This is a guest blog created by Daniel Glazer and Robert Mollen from Fried Frank – a NYC based international law firm. It originally appeared on the European American Chamber of Commerce website.
When UK emerging companies venture outside the UK, they quickly need to address whether – and how – to extend equity-based compensation to non-UK employees.
However, few jurisdictions offer a regime as favourable as the UK’s Enterprise Management Incentives (EMI) scheme for providing equity compensation to emerging company employees.
The discussion below provides guidelines for making this work. Although the focus is on extending equity-based compensation to US employees, the issues addressed have broader applicability.
1. Provide for non-EMI grants of options and shares. When adopting an EMI scheme, include provisions (potentially in a separate Part 2) that permit the issuance of options that do not qualify under EMI. Otherwise, shareholder approval issues will need to be addressed in connection with every non-qualified grant. Ideally, the plan also should permit equity awards other than options, including share awards. For example, if the valuation of your shares is low, a US employee may prefer to obtain better tax treatment by receiving a share grant and electing to be taxed as ordinary income at the time of grant, with future increases in value taxed at capital gains rates. Assuming “reverse vesting” (see below), this will require that the employee file a US Internal Revenue Code Section 83(b) election within 30 days of the grant (this is similar to the employer/employee joint Section 431 election made on an acquisition of restricted shares under UK tax law). In some cases, share awards may even make sense in the UK.
2. Provide for “reverse vesting”. If you wish potentially to issue share awards, you need to have a mechanism to recover awards that have not been fully earned if the individual leaves prematurely. This is referred to as “reverse vesting.” Implementation of reverse vesting requires inclusion of special provisions in your articles of association. It may make sense to include this mechanism in your articles in any case, because you may need to recover shares from a departing founder who has received shares. The British Venture Capital Association has developed standard forms of these provisions, although they may require moderate tailoring for your situation. These provisions avoid UK company law issues associated with a company’s reacquisition of its own shares by instead converting the forfeited shares into “deferred shares” with no value.
3. Obtain appropriate fair market valuations. You typically are going to need to secure a valuation of your company’s shares at the time of the options or shares grant to comply with relevant tax requirements, whether under UK tax law (for example, for purposes of confirming that the options are being issued at fair market value and consequently won’t trigger tax at the time of exercise, or that the values of the options or shares do not exceed relevant thresholds) or under other tax law.
For example, it is very important under US tax law that the exercise price of employee options is fixed at fair market value (or higher) in order to avoid penal provisions under Section 409A of the US Internal Revenue Code. While these penalties apply to the employee and not to his or her employer, having a very unhappy employee is not the purpose of an employee equity incentive!
A valuation of your shares that meets UK HMRC standards is not likely to suffice for US tax purposes. In particular, the UK permits a higher discount for minority ownership than is considered acceptable by the US Internal Revenue Service. Consequently, if you wish to make grants to US employees, you will need to determine whether to use separate valuations for UK and US purposes or rely on the higher valuations determined under US principles for both UK and US purposes.
4. Set options exercise prices appropriately. It is common in a UK context for emerging companies to issue options with a nominal exercise price or, at most, a UK-qualifying fair market value exercise price. For the reason indicated in (3) above, this will not work for US purposes and options issued to US employees will need to have a US-qualifying fair market value exercise price. Consequently, you need to address up-front whether you are going to have different exercise prices in simultaneous grants of options to your UK and US employees and, if so, whether this should have any impact on grant levels.
5. Differences in market practice may affect the determination of fair market value of employee grants. One way in which US issuers can justify a lower fair market value for their common stock (ordinary shares) or common stock options issued to employees is that outside investors in those issuers instead receive convertible preferred stock (convertible preference shares) with a liquidation preference. This liquidation preference provides, at a minimum, a right to get paid first in certain circumstances before the common stock receives any value. While this approach would in theory also work in the UK, the Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS), which are UK tax-incentivized programmes, specify that only ordinary shares (without a liquidation preference) qualify for SEIS and EIS tax treatment. As a result, a liquidation preference may not be available to justify a difference in the valuation of the shares issued to investors and the valuation of contemporaneous shares or options issued to employees, although UK companies sometimes attempt to use dual ordinary class structures (e.g., with partially paid shares issued to founders) to build in something akin to a liquidation preference for SEIS or EIS qualifying investors.
This is a problem that simply needs to be managed – there is no clear solution to this if the UK company wishes to issue SEIS or EIS qualifying shares to investors and make contemporaneous grants to US employees.
6. Take into account the local taxation of share and option grants. You will need advice in each jurisdiction in which you make equity grants as to what mechanisms work best.
In the US, as suggested above, a share grant that is taxed as ordinary income at fair market value at the time of grant (with no discount for risk of forfeiture due to reverse vesting) may make sense for some senior executives if the current valuation of your shares is low enough; otherwise, you will need to grant options.
While the US has a class of tax favoured options known as Incentive Stock Options (ISO’s), they do not work well for early-stage companies and we do not recommend their use. Specifically, in order to benefit from tax-favoured treatment, the ISO needs to be exercised and the shares so obtained need to be held for at least one year prior to disposition. This is an unlikely scenario for most employees, particularly in the context of a trade sale exit. ISO’s also attract unfavourable tax treatment in certain circumstances (e.g., for purposes of the so-called alternative minimum tax) and the value of the share grant is not deductible as a compensation expense by the company.
Rather, we recommend the use of non-qualified stock options (NQSO’s) for US employees. The value of these options above their exercise price is taxed at ordinary income rates at the time of exercise (which in most instances is likely to be at the time of exit), but this would also be the case for an ISO if it is only exercised at the time of exit. With an NQSO, the value of the shares so issued (over the option exercise price) is deductible by the company as a compensation expense – the company can, if it wishes, choose to share the benefit of this with the employee.
Managing cross-border employee compensation is complex, particularly so with respect to equity compensation. However, with a little effort, you can adapt your equity compensation plan to give you the flexibility to deal with these cross-border issues when and if they arise.
Daniel Glazer leads the Tech Group at the New York-based global law firm Fried Frank and is co-resident in the firm’s London and NYC offices. Dan’s team provides US legal advice and practical business guidance to European early-stage and growth-stage companies seeking to expand to the US, raise US capital, and transact with US business partners. Dan can be reached at firstname.lastname@example.org.
Robert P. Mollen is a US-qualified corporate partner who has been resident in Fried Frank’s London office since 1991. Bob regularly advises technology companies, including early stage companies, in connection with their establishment and expansion of US operations, US commercial agreements and joint ventures, and securing of US investment by venture capital firms and others. Bob also works with VC firms with respect to US challenges faced by their portfolio companies, and with the UK and US governments in their efforts to help UK based companies succeed in the US. Bob can be reached at Robert.email@example.com