Most people will have at least a basic understanding of how a stock exchange works. It’s a marketplace where the stocks or shares of publicly listed companies are bought and sold, with investors hoping to sell what they hold for more than their purchase price, thereby making a profit.
As part of their overall compensation package public companies will often offer their staff shares in the company through an employee equity plan. These shares are generally either awarded for free or made available to staff to purchase at a discount. They act as an incentive which helps to attract, reward, retain and motivate talented individuals.
But what about private companies, those without any shares made public? Thankfully they don’t have to miss out as there are options available which allow them to offer equity compensation to their employees too.
To help you and your employees develop an understanding of how equity compensation works in a private company we will explore this topic further, starting today by asking:
Before we begin some definitions and clarifications:
The primary market is where investors directly inject their capital into a company, for which they will often receive a piece of equity (company ownership) in return. This represents the first time that shares in a company are traded, i.e. changing ownership from the company to someone else.
The public stock market, also referred to as the public secondary market, offers a facility which allows existing shareholders to sell their shares to willing buyers. Well-known examples of these public secondary markets include the New York Stock Exchange (NYSE), the NASDAQ and the FTSE 100 Index.
A private secondary market therefore is one where the company is not publicly floated, either because they have not yet gone through an IPO or have decided to remain private.
The issuing of private company stock options, also referred to as pre-IPO stock, is where a private company wants to offer stock as a reward or incentive to their staff. Since they are not publicly traded stocks these differ in a number of ways and the company may have a more complex path to navigate with restrictions or limitations. Whether a company is public or private however it’s worth noting that their treatment of equity awards share a similar cycle: Issue equity award➜ Vesting➜ Exercise ➜Sale.
The main differences lie in that while private company stocks have the potential to grow in value faster than those of public companies the sale event differs, i.e. when it comes to liquidating or selling the stock.
All private companies are small right? Wrong
While an IPO, Merger/Acquisition or buy-out may be the goal for some not every private company is rushing to go public.
Reports show that in 2022 there was a 44% fall in global initial public offerings between January and September of the year and there appears to be a trend lately towards companies choosing to remain private for longer.
So why issue employee equity awards?
Money is a short term motivator.
Newer companies often don’t have the liquid cash available to reward employees this way either, but by choosing to issues stocks you make your employees shareholders in the business, meaning they are invested in its performance.
Giving your staff an actual stake in the company encourages dedication, loyalty and provides motivation by allowing them to benefit financially and to take pride when it does well.
Award now or award later?
Employee share incentive arrangements can generally be classed into two main types:
1 – Those where the employee is given the right, but not the obligation, to acquire stocks in the future. This normally follows the achievement of some specified target, after a set period of time or else the occurrence of an event e.g. a company goal or event of some sort.
2 – Those where the employee acquires the stocks upfront. These are often subject to conditions where the employee must remain with the company for a specified period of time after they’ve been granted or where an event or target has to be met before the employee can exercise them.
What about selling stocks in a private company?
For selling stocks held in a private company there is a much smaller market than for public stocks and there are far more restrictions. Two key points to be aware of are:
1 – Any sale must be first of all approved by the company itself, who will often retain the right to decide if they want to make shares available to an outside 3rd party or if they must be sold back to the company itself. This is a common clause called the Right Of First Refusal (ROFR).
2 – The shareholder must find a willing purchaser. Often this will involve selling the shares back to the company itself, as above, which may in fact be a condition of the equity plan. Otherwise the transaction may take place through a stock brokers.
Managing your plan efficiently
Operating an employee stock plan is complicated and time-consuming, with many moving parts to keep track of. That’s why when choosing an equity compensation management provider you should consider everything from plan implementation, to the taking care of day-to-day admin burdens like grants, vesting and reports, through to ensuring they can provide participant support.
You should even take into account whether they have to the ability to continue managing your stock plans as your company grows.
While you may not have any plans to go public just yet it’s always best to be prepared so consider choosing a provider from the outset who can support both public and private companies. It will mean if that time comes you’ll be free to select the exit or liquidity event that’s most right for you without having to worry about switching providers along the way. Having that consistent continuity of service will help provide peace of mind should your company transition from one form to another.
Also, don’t underestimate the importance of having all of your information organized and in the one, secure location. As your company expands so too will the complexity of your share plans grow and should you decide to move into international territories you’ll require a service provider who can facilitate this for your staff.
Plan types and tax implications
There are a range of plan types potentially available to private companies including:
- Growth Shares
- Incentive Stock Options (ISOs)
- Trusts and Upfront Acquisitions
Not all of these may be suitable or available to your company and the route you choose will of course depend on your own company’s individual circumstances. It’s always recommended you seek professional advice before making any decision.
Whichever avenue you choose there will of course be tax implications. These will differ depending on where you and your employees are in the world and could potentially fall on either or both of the company and the participants. Again, it is advised to seek professional advice to find out more.