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.
If you have a small private company with 10 shareholders, the job of issuing share certificates to them, and cancelling and issuing new ones when there are transfers, is a pretty non-time consuming task that can be handled by one of the founders. If you are Microsoft Corporation, where over 30 million shares change hands every day on average, needless to say, a person seated in front of a stock ledger book couldn’t keep up with the flow. Accordingly, for public companies, a back-office infrastructure has developed, with stock transfer agents serving the function of keeping track of record ownership of shares for these companies.
As described in this Q&A from Luis A. Aguilar, one of the Commissioners of the SEC, an important function of transfer agents is to distinguish between restricted shares – ones that were recently sold in an exempt transaction under the Securities Act of 1933 or were issued to company affiliates – and unrestricted, free-trading shares. In my practice, I typically deal with the larger and more established transfer agents, which employ full-time compliance professionals to ensure that restricted shares are policed properly. For example, if a shareholder of a client of mine asks the transfer agent to remove the restrictive legend because the shares have been held over a year and the holder isn’t an affiliate, the compliance department of the transfer agent will want to see an opinion of counsel from my firm, to the effect that the legend can be removed under Rule 144.
Unfortunately, as described by Commissioner Aguilar, some transfer agents are not as scrupulous about adhering to these rules. Under current (non-)regulation, the same individuals can operate a transfer agent, a brokerage firm and a microcap public company. In such a scenario, if those individuals want to initiate a scheme involving the sale of unregistered shares, the transfer agent (being the same people) won’t police the transactions to prevent them from happening. This is just one of many examples cited by Commissioner Aguilar making clear that a more aggressive regulatory approach is needed.
The short answer to the above question is “no,” but there are some caveats that we need to discuss (otherwise, this would be my shortest blog post ever).
Limited liability companies do not require ownership to be evidenced by physical certificates, though a company’s operating agreement can provide, voluntarily, that certificates will be issued. More often than not, in my experience, ownership in LLCs is set forth in a table attached to the operating agreement that is updated as ownership changes. This table can reflect either share-like units of ownership called, appropriately, “units” or percentage ownership. The latter is more unwieldy, I think, particularly with LLCs with many members, but you see it a lot particularly in more old fashioned forms.
For privately-held corporations, most states now permit the issuance of “uncertificated” shares, meaning as with LLCs that there is no physical certificate issued and the corporate records must reflect current ownership. Both New York and Delaware permit the issuance of uncertificated shares by resolution of the Board of Directors (Section 508 of the NYBCL and Section 158 of the DGCL, respectively). In some cases, the corporation will send a notice of issuance of stock to the holder. This open source form from Orrick resembles an actual stock certificate in some ways – it’s not really necessary to do it this way, but it may be more reassuring to old school investors who aren’t aware of the trend toward (and legality of) uncertificated shares.
Finally, there are public companies (usually corporations), where uncertificated shares have been more prevalent for a longer period. This SEC summary outlines the possibilities – if you don’t hold a physical certificate, you either have “street name” registration or “direct” registration (DRS). Since 2008, all public companies with stock listed on a major exchange have been required to have DRS-eligible shares.
One of the reasons that limited liability companies have become so popular as an alternative to corporations is that the state laws governing LLCs are so much more liberal in terms of formal requirements for documenting company decisions. For the most part, LLCs are free to shape the management provisions in operating agreements in the manner desired by the parties. Corporations, in contrast, are required by statute to adhere to certain procedures in their operation. In particular, the corporation’s Board of Directors must formally approve certain acts, such as issuing new shares or entering into a significant contract, and this approval must be documented, either via minutes of a board meeting or unanimous written consent of the board. [Read more…]