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In October of last year, we submitted an article regarding whether stock options still held any incentive in privately held companies with falling valuations, and we looked at ways in which to improve option granting practices in the future. This year, unfortunately, we find ourselves discussing companies whose enterprise values seem to have fallen even further or, at least, show less signs of rebounding in the near future. We hope that next year we will be able to discuss a compensation issue with a more optimistic outlook.

The Overhang Problem

Over the past couple of years, many growth companies have found that they have built up a seemingly insurmountable obstacle to creating an incentive to management through the normal means (that is, except for the incentive of gainful employment in an otherwise bleak job market). This obstacle is often called a "preference overhang" or "preferred stock overhang," and it refers to the amount of liquidation preference that must be paid out to the preferred investors upon the sale of the company before the holders of common stock (often founders’ stock) or common stock options will receive any of the sale proceeds.

Due to a number of factors, many technology companies find themselves in the situation where the preference overhang greatly exceeds even the most optimistic sales price of the company. One of the reasons is that the general market demand for technology is still very low – many large business consumers of technology have cut back infrastructure spending, and especially technology infrastructure spending, considerably over the past couple of years. This has resulted in technology start-ups being forced to raise more capital from investors in order to keep the company alive while waiting out this soft market.

Along with additional rounds of financing comes additional layers of liquidation preference, pushing the common stock even further to the back of the payout line. This effect has been exacerbated by the sluggish capital markets for technology companies. This tough market means that what little money is invested will come with tough terms attached, including such preference-enhancing features as cumulative dividends accruing on preferred stock and also liquidation preferences that are multiples of the amount of the money originally invested. Cumulative dividends provide investors with an interest-like rate of return (often compounding) which must also be paid back before any payments are made to the holders of common stock. Multiple liquidation preferences provide that if a financing round raised $X, the investors in that round will receive, for example, 3 times $X before other investors and stockholders will be paid. These features can obviously quickly push the potential value of common stock far beneath the preferred stock overhang.

The Decision Point

When the technology spending market looks like it will not rebound before a company’s money runs out, the preferred investors will decide whether it is likely that they (or other investors) will be willing to invest again when the company’s current financing has been spent. If further financing appears unlikely, they may decide that the company should begin looking for potential buyers to receive at least some return of their invested capital. As the technology assets of most start-ups have a tremendously short shelf-life once the company has laid off its development staff or has otherwise stopped operations, selling such a company requires quick and intensive work by people who know the technology and potential buyers well – typically, the company’s current management. Savvy management keeps track of the value of their founders’ stock and stock options under various exit scenarios. Unfortunately, in the current environment, they often quickly see that due to the preference overhang and the realistic sales price of the company, their founders’ stock and stock options are worthless.

Even if this decision has not been made, management can often see that such a decision may not be far off and, at the time of an investment adding to the preference overhang, will often demand that some mechanism be put in place to provide an incentive to management upon the sale of the company. In the past, this was often done by "refreshing" the option pool simultaneously with the closing of an investment. However, in the situation we are discussing here, there is no amount of additional common stock options that would create additional incentive – five million stock options create no more incentive than does one stock option.

The Solutions

There are several creative solutions to this problem. One is a stock option plan under which options for preferred stock may be granted to management. This means that rather than issuing more common stock options, management is issued options to purchase shares of preferred stock, either the same series of preferred stock as issued in the current financing or, more likely, a series of preferred stock with a liquidation preference that is just "below" that being issued to current investors. In other words, having a liquidation preference to prior rounds of financing, but only being paid after the current investors have received their liquidation preference.

A somewhat simpler (at least in concept) idea that has been used more commonly in recent years is a plan that provides a direct payment of some sort to management upon a sale of the company. The structures vary depending on the situation (common structural questions are discussed below), but these are essentially taking a concept that is often included in the employment contracts of high-level executives – i.e., a payment upon a "change of control" – and put it into a more formal plan that effectively serves the purpose of an option plan. This can feel like the company hiring its own management as an investment banker to sell the company, albeit one with extreme familiarity with the company and its products.

Structural Questions

These plans are referred to by a variety of names including "Change-of-Control Incentive Plans," "Sale Incentive Plans," and "Senior Management Incentive Plans," However named, there are many factors that should be considered when documenting such a plan in order to provide clarity upon the exit event. Among these factors are:

Trigger Event – What types of events will trigger a payout? Certainly a sale of substantially all of the assets or stock of the company (or a license of substantially all of the assets), but what if there are various distinct lines or products? Should multiple payout events be taken into account?

Threshold Requirements — Will there be a minimum proceeds threshold that must be met before there will be payout to management? If so, how is that minimum threshold tied to current liquidation preferences, if at all?

