In most scenarios it benefits both the company and employees to give employees equity in the company. The employees are inspired by a sense of ownership and the company saves some cash. The trickier question is one of form: does the company offer stock options or restricted stock?
The mechanics of stock options are pretty basic: the company grants to the employee a call option to purchase - at a discount - X number of shares of the company's common stock. The discount is called the "exercise" (or "strike") price. Under this scenario, on the date the employee wants to sell and profit from his stock award, he purchases up to X number of shares and then turns around and sells the shares at a (presumably) much higher market value price and pockets the difference.FN1
Restricted stock, by contrast, is a straight gift of stock.FN2 The employee does not need to outlay any money. The "restricted" part is the caveat: the company retains the conditional right to purchase the stock back from you at some super cheap price - and usually this right expresses itself through a vesting requirement (i.e., although the stock is a straight gift it requires the employee to stick around the company for a certain period of time (market standard is 4 years to receive the full amount, with 1/4 of the total becoming available each year)).FN3
These structural differences implicate three main issues.
First, restricted stock gives the employee real as opposed to theoretical (in the case of options) value, and such real value is taxable to the employee upfront (stock options will not be taxed until the option is exercised (if ever)).FN4 So long as the initial value of the stock is low (such as in a start-up situation) this is probably to the advantage of the employee. The payment of that initial income tax aside, the employee won't pay any taxes until he sells the stock, at which point, so long as certain holding requirements are met, the tax will be capital gains rather than (historically higher) income tax.
By contrast, stock options will almost always result in ordinary income to the recipient when exercised (at least in the typical case where the underlying stock appreciates prior to exercise of the option).
Second, the grant of stock options require as a predicate the determination by the company of the "exercise" price. Because Section 409A of the Internal Revenue Code requires that the exercise price must be equal to (or greater than) the fair market value of the underlying stock as of the grant date, the company must coordinate (by the time of the grant) (i) an independent appraisal or (ii) if the company is an “illiquid start-up corporation,” a valuation of a person with “significant knowledge and experience or training in performing similar valuations” (who could be a company employee), which costs time and money.
Third, stock options give employees only the opportunity to benefit from the increase in the company’s value. If at a future date the market value of the shares drops beneath the exercise price per share (which is fixed to the time of the grant) then the stock options will be worthless.FN5
FN1. Two caveats here. First, in most cases, stock options are qualified/restricted by "vesting", which means that the right won't actually be triggered until a future date. Prevailing standards put the right to purchase 1/4 of the shares at the 1 year anniversary of the start date, 1/2 the shares become available to purchase at the 2 year anniversary, 3/4 on the third and all the shares on the 4th anniversary. In addition, most vesting provisions include acceleration clauses which accelerate vesting in the event of certain transactions (usually an IPO or acquisition). Second, more sophisticated service providers may exercise the option to purchase their stock before they intend to sell (because, essentially, the appreciation prior to exercise is taxed as income and the appreciation post exercise is taxed as capital gain).
FN2. Both stock options and restricted stock are sourced from the "incentive equity pool" of common stock reserved for employees. In most funded start-ups this pool will represent between 5-15% of the issued stock.
FN3. Restrictions can also be some sort of performance condition, such as the company reaching earnings per share goals or financial targets.
FN4. In most scenarios the employee will want to file here what is termed an "83(b) election" with the IRS so as to be taxed immediately upon the grant for the value (if any) of the restricted stock. If he doesn't make that filing within 30 days of the grant then he will be taxed incrementally over time as the restrictions to the stock disappear (i.e., the stock vests) - which can be prohibitively unaffordable if the stock appreciates significantly (yet remains illiquid).
FN5. Stock options have fallen out of favor during the last (markedly volatile) decade or so precisely due to this possibility.
Thursday, March 31, 2011
Monday, March 28, 2011
Contracts and Electronic Signatures
It's unnecessary to sign commercial contracts with a pen but the practice persists.FN1
The federal Electronic Signatures in Global and National Commerce Act, enacted in 2000 (note the federal law does not apply to intra-state transactions) and most states (due to the Uniform Electronic Transactions Act being adopted by most states) allow electronic signatures (or signature via an electronic record) for the valid execution of a contract. Neither law imposes a rigid format on the signature, so the fact that there isn't a “digital signature” - i.e., something like "/s/ Firstname Lastname" - doesn’t affect the fact that you can be deemed to have signed a contract by email correspondence.
Manual signature remains the custom in part because manual signature is a pretty effective authentication of the signator's willful and knowing acceptance of the terms of the contract (because a manual signature is personally identifiable in a (somewhat) unique way). Thus, reliance on an electronic signatures demands i) some proof of identity - something to verify that the putative signator's brother/aunt/stalker didn't send the electronic signature and ii) something to indicate that the signator knew what he was agreeing to (which is why when you go to amazon or bestbuy.com or wherever they require you to scroll down through terms and conditions or check some box (or an equivalent)) before you click through.
To the extent there is a mechanism in place that addresses these two issues statutory requirements will be satisfied. In most cases, verbal confirmation followed by an email from the signator enclosing the signature page with his electronic signature (first and last name) should suffice.
The effect of this, beware, cuts two ways. First, it means the process for executing a contract has been simplified. Second, however, it means e-mail correspondence may have unintended results. A vaguely worded or poorly thought through email can trigger all the responsibilities and obligations of an agreement. (Note that this could happen AFTER the agreement has been executed.FN2).
FN1. Note that certain contracts, such as trusts and certain real estate contracts, still require old school, manual signature and probably will for a good while longer.
FN2. E.g., in Stevens v. Publicis, S.A. (2008) the New York State Supreme Court held that a written agreement could be modified (i.e., amended) by e-mail correspondence.
