
Most commonly “vesting” takes place either (a) a set time after an option is granted, such as three years, or (b) a set time after an employee has worked for a company, such as 18 months.
Some options may vest over time, such as 1/3 each year for three years. We call this “serial vesting.” The alternative is where options all vest at once, such as all options vesting 24 months after the stock option grant, which we refer to as “cliff vesting.”
Leaving but Want Your Options Vested? This is especially possible for those who are laid off without “cause.” We offer a Model Memo Requesting Vesting of Unvested Options When Laid Off. It shows you “What to Say and How to Say It.”™ To obtain a copy, just [ click here.] Delivered by Email – Instantly!
7. “Exercise” – “Exercise” of stock options generally refers to “pulling the plug,” “flipping the switch” or “making the election” to become an owner of vested equity. You “exercise” your options by whatever method is set down for doing so in the equity “Plan,” described above. Strict adherence to the exercise method is essential. “Exercise” of stock options must be during the Exercise Period, not before or after. Failure to exercise a stock option, or other election to take ownership of an equity grant, almost always results in that grant “lapsing,” or being lost forever.
Sometimes an employer may grant employees the right to make a “cashless exercise” of stock options. What this means is this: suppose you have 10 stock options, each worth $20.00 to you, that is, a total of $200. And let’s suppose the “strike” price for each stock option is $4, meaning that to exercise your stock options you need to pay $40. Instead of paying the $40 in cash, you can instead give up two of your stock options (worth 2 times $20, or a total of $40), and then keep the remaining 18 shares of stock, without having to come up with any of the “strike” price monies yourself. This is seen in perhaps 25% of stock option grants to employees.
The last date upon which an employee can exercise his or her stock options (or election to take ownership of other equity) is called the “expiration date.” After the “expiration date” the stock option is no longer valid, and ceases to exist.
8. “Accelerated Vesting” – This is simply vesting of equity at a faster rate than is originally anticipated. This is most commonly permitted in the event of a “change in control” of the company, or retirement from employment after a specified period of service to the employer.
9. “Forfeiture” – “Forfeiture” is the loss of the equity, commonly due to the occurrence (or non-occurrence) of a specified condition or event. Depending on the “rules” of the Plan, even “vested” equity can be forfeited. The most common causes of forfeiture are (a) termination for “cause,” (b) violation of a non-competition agreement, and (c) violating some other rule, such as not providing the required resignation notice.
Equity Plans often have many events of “forfeiture.” Some are quite clear; some are not clear, but implied. Not paying attention to what acts, events or circumstances may lead to “forfeiture” is perhaps the most common, and most expensive, mistake that employees make regarding long-term incentive compensation.
10. “Good Leaver” or “Bad Leaver” – When employees depart from their employers, how they do so often determines whether they (a) enjoy accelerated vesting, (b) continue to vest according to a pre-determined schedule, (c) lose all further vesting, or even (d) suffer forfeiture of unvested – or even vested – equity. Those who leave in the ways preferred by their employers are commonly referred to as “Good Leavers,” and are treated more advantageously in terms of equity. Those who leave in ways that are not preferred by their employers often suffer in terms of their equity as a result.
One of the most valuable Checklists we offer on our Model Letters Blogsite section is our “Model Equity and Benefit Inventory.” This is designed to help you keep a record of your equity entitlements, important vesting and exercise dates, and treacherous forfeiture conditions. It’s a great way to prevent your loss of a whole lot of money. If interested in obtaining a copy, simply [click here.]
My experience counseling, strategizing and representing employees regarding their long-term incentive compensation can be summed up this way: “The road to the gold mine is full of land mines.” Don’t presume that you will enjoy the benefits of long-term incentive compensation merely by remaining employed; there are innumerable other precautions and measures you need to take. This is the way to start.
SkloverWorkingWisdom™ emphasizes smart negotiating – and navigating – for yourself at work. Negotiation and navigation of work and career issues requires that you think “out of the box,” and avoid risks at every point in your career. Knowing ways to resolve disputes when they arise is a distinct advantage in navigating workplace life. Knowing ways to avoid disputes is even more advantageous. Learning the “in’s and out’s” of doing so is what we are here for. Now it’s up to you.
Always be proactive. Always be creative. Always be persistent. Always be vigilant. And always do what you can to achieve for yourself, your family, and your career. Take all available steps to increase and secure employment “rewards” and eliminate or reduce employment “risks.” That’s what SkloverWorkingWisdom™ is all about.
*A note about our Actual Case Histories: In order to preserve client confidences, and protect client identities, we alter certain facts, including the name, age, gender, position, date, geographical location, and industry of our clients. The essential facts, the point illustrated and the lesson to be learned, remain actual.
Please Note: This Newsletter is not legal advice, but only an effort to provide generalized information about important topics related to employment and the law. Legal advice can only be rendered after formal retention of counsel, and must take into account the facts and circumstances of a particular case. Those in need of legal advice, counsel or representation should retain competent legal counsel licensed to practice law in their locale.
© 2011, Alan L. SkloverAll Rights Reserved. Commercial Use Prohibited.