Equity Compensation: What are different forms of equities that companies offer? What are differences?

This is a recent question asked on Quora: "I am a layman and would like to know these basic information. I would also like to know how much of ownership is in the hands of employees? What are Non Qualified Stock option? How do you know how much a share is dilutable ( to what extent)? Are there really any non-dilutable shares? When the stocks are given in a start-up, do they get value only when the company goes to IPO? What if company never goes to IPO? What are the different reasons for a company to go to public(IPO)? Please try to explain it in details and it would be really helpful if you associate current scenario(Facebook IPO) with your solution."

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Dan provided his answer below:

This is a long list of questions, so I will start with a couple quick reference tools.

· Here's link to a Matrix with the most common types of time-vested equity. The 2012 Equity Compensation Design and Use Matrix. http://www.slideshare.net/perfor...

· Here's a link to a Matrix with the most common types of performance-based equity. The 2012 Performance Equity Design and Use Matrix.  http://www.slideshare.net/perfor...

What are different forms of equities that companies offer? Basically there are three forms of equity compensation ·       Full Value – These include Restricted Stock, Restricted Stock Units, Phantom Stock and any other award type where the individual gets the full underlying stock value (in stock or cash) upon vesting or lapse of restrictions.

·       Appreciation Only – These include Stock Options (both ISO and Non-Qual), Stock Appreciation Rights (SARs) and any award type where the individual only receives the difference between the grant price (general at the Fair Market Value or “stock price” of the underlying stock) and the value on the date of exercise. Sometimes exercise is forced to occur upon vesting.

·       Purchase (with or without a discount) – These include any type of program where the company sells stock directly to their employees. These may include IC+RC 423 “qualified” ESPP (offering a discount and tax benefits), non-qualified ESPP, Direct Purchase, Executive purchase and other programs where the individual gives funds to the company (sometimes in the form of sweat equity) in return for ownership of stock. This stock may still be subject to a wide array of additional restrictions.

What are differences? ·       Full Value – Downside protection because some value is already built in. Lower leverage than appreciation-only instruments due to built in intrinsic value at time of award. Income and tax event usually occurs automatically at lapse of restrictions. Potential 83(b) election, only for restricted stock. Potential deferral considerations (units). For private companies: No 409A valuation required for restricted stock.

·      Appreciation Only – More risk, since stock price must go up for real value to be attained. Higher leverage since no intrinsic value at grant usually means access to more shares (2-3x is common) when compared to full value.  If stock price rises significantly, value grows faster due to the multiple of shares. Income and taxation event is general voluntary, chosen by the individual at the time of exercise.

·       Purchase (with or without a discount) – Usually requires initial cash outlay by participant. Generally less restrictions, often no vesting at all.

I would also like to know how much of ownership is in the hands of employees? ·       Most companies allocate 10-20% to employees. But, many companies g far higher, some companies don’t get above 1-2%.  Depends on purpose of equity. Goals for company. Company entity type.

What are Non Qualified Stock options? ·       Non-Qualified stock options give the participant the right to purchase stock, usually at some point in the future, usually at a price specified at the time of grant.  Basically you get to buy stock down the road for the, theoretically, lower price of today. For more basic on stock options try this article.

How do you know how much a share is dilutable (to what extent)? ·       This is generally defined by the class of stock the award is awarded or granted in. Each new share dilutes current owners by requiring the value of the company to be divided into more pieces. Assume the company is worth $200 and there is 1 share of stock outstanding.  If you issue one more share, or promise to issue one more share, you dilute the original shareholder by 50%.  Note:  There may be differences between dilution for the purpose of value and dilution for the purpose of voting rights.

Are there really any non-dilutable shares? ·       Some ownership positions define that the owner will not be diluted.  It is important to note that for this to work, other shareholder will have to “pick up the slack” and accept even higher dilution (since the company value will not change)

When the stocks are given in a start-up, do they get value only when the company goes to IPO? ·       No. Stock can have value under a variety of scenarios.  The most common are IPO and Acquisition.

What if company never goes to IPO? ·       Hopefully there will an acquisition and value will still be attainable.  In fact, most companies are not aiming for IPO, they are aiming for acquisition.  Of course, many company never intend for an “exit event”. In these cases the goal is for the company to grow in value enough that the company, or investors can purchase shares away from employees. There are other scenarios as well….

What are the different reasons for a company to go to public(IPO)? ·       Most companies have a public offering because they are looking to cash in on current or potential success.  The value of the shares sold at the “IPO price” goes to the company (minuses fees etc.).  The value of the stock above, or below the IPO price is gained or lost by the investors in the shares.

Please try to explain it in details and it would be really helpful if you associate current scenario (Facebook IPO) with your solution. ·       Facebook is a very unique situation. Like Google before it, Facebook is not a great representation of how the process, values or pre-IPO equity compensation work. Facebook’s value was far higher than prior IPOs. Facebook had far more employees, and potential shareholders when then went public.  They had to deal with issues like the 500 shareholder public filing rule long before going public was a reality.  They granted Restricted Stock Units with trigger (the IPO) based vesting to avoid income and taxation to their employees and to avoid creating even more shareholders prior to being publicly traded.  I will say nothing about their IPO value and the prices that followed.  Many people can address that far more expertly than I.

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