Today’s blog features guest author Corey Rosen of the NCEO on how companies can share equity and stay private.
Yes, You Can Share Equity and Stay Private: Part One
By Corey Rosen, Founder, National Center for Employee Ownership
Recent reports show that more and more entrepreneurial companies are choosing to stay private for much longer periods of time. That may be because they do not believe the IPO market is ripe for an offering, or that they realize that the chances of actually having an IPO for most start-ups is comparable to high school basketball players making the pros. Some companies could find another company to buy them, but may not find the terms attractive. Still other entrepreneurs just don’t want to give up control. They may like what they do or, increasingly, have a social purpose that they believe the buyer will undermine.
Many of these companies share equity with employees, but wonder about how that can become liquid. Some are reluctant to spread equity too widely for just this reason, even though they like the idea of employee ownership.
In fact, there are lots of practical ways to share equity, stay private, and provide liquidity. In this two-part series, I look at how to do that. The National Center for Employee Ownership’s Staying Private: Liquidity Options for Entrepreneurial Companies, provides a detailed examination of these issues.
Design Your Plan with Liquidity in Mind
Many entrepreneurs I talk to say that equity stakes will become liquid when there is a liquidity event, but they don’t know when, if, or how that will occur. To them, this is not a big issue—they plan to stay until that happens and maybe beyond. But for employees, the uncertainty makes equity grants far less valuable than they really are because, as we know from behavioral economics research, people vastly overweight risk and uncertainty in assessing economic value. On top of that, some plans may have grants that expire if not exercised, but if they are exercised, employees have to pay a tax now for a benefit that can’t be realized any time soon.
To deal with this problem, companies should consider vesting on liquidity only. If liquidity is too far away and too uncertain, they should look for ways to provide liquidity in the interim, as described below. Companies can limit the cash drain of these approaches by using net settlements, where the employees get the net after tax value of the equity holdings on exercise in the form of shares. That way, at least employees aren’t paying out of pocket, something that makes the award look like punishment.
Second, you need a realistic way to assess value. Formula approaches like book value and multiples of revenues are frequently used and almost invariably wrong. A basic valuation by an outside appraiser is not very expensive and is well worth the several thousand dollar cost. It gives your plan a lot more credibility, it assures that you are paying an appropriate amount, and gives you a good sense of how your company can become more valuable.
So how can you provide liquidity?
Redemptions
The simplest approach is for the company to buy back the stock. This must be done with after-tax dollars. Equity holders who paid for their shares get capital gains treatment on the sale if they are effectively exiting the business; otherwise, dividend rates apply. Currently, there is little difference between the two, however, unless the owner has a substantial basis in the shares, in which case capital gains treatment is preferable. The shares can be retired (meaning the enterprise value of the company goes down, but the per share value of remaining shares remains the same) or made available for sale to other buyers or for awards to employees.
In part two of this article, we will look at four other alternatives: sales to employees, outside investment, secondary markets, and ESOPs.
Corey Rosen, Ph.D., is the cofounder and senior staff member of the NCEO. He co-authored, along with John Case and Martin Staubus, Equity: Why Employee Ownership Is Good for Business (Harvard Business School Press, May 2005). Over the years, he has written, edited, or contributed to dozens of books, articles and research papers on employee ownership. He is generally regarded as the leading expert on employee ownership in the world.
Tags: fair market value, liquidity, private companies, repurchase programs
Here’s what’s happening at your local NASPP chapter this week:
Chicago: Catherine Sanders Reach of The Chicago Bar Association presents on time management (Wednesday, April 13, 7:30 AM)
Philadelphia: Aon and Morgan Lewis present “Pay Versus Performance: SEC Proposed Disclosure Rules.”(Wednesday, April 13, 8:30 AM)
Austin: The chapter hosts a happy hour to introduce you to the new chapter board. (Thursday, April 14, 5:30 PM)
Atlanta: Reid Pearson of Alliance Advisors presents a review of the 2016 proxy season. (Friday, April 15, 11:30 AM)
NY/NJ: Baker & McKenzie presents “What Now? – Global Equity Updates and Take Aways.” (Friday, April 15, 8:30 AM)
Tags: NASPP chapter meetings
As noted last week, the FASB has issued the final Accounting Standards Update to ASC 718. Here are a few more tidbits about it.
The ASU Has a Name
Handily, the ASU now has a name that we can use to refer to it: ASU 2016-09. Now I can stop calling it “the ASU to ASC 718,” which was awkward—too many acronyms.
Transition Wrinkle
One surprise to me is how the transition works if the ASU is adopted in an interim period other than the company’s first fiscal quarter. When the ASU is adopted in Q2, Q3, or Q4, the update requires that any adjustments required for the transition be calculated as of the beginning of the fiscal year. Consequently, where companies adopt the ASU in these periods, they will end up having to recalculate the earlier periods in their fiscal year (and restate these periods wherever they appear in their financial statements), even if the transition method is prospective or modified retrospective, which normally would not require recalculation or restatement of prior periods.
