Corporate & Securities Blog

The Basics of Granting Equity-Based Compensation Awards

Companies are increasingly moving toward performance-based compensation arrangements for their executives.¹ These pay-for-performance arrangements typically apply to equity-based compensation. More broadly, equity-based awards can be a significant component of a company’s compensation program. An equity incentive plan can serve as a powerful tool to attract and retain talent. Whether a startup or a public company, it is imperative that equity awards be properly granted. A few key considerations include:

  • Adopt an Equity Plan. First, it is important for the company’s Board of Directors (Board) to adopt an equity plan. The company should determine what type of plan is appropriate for it, giving consideration to the short-term and long-term intentions of the company. For example, omnibus plans typically provide greater flexibility in the types of awards that can be granted, including incentive stock options (ISOs), non-qualified stock options (NSOs), stock appreciation rights (SARs), restricted stock, restricted stock units (RSUs), performance shares, performance share units, phantom stock and phantom stock units. On the other hand, a more limited plan, like a stock option-only plan, can be more narrowly tailored.
  • Adopt Forms of Award Agreements. Just as a company’s Board should adopt an equity plan, the Board should also approve forms of award agreements. As a practical matter, the Board may want to authorize officers of the company to make grants or to modify or amend the forms to allow grants to be made quickly in connection with new hires or employee promotion, recognition or retention so that there is no need to wait until the next Board or compensation committee meeting for approval of individual grants. The plan (and applicable state law) must allow for such delegation.² In addition, it is prudent for the Board to limit the officers’ authority to modify grants such that any changes to the forms of agreements do not, individually or in the aggregate, have a material financial, legal, tax or accounting impact on the company or any of its affiliates.
  • Grant Awards in Accordance with the Governing Documents. While it’s great to have a plan, it’s even better to follow its terms. The plan must be administered in accordance with its terms, and awards must be granted in accordance with the governing documents. For example, in order to grant a restricted stock award, the equity plan must allow for the grant of restricted stock. Similarly, to permit an optionee to exercise options that have not yet vested, the governing documents must allow for the early exercise of options. Failure to adhere to the governing documents can lead to complex and costly issues.
  • Beware of Tax Implications and Considerations. Each type of equity-based compensation is subject to different tax considerations with respect to both the grantee and the company. It is important to understand the potential tax considerations in connection with each award. For example, the methodology for determining the fair market value of an ISO is subject to Internal Revenue Code (IRC) Sections 421 and 422, but the methodology for determining the fair market value for NSOs and SARs is set forth in IRC Section 409A (409A). The determination of fair market value of restricted stock is subject to IRC Section 83.

Under 409A, the value of stock not readily tradable on an established securities market must be determined by the “reasonable application of a reasonable valuation method.”³ The IRS will presume a valuation is correct if an employer uses one of the “safe harbor” methods set forth in the final 409A regulations to determine the stock’s FMV. On the other hand, if an employer does not use a safe harbor method, then the employer will have the burden to prove to the IRS that the exercise price of the stock option is no less than FMV on the date of grant. In general, a reasonable valuation method is one that considers all available information that is material to the value of a company. It is important to note that a 409A valuation generally expires after 12 months if it has not expired earlier due to new information that has a material effect on the value of the company.

There are three safe harbor methods for determining FMV under 409A:

  • Qualified independent appraisal method. A valuation that is determined by a qualified independent appraiser as of a date no more than 12 months before the date of grant.
  • Illiquid method for certain startups. The 409A regulations provide a safe harbor for internally-produced valuations of private startups that are younger than ten years old and are not reasonably expected to undergo a change in control within 90 days or a public offering within 180 days of the date the internal valuation report is used. The common stock may not be subject to any put, call or other right or obligation to purchase such stock (other than a right of first refusal upon an offer to purchase by an unrelated third party or obligation that constitutes a “lapse restriction”). The safe harbor requires that a valuation:
    • Be performed by a person whom the corporation reasonably determines to be qualified based on the person’s “significant knowledge, experience, education and training” (generally meaning a person who has at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or other comparable business experience in the relevant industry);
    • be evidenced by a written report; and
    • take into account the value of the company’s tangible and intangible assets, the present value of future cash flows, the market value of similar entities engaged in a substantially similar business and other relevant factors such as control premiums or discounts for lack of marketability.
  • Non-lapse restriction valuation method. Under this method, the use of a valuation formula that, if used as a non-lapse restriction under IRC Section 83, would be considered fair market value for purposes of Section 83 is presumed to be reasonable if the formula is applied consistently to other transfers of shares of the same or substantially similar classes of stock to the issuer or any person who owns stock possessing more than 10% of the total combined voting power of all classes of stock of the issuer.

Failure to comply with 409A has hefty consequences. For individual taxpayers: income tax recognition is accelerated to the year of vesting (rather than on the date of exercise); an additional federal 20% excise tax applies; further increases in the intrinsic gain of the stock right continue to be taxed (and excise taxes continue to apply) in future years until the stock right is ultimately exercised or otherwise expires and premium interest and other potential penalties apply to the extent 409A taxes are not timely reported or withheld by the employer. Employers have an obligation to report a 409A violation on Form W-2 or Form 1099 and to withhold on accelerated income (but not FICA). In addition, there may be state tax law consequences. Given these potential consequences, it’s not hard to imagine a scenario where an employee loses all of the value of the equity-based award.

  • Look out for Securities Law Implications. Because equity incentive plans involve issuing securities, companies need to consider applicable federal and state securities laws. There must be an exemption available for all grants. Most companies will rely on Rule 701 of the Securities Act of 1933 when making grants to individual employees pursuant to the company’s equity plan. However, this rule has certain limitations, including exclusions for certain consultants and does not cover non-service providers. Keep in mind that similar limitations are often built into a company’s equity plan (which is intended to incentivize service providers) both for business reasons as well as to ensure the plan is generally compliant with Rule 701. Therefore, certain types of equity grants may not be eligible for issuance pursuant to the plan or may require the applicability of a different exemption. Also, Rule 701 requires a company that issues more than $10 million in equity to employees over a 12-month period to supply Rule 701 disclosures to all employees who might exercise their stock options. Companies may face serious penalties for noncompliance with this requirement. For example, in 2018, the SEC brought an enforcement action against Credit Karma for failure to comply with Rule 701. Companies should also be aware of any state blue sky laws that may apply.

¹ Does performance-based compensation actually improve a CEO’s performance? (

² For example, the Delaware General Corporation Law permits delegation of authority by the Board subject to certain limitations, including that the resolution authorizing the delegation must fix (a) the maximum number of options or RSUs that may be granted by the delegate, and (b) the maximum number of shares exercisable upon the exercises of the awards granted by the delegate. The Board must also set a time period during which the options or RSUs may be granted and fix the time period during which shares may be issued in respect of the exercise of awards granted by the delegate. See DGCL Section 157(c).

³ Note that the only method that provides protection in the event of a faulty valuation is the independent appraisal, which is discussed herein.

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