Steven Davidoff Solomon, the New York Times DealBook’s Deal Professor, highlights an academic paper that he and others wrote, advocating tenure voting for public companies. The basic concept is that the longer you hold a company’s shares, the more voting power you have when the company conducts shareholder votes. The purpose is to incentivize long-term holding and accordingly dilute the voting power of activist shareholders that buy up a block of shares, immediately agitate for change that helps them in the short term, and then unload the shares, to the ultimate detriment of the company. In fairness, I should note that the activist investor community contests this characterization of what they do, arguing that the changes they demand are beneficial to the companies in the long-term as well. I will not wade into that argument but simply assume for the sake of this post that as a policy matter, we should try to encourage a long-term orientation among shareholders. [Read more…]
The Wall Street Journal recently detailed the increasing willingness of service providers to startups to accept the startup’s equity as payment for services. With the startling growth of so-called unicorns, private companies like Uber that have achieved stratospheric valuations, there is a hope among many vendors that they’ll get lucky with one or more of the startups in which they accept equity. I previously wrote on this topic, focusing specifically on law firm payment arrangements. That post mainly addressed the possible conflicts of interest that can be associated with equity compensation, but for today I want to focus on whether it makes sense, as a business matter, for service providers to accept equity.
When I assist clients in setting up entities, one of the threshold matters, of course, is the selection of a name for the entity. Once that is settled, and the entity is set up, many clients assume the job is complete as far as protecting the business name, unaware that protection of the name for purposes of trademark law involves a completely separate legal analysis and process. The purpose of this post is to briefly explain the difference.
In my practice, the question of classification of service providers as employees or independent contractors has come up with increasing frequency. This probably results from the increasing amount of freelancing in the economy in recent years. It’s also been in the mainstream news recently, with highly publicized actions against Uber and Lyft for alleged misclassification of their drivers. A classification of a worker as a contractor is generally preferred by companies, as it eliminates a wide range of costs and legal protections available only to employees, e.g., unemployment insurance, workers compensation, tax withholding, minimum wage and overtime laws. Because of this, federal and state regulators are increasingly scrutinizing classification issues, and employers need to be aware of this and be careful and conservative in their classification decisions. [Read more…]
Companies looking to compensate their employees and other service providers in equity will often employ stock options or restricted stock (for corporations) or profits interests (for LLCs). An alternative approach that should be considered is to offer so-called “phantom” equity, which is essentially a deferred compensation plan, where the employee receives cash payments that are calculated as if the employee had received an equity grant. (A similar alternative is stock appreciation rights, or SARs, but I will focus on phantom equity here.)
For example, the recipient could receive a cash payment at the time the company is sold that’s equivalent to the distribution that would have gone to someone receiving 1% of the company’s common equity at the time of the grant. There can be other triggering events besides a sale, depending on the plan, including regular company distributions of earnings. Like true equity, the plan can have vesting, repurchase and similar provisions seeking to incentivize the recipient’s continued employment with the company for a lengthy time. So, the employee receives the benefits of equity without the parties having to go through the trouble of documenting an actual issuance of equity. Unfortunately, the term “phantom” seems to imply that it’s somehow fake equity, meaning employees can be skeptical of the concept, so it takes some explanation.
Like any employee compensation plan, phantom equity plans need to be carefully structured using the advice of a qualified tax professional, seeking among other things to avoid issues with Section 409A deferred compensation penalties. As I do not myself have such expertise, I’ll leave out discussion of tax consequences here, except to note that a disadvantage of phantom equity from the employee’s perspective is that the cash payments are taxed as ordinary income, not capital gain, though the tax is assessed only if and when the cash is paid, not when the phantom equity is granted.
One advantage of phantom over true equity is that it’s generally easier to document, saving on legal costs (wait, why am I writing this?). Recipients of phantom equity will not need to be directly accounted for in operating or stockholder agreements, making simpler the mechanics of drafting provisions such as share transfer restrictions, management, and distribution of company earnings. Outside investors may prefer the simpler capital structure, though of course they would take into account the company obligations inherent in the phantom equity when valuing the company and their investment.
From the company’s perspective, phantom equity also avoids creating new shareholders or members that have statutory rights under state law, such as the right to examine records, which as a practical matter are not valuable to the typical service provider.