Let’s look at some examples of how a company could use an EIP to its advantage. In the first example we’ll look at how a hypothetical struggling footwear brand could use stock options to attract talent. In the second example, we’ll look at how a hypothetical surf apparel brand could grant equity incentives as part of its compensation structure to retain employees during an economic downturn.
The Struggling Footwear Brand
Assume that Emerging Footwear Brand (EFB) is a 5 year old company, with $5 million in annual sales. EFB is owned by only a handful of people who started the company with their own money. It has been struggling to grow and lacks the capital needed to expand its marketing and sales efforts. EFB wants to achieve $25 million in annual revenues within the next 3 years and then the owners may want to sell the company. EFB believes the only way to meet this goal is to bring on talented individuals who have grown companies before and can take EFB to the next level.
EFB decides to hire a new VP of Marketing and VP of Sales who have the experience it needs to reach its goals, but finds that these candidates want a big paycheck and EFB lacks the resources. The potential hires are excited about working with a smaller brand and helping it grow, but it is risky and they need to be compensated for what they bring to the table. EFB decides to adopt a stock option plan and offer options to these potential hires as an additional incentive based on performance targets of hitting incremental sales goals over the next 3 years. The potential hires are intrigued by this and see the potential pay-off if they can grow the company. The owners realize that although they will be diluted, these employees will only be able to exercise their options if the company has reached its goals, in which case the owners will still make a huge return on their investment.
The Troubled Surf Apparel Company
Standard Surf Apparel (SSA) is a private company that has been in business for 15 years and is majority-owned by a small group of individuals and a dozen minority stockholders. SSA has a stock option plan in place, but has not actively used option grants in the past couple of years, and most of the outstanding options that were already issued to employees are now fully vested. The outstanding options only represent 2% of SSA’s issued and outstanding stock. SSA has seen its ups and downs, but the company has really taken a beating during the latest economic recession. SSA’s revenues have dropped 30% leaving it with no choice but to lay off 15% of its labor force and to reduce salaries across the board by 10%. SSA believes that the fair market value of its stock is below $1 per share; however, most of the outstanding options held by current employees are “underwater” with an exercise price above $1, so they are basically worthless.
SSA is worried because employee moral has been low and competition for key talent has been increasing. SSA believes that it is ready for growth in the next two years, but cannot afford to lose its key employees who it sees as essential to its growth strategy. One of SSA’s biggest competitors, which is well-financed by overseas investors, just announced the launch of a new juniors apparel division and that it is looking for experienced people.
SSA decides to approve an increase of additional stock options under its stock option plan. After receiving an appraisal, the company grants new options to employees with an exercise price of $0.50 a share, which triples the number of outstanding stock options. It also gets the necessary approvals to lower the exercise price of the existing options held by key management personnel by re-pricing them to $0.50 per share as a further incentive for the “old guard.” SSA’s strategy enables it to offer enough incentives to keep most of its top employees even though it lacks the financial resources of its competitor. SSA’s decision sends a message to its employees that it needs its core people to grow the company and that it wants the whole team to join in the success. SSA’s move inspires company loyalty and provides additional motivation for employees to stick with the company and to work hard.
EIPs have the potential to create a lot of value both for a company and for the recipients who are granted awards. Better yet, the cost of creating an EIP is very low when considered next to its potential benefits. Setting up a standard EIP generally costs less than $5,000, with additional costs if the company chooses to have outside counsel oversee the actual grants and monitor securities law and tax compliance. There are a number of specific tax considerations and issues related to EIPs that aren’t touched on here, such as Federal and State Securities law compliance and exemptions, including Federal SEC Rule 701, the use of EIPs with limited liability companies, and minority stockholder and management control issues. Companies should consult their legal counsel before implementing or changing an EIP, as well as to determine how the various rules, regulations and other special considerations would apply. The bottom line is that EIPs should be considered when determining a company’s overall compensation structure because they are a cost-effective way to build steam, create energy, and grow brand loyalty both in-house and in the market, without having to dip into already tight budgets.
* Michael Orlando and Ryan Connor are business attorneys and members of the Action Sports Industry Team at Sheppard, Mullin, Richter & Hampton, LLP in Del Mar, California. They can be contacted at 858-720-8900 or by visiting the firm website at www.sheppardmullin.com.