For many employees, equity – as a component of their compensation package – is as valuable to them as their ability to access the equity's value. For private companies, valuation and tax issues present unique challenges for employees in accessing the value of their equity awards. As valuations increase for companies, executives and board members may broach pathways for employees to utilize their equity. Below are a few conceptual ways to frame the conversations around two popular avenues companies may consider to create liquidity opportunities for their employees holding equity awards with significant value: (1) the extension of employee loans and (2) launching tender offers.
- Employee Loans – When companies reach a
certain valuation, employees (including senior executives) may find
it cost-prohibitive to pay the taxes on restricted stock grants
and/or pay the exercise price and taxes upon the exercise of a
stock option. One solution is for the company to extend an employee
loan to an employee to assist in one of the aforementioned
transactions.
Employee loans must include certain terms in order to avoid the IRS making a later determination that the loan value was disguised compensation that was immediately taxable upon its issuance. Most practitioners take the position that the employee loan must be at least 50% personal recourse to the employee and/or secured by collateral, which is two to three times the value of the loan. In addition, the terms of the loan must provide for interest to accrue at the then applicable federal rate compounded semiannually if the value of the loan is in excess of $10,000 and includes a specified repayment schedule. Other standard provisions include requiring the purchased shares to serve as collateral for the loan, a fixed maturity date, and includes certain maturity events such as a termination of employment, IPO or sale transaction. If either the company or employee is audited by the IRS, documentary evidence establishing these required terms will be critical. To that end, we recommend seeking legal counsel to structure the loans and draft the requisite promissory note and pledge agreements to limit any potential tax exposure due to the mischaracterization of any such loan.
There are a number of drawbacks for companies and employee executives to consider when a company is deciding to extend an employee loan. A key limitation is that, generally, this mechanism is only available for private companies because the Sarbanes Oxley Act of 2002 bars loans between a company and its directors or executive officers (i.e., the specific class of service providers who hold equity awards with significant value necessitating a loan). In addition, the recent increases in the applicable federal rates may make loans an unattractive vehicle for employees until there are significant reductions in the rates.
Companies should also seek legal counsel to understand how a significant depreciation in the value of the collateral securing the loan due to market conditions or otherwise is likely to impact repayment of the loan and other risks to the company in the event of an employee's failure to make timely repayments. Since loan forgiveness results in taxable compensation to the employee, tax withholding obligations and possibly adverse accounting consequences for the company, weighing these factors should be part of the decision-making process when establishing any policies or practices around extending loans to employees.
- Tender Offers – Private company equity
awards can be a meaningful component of employee compensation, but
one of the key drawbacks of such awards is their illiquidity unless
and until a liquidity event occurs, which may take several years
(if such event occurs at all). However, late-stage start-ups can
create opportunities for employees to participate in liquidity
events that allow shareholders to monetize their equity
compensation without waiting for the company to undergo an IPO or
sale transaction via a tender offer. A tender offer is a
transaction in the secondary market in which employees and/or early
investors can sell their vested shares to the company.
Typically, tender offers are transactions that are only available for late-stage companies that have issued outstanding equity awards with imminent expiration dates, but such a company is not in the process of undergoing a sale or IPO. Companies set the price, terms and eligibility requirements of the offering and distribute offering documents detailing such key terms. The disclosure documents require legal review since the decision to participate in the tender offer is an investment decision, which will raise securities law considerations.
Further, the transaction will result in a variety of tax consequences for both the company and the employees, including, but not limited to, different tax treatment for different types of equity awards and forfeiture of certain potential tax benefits for tax-qualified stock options. Employees will need to weigh various factors in their decision. For example, does the immediacy of the access to liquidity presented by the tender offer outweigh the potential future increases in the value of the equity awards if they continue to remain outstanding or forfeiture of the favorable tax treatment of tax-qualified stock options if certain applicable holding period requirements are not met? Employees who opt to participate need to understand the financial and tax implications of their participation and that the company is not offering any professional advice on their decision to participate or not participate in any capacity.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