For example, if a company adopts the ASU in its second fiscal quarter, the company will have to go back recalculate APIC and tax expense as required under tax accounting approach specified in the ASU for its first fiscal quarter. Likewise, if the company decides to account for forfeitures as they occur, the company will have to recalculate expense for the first fiscal quarter under the new approach and record a cumulative adjustment to retained earnings as of the beginning of the year, not the beginning of Q2.
While I can understand the rationale for this requirement, it is different than how I expected the transition to work for interim period adoptions.
No Other Surprises
The ASU 2016-09 seems to be an accurate reflection of the decisions made at the FASB’s meeting last November and documented ad nauseam here in this blog. I still haven’t read every last word of the amended language in the ASC 718, but I don’t think there are any other significant surprises.
For more information on ASU 2016-09, be sure to tune in to the NASPP May webcast, “ASC 718 in Motion: The FASB’s Amendments.”
– Barbara
Tags: accounting, Accounting standards update, ASC 718, expected forfeitures, Exposure Draft, FASB, forfeitures, liability treatment, share withholding, tax accounting
Last Chance to Participate in the Domestic Stock Plan Design Survey!
Don’t miss your chance to participate in the NASPP/Deloitte Consulting Domestic Stock Plan Design Survey; you must register to participate by this Friday, April 8. Check out the podcasts I recorded on ten things I’m looking forward to finding out from the survey and tips for participating in the survey.
NASPP To Do List
Here’s your NASPP To Do List for the week:
– Barbara
Tags: NASPP To Do List
The latest in a long series of SEC enforcement initiatives seemed to arrive last week when both the SEC’s Chair and its Enforcement Director, while visiting Silicon Valley and San Francisco, appeared to deliver a unified message that law firm Fenwick summarized in a publication titled “Securities Enforcement Alert: SEC Increases Scrutiny of “Unicorns” and Other Private Companies and Secondary Market Trading of Pre-IPO Shares” as: “the SEC is closely watching the conduct of private companies as well as emerging platforms that trade in private company securities, and will bring enforcement cases as needed to protect investors. Dubbed the “Silicon Valley Initiative,” the senior officials emphasized that although the SEC wants to encourage capital formation for innovative Bay Area companies, because they play such a critical role in our economy and our markets, the SEC expects even private companies to embrace and demonstrate sound corporate governance.”
It appears to be a growing concern of the SEC’s that private companies may be lacking in sound corporate governance policies, practices and internal controls. Enforcement Director Andrew Ceresney emphasized that companies “can’t simply just turn on effective controls” once they become public; instead companies need to develop such controls while they are still private. This has the makings of a new wave of scrutiny and enforcement actions focused on private company governance.
Secondary Market Focus
The Fenwick memo also described comments made by Chair White suggesting there is concern around secondary market trading of pre-IPO shares. It also captured detail shared by enforcement chief Ceresney:
In particular, enforcement chief Ceresney singled out the SEC’s concern about trading platforms that enable investors to purchase derivative interests in private shares. He noted that this new model has arisen because companies have restricted the transfer of shares, leading to employees and others retaining the shares themselves but selling an economic interest in the shares or promising to deliver shares after a liquidity event. Ceresney noted that, depending on the structure of the deals, such transactions may be securities-based swaps which are most likely illegal if sold to retail investors under SEC rules passed in the wake of Dodd-Frank. Last year, the SEC brought its first enforcement case under these rules against a Silicon-Valley start-up who was offering investors swap contracts based on the value of pre-IPO shares.
Mitigation
While this new wave of enforcement focus may not apply specifically to public companies, I can still think of scenarios where private company actions could still have a ripple effect. Take M&A activity, for example. A public company acquires a private company that has historically shown poor governance practices. Later, those practices become the target of a shareholder lawsuit. Fenwick offered some suggestions to private companies to aid in evaluating their practices and help stand up to a potential SEC investigation.
- Develop written and enforceable compliance policies and procedures over financial reporting, disclosure, compensation (including the granting of equity-based compensation), cybersecurity, insider trading, and policies designed to prevent violations of the Foreign Corrupt Practices Act (if the company does business overseas).
- Develop a whistleblower program that provides an avenue for employees and consultants to bring issues to the attention of senior management and the Board.
- If their shares trade in the secondary market, companies should develop procedures to monitor and review company disclosures or other publicly available information that may impact trading, as well as monitoring what material, nonpublic information is available to directors, employees and others who may be selling shares in the secondary market.
- Boards should consider meeting with experienced regulatory counsel on a regular basis—as public companies do—to keep abreast of current issues and best practices.
This is likely not the last word we’ve heard on this topic.
-Jenn