General Corporate/M&A Matters

Whether to Pay Profits out to Shareholders

Whether to Pay Profits out to Shareholders | Andrew Abramowitz, PLLCMatt Levine writes in Bloomberg View about Facebook’s announced $6 billion stock buyback program (scroll down in the newsletter past the other topics). Basically, Facebook’s business generates far more cash than the company knows how to put to use anytime soon, so it is returning the cash to shareholders by buying back the shares of those who want to sell. This is the corporate finance version of a first-world problem – many of my early-stage clients burn through cash and constantly need to think about fundraising (Facebook was that type of company at one point) – but for those companies generating large profits, what to do with excess cash is an interesting issue.

Increased Scrutiny of Non-Competes in New York

non-competition-laws-in-nysAlthough it has historically been relatively easy for companies to enforce non-competition agreements against employees in New York State, compared to, say, California, where such provisions are unenforceable, the New York Attorney General’s office has recently been cracking down on broad use of non-competes on lower-level employees.

Although the two types of provisions are often conceptually lumped together, it’s important to distinguish non-competes from non-solicitation agreements. With non-competes, although companies have valid business reasons for wanting their employees to refrain from leaving and starting a competitive business, potentially using the trade secrets they have learned on the job, as a matter of public policy, they are frowned upon for reducing worker mobility and harming economic growth. Non-solicitation provisions, on the other hand, which prevent departing employees from taking other employees or customers with them to their new venture, don’t raise the same policy concerns and, accordingly, are not the focus of the New York initiative.

Allowing Departing Employees a Longer Stock Option Exercise Period

The well-known venture capital firm, Andreessen Horowitz, is now recommending to its portfolio companies that employees who hold vested stock options and leave the company have a much longer period following departure in which to exercise the option. As noted in the Andreessen article, the typical stock option will permit exercise within 90 days following departure. Andreessen is recommending that the period be extended to 10 years.

stock-optionsThe rationale for this change is that, upon departure, many employees simply do not have the cash needed to exercise the option and then to pay the taxes that are imposed upon exercise. If the company is still private, the employee will likely not have the ability to immediately sell the shares following exercise, which would otherwise solve the cash flow issue, at least as to the taxes. By extending the period in which the employee can exercise, there is time for the employee to raise the funds to pay the exercise price and taxes, or even better, for the company to be sold or go public, allowing the employee to immediately realize value on the option. Alternatively, the company might fail sometime during the 10 years following departure, in which case the employee will be happy not to have forked over money for a share purchase and taxes and nothing to show for it.

This is an unambiguously better deal for employees, though the Andreessen post details some tweaks companies can make to the grants to protect itself. One might wonder why a VC firm is advocating a pro-employee change in terms. I think the answer is that a 90-day exercise period poses significant practical issues for employees who don’t have much ready cash and it therefore could discourage potential employees from joining a startup and not practically being able to realize value in an equity grant. By extending the period to 10 years, companies can potentially increase the pool of qualified employees.

Tenure Voting for Shareholders

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. …

Should Vendors Agree to Be Paid in Equity?

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.

The Distinction Between Entity Name and Trademark

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.

Employee vs. Independent Contractor

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. …

The Phantom Equity Alternative

Accredited InvestorCompanies 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.

Under-Regulation of Stock Transfer Agents

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.

Stock Transfer Agents | Regulation Stock Transfer AgentsAs 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.

Does My Company Need to Issue Stock Certificates?

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.