United States: Practical Advice For The Business Owner

Avoiding common mistakes when making incentive compensation grants to employees

Incentive compensation (e.g., stock options, restricted stock, bonus plans, phantom stock, stock appreciation rights, etc.) can be a very useful tool for aligning the incentives of employees and shareholders, as well as a means of recruiting talent to early-stage companies who often lack sufficient cash to offer competitive salaries. Due to these factors, incentive compensation plans have become widespread and continue to be popular with companies of all sizes.

While popular and conceptually straightforward, a properly structured incentive compensation plan must comply with several areas of the law, including tax, securities, employment, employee benefits, contract and corporate laws. Reflecting these numerous underlying legal issues, the resulting plan document and grant agreements will tend to be fairly complex; however, well-crafted documents can (and should) be quite user-friendly. 

However, as we have seen often in recent months, even a user-friendly set of documents can be undermined if the issuing company does not maintain a disciplined process when communicating grants, offers and other incentive compensation-related information to its employees and consultants. Consider the following scenarios, which are similar to fact patterns we have recently encountered in our practice:

• Scenario 1: Company A's incentive compensation plan required that the exercise price for stock options be at least 100% of the fair market value of a share of stock on the date of grant, as established by the company's board of directors. Company A sent an offer letter to a prospective employee promising that he would be issued "stock options with an exercise price of $5 per share," but by the time the employee accepted employment and the company issued the stock options, the board had negotiated an arm's length transaction wherein Company A's stock was implicitly valued at $7 per share.
• Scenario 2: Company B sent an offer letter to a new executive stating that the executive would "be awarded an initial option grant to purchase 25,000 shares of Company B's common stock at current fair market value, which is currently $25.50 per share." By the time that the employee accepted employment, Company B had entered into a letter of intent to be acquired, which included contractually binding prohibitions on Company B issuing any new stock options.
• Scenario 3: Employee C entered into a consulting agreement with Company D, which did not provide for any equity compensation. Over the next several months, however, Company D's CEO repeatedly made oral and written statements to the effect that Employee C and other members of "the management group" would receive grants of restricted stock from Company D. Employee C was subsequently terminated without cause and did not receive the promised stock grant.

Each of these scenarios resulted in what should have been easily avoidable difficulties. In Scenario 1, Company A put itself in a position of potentially breaching either its offer letter (by not granting the options at the promised exercise price) or its incentive compensation plan (by granting options with an exercise price that was less than 100% of fair market value). Similarly, in Scenario 2, the offer letter's language was absolute, but Company B subsequently entered into a binding agreement with a third party that directly conflicted with its obligations under the offer letter. In Scenario 3, Company D's imprecise internal communications created ambiguity regarding Employee C's right to receive equity compensation (or lack thereof). 

These are all thorny but easily avoidable problems if appropriate processes are implemented and followed by the issuing company. Below are some practical tips for avoiding these and similar scenarios when administering an incentive compensation plan:

1. Use a standard, attorney-vetted employment offer letter. Engage legal counsel to review and confirm that the company's standard form of employment offer letter does not conflict with its incentive compensation plan or applicable laws. Once the form letter has been approved by legal counsel, do not change the standard language without first consulting legal counsel. If these offer letters refer to incentive compensation grants, they should include appropriate caveats to conform with the company's incentive compensation plan—e.g., "Subject to the approval of the Board of Directors, we anticipate that within X months of your employment start date, you will be granted options to purchase X shares of the Company's common stock for an exercise price per share equal to the fair market value of a share on the grant date."
2. Avoid making unqualified promises regarding incentive compensation grants. Any mention of incentive compensation grants should be expressly subject to the terms of the plan and any required corporate approvals. Such qualifications should be part of the company's standard form of offer letter, but the company should be careful not to make unqualified promises in other communications.
3. Do not make broad, imprecise statements regarding proposed incentive compensation grants. The company's internal communications should be clear regarding who will be granted rights to participate in incentive compensation plans and that only those persons who enter into written grant agreements will be entitled to receive incentive compensation. Statements to the effect that "the management group" or "key personnel" will be receiving incentive compensation are examples of overly broad language that should be avoided. 

Poyner Spruill attorneys have expertise in all of the relevant practice areas necessary to create, review and amend your company's incentive compensation arrangements. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.