Last week, guest author Corey Rosen of the NCEO started a two-part series on how companies can share equity and stay private. This week, he concludes the series.
Yes, You Can Share Equity and Stay Private: Part Two
By Corey Rosen, National Center for Employee Ownership
In Part One of this article, we looked at general issues for staying private, including plan design and redemptions. Below are four more liquidity options.
Sales to Employees
Employees can buy shares from sellers. The purchase is with after-tax dollars; the proceeds are taxed as a capital gain. Some companies pay employees a bonus to use to buy the shares or loan the money at a reasonable rate, which right now could be very low without incurring a tax problem. It is also possible to set up an internal stock market. The details are beyond the scope of this article. Suffice it to say here that the SEC has made it possible to do this is a way that avoids most significant regulatory burdens.
Outside Investors
We have seen a growing trend in recent years for investors in private companies, whether angel investors or private equity firms, to be willing to invest in closely held companied with the intention of selling to another investor group in 5-7 years instead of forcing a sale to another company. This lets the company stay private, but be aware that these investors may want some level of control even for a minority interest, preferred stock, and/or a relatively high rate of return on their money.
Secondary Markets
If your company is a high-flyer with real prospects to go public at some point, there are now secondary markets such as NASDAQ’s SecondMarket and SharesPost,that allow investors to buy equity (usually equity held by employees in the form of options or restricted shares). These rights are then traded on the market until a liquidity event. Only the most promising companies can do this, however.
ESOPs
Employee Stock Ownership Plans (ESOPs) are highly tax-favored ways for companies to redeem their own shares by setting up an employee benefit trust similar to profit sharing or 401(k) trusts that are designed to hold company stock. Companies can use pretax money to redeem the shares through the ESOP, which then allocates them to employees. All full-time employees with a year or more of service are included and allocations are based on relative pay or a more level formula. Sellers can defer capital gains tax on the sale, and S corporation ESOPs can reduce their tax obligation by the percentage of shares the ESOP owns.
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.
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.
For today’s blog entry, I have a grab bag of topics, but with a theme–all of the topics are interesting things pre-IPO companies (or their employees) have done lately.
Pinterest Extends Post-Termination Exercise Period Pinterest recently announced that they are going to extend the post-termination exercise period from the traditional 30-90 days to seven years, for employees that have been with the company for at least two years. We discussed this development in the May-June 2015 Advisor, with a link to an article in Fortune (with the somewhat misleading title of “Pinterest Unpins Employee Tax Bills“).
Most companies don’t do this because allowing terminated employees longer to exercise potentially takes shares away from current employees, who are still contributing to the company. This can also be an administrative challenge, since the company could end up having to process exercises (and withhold taxes and report income) for employees that have been gone for up to seven years. Not to mention, it’s hard to keep track of terminated employees for seven years. (Then again, Pinterest is located in San Francisco. With the median rent upwards of $3,000 for a one-bedroom and with rent control, maybe it won’t be so hard for them to keep track of their employees. Who can afford to move before their options pay out?)
Pinterest Facilitates Sales for Employees Another interesting thing Pinterest is doing is allowing employees to sell some of their vested stock to the company’s external investors (see “Pinterest Adds $186 Million to Series G Round, Lets Employees Sell Shares” in Re/Code). This will enable Pinterest employees to realize a return on some of their stock before the company goes public. Usually when private companies want to allow employees to liquidate, they implement a repurchase program. Allowing employees to sell stock to outside investors is somewhat novel.
Presumably there is a limit on the size of investment Pinterest’s external investors are willing to make in the company, so allowing employees to sell stock to their investors potentially means less capital is available to Pinterest. But internal repurchase programs require the company to come up with the cash and can trigger additional compensation cost under ASC 718. Pinterest may feel this is preferable to allowing employees to sell shares in the secondary markets, where Pinterest would have no control over who buys the stock.
Stock Options for Houses While we’re on the subject of the crazy real estate market in San Francisco, I recently came across an article about people including stock options in bids to purchase houses: “Desperate Local Home Buyers Now Bidding With Stock Options.” The article says the tax consequences are too complicated to make it worthwhile. I am sure they are right about that, nevermind the valuation issues.
Stock Options for Customers Jet.com is taking a different tactic. In November of last year, they announced a contest in which subscribers competed to receive a stock option by referring other people to the website. The overall winner got an option for 100,000 shares and the next top ten finishers got an option for 10,000 shares. The winner spent about $18,000 to generate about 8,000 new subscriptions to Jet.com (see “How This CEO Hustled His Way to an Equity Stake in Jet.com” and “What’s It Take to Challenge Amazon? For Jet.com, Giving Away Equity to Lure New Users“).
I’m sure this idea is a rabbit hole of complex legal issues, not the least of which is, are participants in a contest like this considered service providers and are the options compensation? Or are the options treated like some sort of prize/gambling winnings? Ten points to anyone who figures this out.
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.