Negotiating and Structuring Your Stock Compensation (Avoiding Inconsistencies): Part 1

Author(s): Clayton Foster
Synopsis: Clauses affecting equity compensation appear in a wide variety of interconnected corporate and employment documents. To avoid surprises later, make sure to review all related documents carefully before closing your deal. This article by Clayton Foster is also featured on the website.

In recent years, I’ve worked with many executives who had the misfortune to find a gap between what they expected from the equity compensation package negotiated at hire and what they ultimately received, either at termination or in a corporate transaction (e.g., a merger). Often the problem lies not in the intentions of the company or the executive (although, of course, that can happen) but in the complexity of the documents and rules that affect stock compensation.

This series of articles is intended to help you understand where to look to ensure that your equity compensation package is correctly documented. Part 1 describes the importance of the many different documents and why you must focus on conflicting or inconsistent provisions.

Get It In Writing

For most employees, the general practice under a company’s stock plan program will dictate the terms of their individual grants. However, if you are an executive in a position to negotiate your equity compensation package, you would be wise to understand which documents must be drafted, reviewed, and harmonized to make sure your deal works. While in many cases the possibilities for negotiation are wide open, careless drafting, conflicting references, or inconsistencies throughout the documents can (and often do) undermine the intentions of the parties.

Make Sure Your Agreement Sticks

When you negotiate an individual equity compensation deal, be sure to get the terms in writing and have both parties agree on them. Unwritten (or unstated) assumptions can result in big disappointments, particularly if an employment relationship goes sour.

The case law is rife with examples of executives whose interpretations of their equity rights ultimately differed from their employers’ interpretations. Assumptions about the timing of acceleration on a corporate event, the right to continue to vest after a corporate spinoff or other transaction, and the extent of post-termination exercise periods have proved to be a rich source of litigation in recent years.

Oral promises to grant or modify the terms of stock options are always a bad idea, no matter how trustworthy the promisor. See:

  • Braun v. CMGI, Inc., 2003 U.S.App. (2d Cir. NY 2003) (oral promise by CEO)
  •  Romaine v. Colonial Tanning Corp., 301 AD2d 732 (NY App. 2003) (oral promise by president)
  • Rodriguez v. Vision Corr. Group, 260 Ga. App. 478 (2003) (oral promise by board)
  • Bailey v. Grey, Siefert & Co., Inc., 752 NY App. (2002) (oral modification by administrator)

Even written agreements, when inconsistent, can produce unhappy results. For example, in the recent case of Donaldson v. Digital General System, 168 S.W.3d 909 (Tex. App. Dist. 5 2005), an executive who had negotiated a one-year post-termination exercise period in his employment agreement was nonetheless held to the 30-day period set out in the option agreement because, in the court’s view, the general language of the plan documents (without more) overrode the ambiguity created by the nonplan employment agreement.

Although the conventional wisdom in contract law is that ambiguities are “construed against the drafter,” this truism will be cold comfort if you are forced to spend your time and money convincing a court that the company drafted the wrong agreement for you. The better way is to study and understand all of the possible interactions before signing your name on the dotted line.

The Default Documents

Your specific individual documents will memorialize the terms of your deal: your stock option and/or stock award documents, their underlying agreements (the “stock award agreements”), and your employment agreement. However, when it comes to equity compensation, you must be aware that clauses in any number of corporate documents may affect the operation of your individual award. Before concluding that you understand your grant, you and your attorney should be sure to thoroughly review the following documents:

The Stock Plan

Generally, a stock plan is an umbrella document that sets out the procedural, corporate, and legal guidelines for administering the program. Because of this, the plan is intended to give broad outlines, within which the company may vary terms at its discretion. It may contain general limitations on grants (such as conditions on issuance or trading of stock), but detailed discussions of the rules are usually avoided to reserve maximum flexibility for individual stock award agreements (within the context of the legal and regulatory scheme).

Vesting schedules, exercise schedules, and financing arrangements are most often reserved to individual grants. These individual grants may also include terms such as nonstandard post-termination exercise periods, performance/milestone criteria, and other special rights.

However, surprises may lurk in the general stock plan document. For example, the plan may provide for special treatment of all grantees on certain corporate events, such as acceleration of vesting on a change in control; alternatively, it may provide that all options terminate with no acceleration at the closing date of the transaction. The document may give the administrator unlimited discretion to make special deals with individual grantees, or it may limit the administrator’s authority to a list of enumerated powers. If not specifically disclaimed or qualified in another document, all of these provisions will be incorporated by reference into your stock award agreement, regardless of your understanding to the contrary.

