Stock Options convey the right for employees to buy company stock at a fixed “strike price” over a certain peirod of time (typically seven to ten years). Stock Options allow participants to share in the increase in the value of the company. If the value of a share increases above the strike price, employees can exercise their options and buy stock for less than the current market value. After exercise, employees can i) sell the stock and monetize their gain or ii) hold the stock and remain a shareholder. Stock Options are one of the longest-term equity awards, allowing employees to share in the (hopefully significant!) increased value of the company over a substantial time horizon.

Full Value awards are shares of company stock that vest if employees provide service through a specified vesting date. Full Value awards provide employees a path to share ownership and allow them to benefit from increases in share price, but unlike stock options, full value awards still have value if the share price declines.

Phantom Equity and Cash Plans mirror the value function of equity awards (like Stock Options or Full Value awards) but are settled in cash instead of company stock. This allows companies to limit dilution while still motivating employees to grow the company by allowing them to benefit from increases in the share price.

Profits Interest is a special equity compensation vehicle for LLC’s that receive preferential income tax treatment. Profits Interest are flexible and can be structured similar to a Stock Option or similar to a Full Value award. But unlike Stock Options or Full Value awards, any gain realized by the employee upon the sale of the Profits Interest or the redemption of the Profits Interest by the company will be taxed at as capital gain, typically as long-term capital gain. Additionally, Profits Interests entitle the holders to share in future cash distributions of the company.

Understanding the exit strategy, including no exit, is critical to ensure equity awards are designed optimally and best achieve their desired objectives:

• Sale: A company’s exit strategy may be to be acquired by a larger industry player. The vesting of awards may be a critical factor in the value of the company to prospective buyers. While the exit event is often the time in which employees receive value for their awards, ensuring there is some “hook” post-acquisition ensures critical talent of a smooth transition that can boost the purchase price value.
• Initial Public Offering: An exit by way of IPO has less potential for disruptive impact versus a sale. Once it becomes clear an IPO is the likely exit strategy, companies will often shift their design to time-based awards that can remain in place once the company’s stock is publicly traded.
• Permanently Private: Businesses that do not plan to have an exit should approach equity and ownership with a longer-term perspective. Additionally, ownership succession amongst employees and potentially the founders’ families plays a much more critical role in how the equity should be distributed, vested, and delivered.

The time horizon associated with the exit strategy is another critical factor in determining the right design. At a company that is expected to remain permanently private or one where exit is not in the foreseeable future, the objective of the equity awards is to reward management for the creation of shareholder value over time. In this scenario vesting of the awards is typically time based. Additionally, in the absence of a sale or IPO the participants will need to be provided with a means to obtain liquidity. But, if the company has matured to the point that an exit event is in the foreseeable future, then to ensure the interests of management are aligned with the founders and investors, vesting of all or part of the awards may be dependent upon the completion of a liquidity event. Prior to the exit event the company’s stage of development has a direct impact on the design of the equity-based incentives.

• Founders/Founding Employees: Founders and founding employees often receive awards that are designed to compensate them for taking the risk of joining a start-up, as well as potentially foregoing cash compensation.
• Expansion: As the company executes on its business plan and brings on more employees, the focus of the equity-based compensation program often shifts to expand to participants lower in the organization. This transition requires a more structured approach that can be sustained over time, with the design of the awards becoming more sophisticated.
• Impact of Financing: Successful companies often go through one or more rounds of financing on their way to the exit event. The impact of the leverage and the conversion and/or participation features of the equity issued in the financing transaction on a company’s stock-based compensation must be considered.

The design of the equity awards should take into consideration the time-period over which the awards are intended to motivate and retain employees.

• Time Vesting: Equity awards can be designed to vest over explicit time periods (e.g., three years). This type of vesting is easy to understand, provides retentive value for a known period, and rewards employees for continuous service.
• Performance-Based Vesting: Vesting can be based on the level of achievement of one or more criteria measuring performance of the award holder or the company (including share value and business or financial performance measures).
• Time and Exit: Vesting can also be tied to exit events, like the sale of the company or an IPO. In the private equity space, portfolio companies often use this type of vesting condition or a variation as described in the next paragraph. Time and Exit vesting schedules can be defined in an “or” function (e.g., awards vest upon either three years of service OR an exit event, whichever occurs first) or an “and” function (e.g., awards vest once three years of service AND an exit event have been completed).
• Qualified Exit: A portion of participants’ awards could vest upon the completion of any liquidity event, while the remainder of the awards (often the majority of the awards) are earned based on the attainment of multiple on invested capital (“MOIC”) and internal rate of return (“IRR”) goals based on the exit price. These can be tiered vesting tranches to create additional leveraged value for higher exit prices.

For awards payable in shares, employees will most often realize value upon certain liquidity events (sale, IPO, or company initiative program). Traditionally this has meant a sale or IPO; however, with today’s private companies remaining private for significantly longer, there has been an increase in the prevalence of company-facilitated liquidity programs.

• Share Buyback By Company: Private companies can offer to buy vested stock options or vested shares from employees, and can exercise the right of first refusal to buy shares that the employees seek to sell elsewhere. These transactions are similar to selling publicly traded shares in the market, where the original owner (the employee) receives cash from the buyer (the company) in exchange for vested shares or vested options. This allows companies to limit dilution while providing employees liquidity. The main benefit of this type of program is company control over how many shares the employees can sell and the price per share offered. This type of program is funded with the company’s balance sheet cash, including cash received from a financing round occurring immediately prior to the buyback.
• Employee to Employee: Some companies may establish an employee-to-employee marketplace, whereby employees can sell their vested shares to other employees. In essence, employees that want to increase their investment in the company provide liquidity to those employees that would prefer more flexibility.
• Outside Investor Pool (Third-Party Tender Offer): In a third-party tender offer, one or more company-approved third-party buyers (such as existing or new investors) would tender to purchase shares directly from a company-approved list of eligible shareholders. The main benefit of this type of program for the company is the efficiency of having the investors purchase shares directly from the eligible participants rather than the company having to raise money to buy back shares from the participants.

Instead of issuing awards payable in shares, companies may choose to grant awards payable in cash such as phantom units and cash-settled stock appreciation rights. Companies using these award types should be prepared to handle the cash flow responsibilities of the awards.