Equity Compensation Structures for Venture-Backed Companies Post-Enron

Companies and their employees are beginning to explore alternative structures that afford some protection from these events. Among these structures are a) performance-based option vesting tied to achievement of individual or company-wide goals, b) options in which the number of shares varies depending on the return outside investors receive in a liquidity event, c) “make-whole” guarantees entitling the employee to a cash payment on a liquidity event hypothetically linked to a deemed conversion of preferred equity, with or without a minimum percentage equity guarantee, d) options on preferred stock, and e) acquisition/IPO cash bonus pools.

Start-ups typically issue restricted stock to founders and to early stage employees until the stock becomes too expensive for an employee to purchase because of valuations established by venture financings. Restricted stock is preferable to options from an employee's point of view since the employee will receive long-term capital gain treatment on a liquidity event if holding period requirements are met. In order to align the employee's incentives to the needs of the business, restricted stock typically has “golden handcuff” vesting provisions, meaning unvested stock is forfeited to the company at cost upon termination, with vesting occurring in increments over three or four years. Because the stock is purchased at “fair market value,” there is no charge to earnings if vesting is solely time-based and the number of shares is fixed.