Another word to the wise: definitions used for purposes of the stock plan document may differ from definitions used for other corporate purposes and benefit plans, or from those in individual employment agreements. The concept of employment “termination” is a big offender in this regard. Understanding this definition and the definition of different types of “termination” (e.g., retirement, death, for cause, “voluntary” vs. “involuntary”) are crucial because termination usually stops the vesting, and for options and stock appreciation rights it triggers post-termination exercise rules.

For purposes of the stock plan, termination is typically defined to occur when the employee (or service provider) is no longer “continuously employed”, either as this term is defined for purposes of the statutory stock option rules under the Internal Revenue Code or as determined by the plan administrator. However, for purposes of a company’s severance policy or an executive’s individual employment agreement, termination may occur at some other date set by management or the board of directors. Which definition will apply if each approach results in a different date? Who makes the final call?

Similarly, definitions of “change in control” set out in a stock plan may differ from those set out in other corporate documents or individual agreements. If such definitions are inconsistent, expected vesting accelerations or cashouts may be at risk.

Charter Documents And Financing Agreements

Privately held companies in particular may be governed by corporate documents that hold traps for the unwary. It’s always important to find out if and what these rights are, and to fully understand how they operate. (These issues will be further discussed in Part 2.)

Company Policies

Most companies have written policies on severance payments, bonuses, and deferred compensation that also stipulate treatment of equity compensation. An overarching policy can be read as a limitation on the extent of payment or acceleration.

Example: You have negotiated a deal that provides you with vesting on 50% of your otherwise unvested stock at termination. If the company’s severance policy states that the maximum separation payment available on termination is two weeks times the number of years worked plus the amount of stock that would have vested during that period, your additional acceleration would need to be drafted to specifically override the general rule.

Similarly, many companies are now in the process of adopting conservative deferred compensation policies that are intended to avoid the troublesome tax implications of Section 409A of the Internal Revenue Code. If your grants are intended to provide for a more aggressive deferral, the general policy will need to be integrated and/or expressly disclaimed.

Dealing With Special Documents

Executives are frequently parties to, or are covered by, employment-related and corporate documents that do not apply to the general workforce but include special terms related to equity compensation. If you have negotiated specific protections for your equity stake as a part of your employment agreement, you need to be alert to the existence of one or more of the following documents:

Change-In-Control Plans For Senior Management That Contain Acceleration And Cashout Triggers

These plans may treat different levels of executives in different ways, making it important to ensure that your agreement either accords with or expressly references and modifies the general plan. For example, many change-in-control plans require a “double trigger” prior to acceleration: i.e., a change-in-control event plus a termination of employment.

At the same time, individual agreements between the company and an executive about what constitutes a “termination” may vary. Do you need to be fired without cause to claim your benefits? Can you quit because of certain events? Is there a time limit for the trigger(s)? If you have negotiated an agreement regarding constructive termination or a single trigger for acceleration, you must make sure that your deal overrides the general rule.

Moreover, change-in-control provisions may implicate thorny tax issues for both the company and the executive (particularly those stemming from Section 280G “golden parachute” payments, and Section 409A nonqualified deferred compensation excise tax). If your arrangement warrants tax protection for any tax penalties, make sure it is spelled out clearly in either the general plan or in your own agreement.

Other Special Documents

Target bonus plans for senior management that use stock (particularly restricted stock) as incentive rewards. If you have negotiated a right to acceleration (whether on termination or a specific event), you will need to ensure that stock awarded outside of the usual stock plan (i.e., under a bonus plan) is correctly incorporated into your agreement.

Shareholder buy-sell agreements that impose formula restrictions on transfer and sale may be required by early stage companies (more on this in Part 2).

Stock repurchase agreements at the early stage may also impose special equity-related limitations (more in Part 2).

M&A purchase agreements often require senior management of the target to agree to modifications to their pre-existing agreements in exchange for equity in the acquiring company. Before agreeing to anything at the time of the transaction, make sure you understand exactly what you are giving up in exchange for your new equity grant. It’s common to be asked for a release of prior claims or a noncompete in exchange for new grants at closing; although these may be presented as a fait accompli, they are not always necessary or legal.

These are only the most common examples of documents that may impact equity arrangements for executives. Each company is different. The best way to find out what the company has in place is to ask-the earlier in the process, the better.

Part 2 in this article series will look at which provisions should get your attention at the early and late stages of the corporate life cycle.

This article was first published by the website () as Part 1 of a 3-part series.

© 2006 Levine & Baker LLP., all rights reserved.