Calculation of Payout – How much will be paid to management upon a triggering event? The formulae vary from exceedingly simple to mind-numbingly complex. Should it be a straight percentage of the proceeds (typically between five and twenty percent, depending on the situation)? A percentage of proceeds over a minimum threshold? Should the calculation of proceeds take into account any debts of the company (almost certainly in an asset sale, since those debts will be paid by the seller thus reducing the payout to other stockholders)? A split of proceeds with a certain series of preferred stock, to happen concurrently with payment of that series’ liquidation preference (i.e., management will receive nothing if proceeds do not exceed the Series C Liquidation Preference but, if there are excess proceeds, management will share such proceeds 30% / 70% with the holders of Series B preferred stock)? Should there be a graduated percentage for finding higher valuations for the company? A regressive percentage?

Type of Consideration –
What if all or part of the purchase price is stock of the buyer? Should management be paid a fair value of the proceeds in cash or should they receive stock like everyone else? Or some combination?

Time of Payout – Should the payout, however calculated, occur simultaneously with the closing of the triggering event? What if the triggering is a license of the assets of the company with license payments to come over time (or provides some other future or contingent payment stream) – should the payout to management be made entirely up front based on a calculation of likely return to other stockholders? Or should they be paid over time like everyone else?

Who Participates – Senior management? All employees? Named individuals? How can people be added (or deleted) later? The plan should certainly provide that any individual’s rights will terminate upon leaving the company, in the same manner as other incentives.

Allocation – Who allocates the total bonus payments among the participants in the plan? Is it allocated specifically now (at time of adoption), or open to allocation at the time of the triggering event based upon individual performance? A combination? Is it based purely on current allocations of vested stock options, so as to reflect current seniority/importance? Should the Board of Directors or a Compensation Committee make such allocations? Investors? A Combination?

Forfeiture of Current Stock – Should management be required to forfeit all current common stock and stock options in order to participate (which is a very typical requirement)? Should they be forced to make that decision now (at time of adoption) or wait until the transaction to make the choice based on actual events? Should a formulaic event take into account a reduction in payout if current stock options actually come into the money? Should the entire plan automatically terminate in such an event?

Termination of Plan – Even if adopted at a time in which sale or liquidation of the company seems the only likely situation, consider when the plan should terminate (i.e., 3 years? 5 years?) – It may be that the economy turns around in the meantime and the company gets back on track to higher valuations. In such a case, it may be difficult to get participants to agree to allow the plan to be taken away even if it probably should be.

Other Conditions – Should certain personnel be "handcuffed" in order to receive the payout (i.e., they must stay with the acquiring company for a period of up to six to twelve months after the sale if so requested)?

Fiduciary and Similar Duties

Another consideration when adopting and structuring such a plan is the fiduciary duties owed by directors to the stockholders, and the duties owed by officers and employees to the company. Due to a conflict of interest, Directors who are likely to be recipients of payouts under the plan (i.e., members of senior management) should abstain from voting on the plan’s adoption. In addition, directors who are affiliated with preferred stockholders should consider whether they are exposing themselves to the charge of breach of duty to other stockholders – by replacing management’s common stock options with a payout tied to the value received by one or more layers of preferred stock, directors could be said to be dis-aligning management’s interest with that of the other common stockholders and placing management’s interest more in line with that of a certain series of preferred stock.

However, if the decision to adopt such a plan reflects the economic reality that common holders are unlikely to receive any proceeds under any exit scenario in the current market and that the only other alternative is to allow the disincentivized management team to leave the company, it may be clear that such a plan does nothing more than make the best of a bad situation. Structuring decisions that may provide incentive to find a transaction benefiting the common stockholders if possible can also help in such a situation. There have been situations in which the remaining management team worked for months with reduced salary, or no salary at all, in order to bring a transaction about – in such a situation, it is fair that management be provided incentive to work hard and be fairly compensated for this work. One consideration would be to have the plan adopted by vote of disinterested stockholders, paying close attention to disclosure requirements under the conflict of interest provisions of the jurisdictions’ corporate code.

Income Tax and Golden Parachute Issues

Finally, the tax issues involved in such a plan should be considered up front and taken into account by management when deciding whether the plan provides sufficient incentive to remain with the company. Payouts under the plan will be taxable income to the participants in the most typical transactions. In addition, generally if the payout to any particular participant is in excess of three times his or her average compensation for the previous five years, the payout could trigger the "golden parachute" rules under the Internal Revenue Code, resulting in an additional excise tax to the participant and also resulting in the payments being non-deductible by the company. These harsh results can be avoided by the fully informed approval of the holders of at least seventy-five percent of the outstanding stock of the company (including only "disinterested" stockholders) at the time of the transaction (i.e., approval at the time of adoption of the plan will not meet this requirement).

This Entrepreneurship article was written by Hutchison and Mason PLLC on 2/11/2005

Hutchison & Mason, PLLC is a Raleigh, North Carolina based law firm specializing in information technology and life science companies. Their web site is