The federal Electronic Signatures in Global and National Commerce Act, enacted in 2000 (note the federal law does not apply to intra-state transactions) and most states (due to the Uniform Electronic Transactions Act being adopted by most states) allow electronic signatures (or signature via an electronic record) for the valid execution of a contract. Neither law imposes a rigid format on the signature, so the fact that there isn't a “digital signature” - i.e., something like "/s/ Firstname Lastname" - doesn’t affect the fact that you can be deemed to have signed a contract by email correspondence.
Manual signature remains the custom in part because manual signature is a pretty effective authentication of the signator's willful and knowing acceptance of the terms of the contract (because a manual signature is personally identifiable in a (somewhat) unique way). Thus, reliance on an electronic signatures demands i) some proof of identity - something to verify that the putative signator's brother/aunt/stalker didn't send the electronic signature and ii) something to indicate that the signator knew what he was agreeing to (which is why when you go to amazon or bestbuy.com or wherever they require you to scroll down through terms and conditions or check some box (or an equivalent)) before you click through.
To the extent there is a mechanism in place that addresses these two issues statutory requirements will be satisfied. In most cases, verbal confirmation followed by an email from the signator enclosing the signature page with his electronic signature (first and last name) should suffice.
The effect of this, beware, cuts two ways. First, it means the process for executing a contract has been simplified. Second, however, it means e-mail correspondence may have unintended results. A vaguely worded or poorly thought through email can trigger all the responsibilities and obligations of an agreement. (Note that this could happen AFTER the agreement has been executed.FN2).
FN1. Note that certain contracts, such as trusts and certain real estate contracts, still require old school, manual signature and probably will for a good while longer.
FN2. E.g., in Stevens v. Publicis, S.A. (2008) the New York State Supreme Court held that a written agreement could be modified (i.e., amended) by e-mail correspondence.
Monday, March 7, 2011
A Primer on Copyleft and Related Open Source Issues
According to the conventional licensing model, holders of copyrighted software grant proprietary licenses to 3rd parties to use the software, usually in exchange for money. Such a license restricts how the software may be used (and modified or distributed) and if the licensee exceeds those restrictions the licensor may bring an action of infringement.
The so-called Copyleft model removes most of these restrictions but does so without making the software public domain (where users could modify then copyright such works, thereby undermining the effort).FN1 Copyleft maintains the licensing framework but aggressively enlarges the scope of the license on a very specific condition: use, modification and redistribution of the software (modified or not) is unlimited so long as this same allowance is given to all future licensees. The exact wording of the original license must be preserved each time the software is modified and distributed. Whatever rights inhere in the original license are there for perpetuity. This mechanism is variously referred to as a "Reciprocal Grant, "Viral License" or "License Inheritance."
As a necessary corollary to or function of the inherited license, all source code (read-only programs are insufficient) must be made accessible to future users (so it may be modified).
These requirements don't prohibit commercialization of the software. Copyleft does not necessarily mean "free." While you cannot charge for a proprietary license, you can charge for each copy or for warranty, support, services, etc. Because selling individual copies is rarely profitable (since the seller cannot by virtue of the sale control/limit what the buyer does with the source code thereafter - like give it away for free), the value of copylefted software to corporate enterprise typically inheres in the sale of products or services in which the copylefted software is embedded.FN2
FN1. In addition to copyleft there are so-called "academic" licenses which comprise with copyleft the two main groups of open source licenses.The Gnu Project's General Public License (the GPL) is probably the best-known and most widely used copyleft license.
FN2. The chief risk is this business model is the inadvertent surrendering of ownership to proprietary software. Determining what is a "derivative work" can be an uncertain inquiry (at least in part because of limited judicial interpretation with respect to the enforceability of copyleft licenses) and thus where the open source software is mingled/bundled with proprietary software, it's possible the proprietary license will be deemed to be a derivative of open source and therefore not protected by copyright.
The so-called Copyleft model removes most of these restrictions but does so without making the software public domain (where users could modify then copyright such works, thereby undermining the effort).FN1 Copyleft maintains the licensing framework but aggressively enlarges the scope of the license on a very specific condition: use, modification and redistribution of the software (modified or not) is unlimited so long as this same allowance is given to all future licensees. The exact wording of the original license must be preserved each time the software is modified and distributed. Whatever rights inhere in the original license are there for perpetuity. This mechanism is variously referred to as a "Reciprocal Grant, "Viral License" or "License Inheritance."
As a necessary corollary to or function of the inherited license, all source code (read-only programs are insufficient) must be made accessible to future users (so it may be modified).
These requirements don't prohibit commercialization of the software. Copyleft does not necessarily mean "free." While you cannot charge for a proprietary license, you can charge for each copy or for warranty, support, services, etc. Because selling individual copies is rarely profitable (since the seller cannot by virtue of the sale control/limit what the buyer does with the source code thereafter - like give it away for free), the value of copylefted software to corporate enterprise typically inheres in the sale of products or services in which the copylefted software is embedded.FN2
FN1. In addition to copyleft there are so-called "academic" licenses which comprise with copyleft the two main groups of open source licenses.The Gnu Project's General Public License (the GPL) is probably the best-known and most widely used copyleft license.
FN2. The chief risk is this business model is the inadvertent surrendering of ownership to proprietary software. Determining what is a "derivative work" can be an uncertain inquiry (at least in part because of limited judicial interpretation with respect to the enforceability of copyleft licenses) and thus where the open source software is mingled/bundled with proprietary software, it's possible the proprietary license will be deemed to be a derivative of open source and therefore not protected by copyright.
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