June 1, 2000

SUBJECT: EQUITY AND QUASI-EQUITY COMPENSATION PLANS

Equity and quasi-equity compensation plans are based on the stock or corporate performance of the company. The plans provide long-term incentives for key employees. They are used to attract and retain key employees for the company. They give employees an opportunity to participate in the growth of the company and to accumulate capital based on that growth.

There are many types of equity and quasi-equity compensation plans. Tax, financial and accounting considerations of the different types of plans vary significantly. This memorandum only describes the different kinds of plans. It does not cover all of the tax, accounting and securities implications of each type of plan

EQUITY COMPENSATION PLANS

Incentive Stock Options

An incentive stock option is an option granted to an employee to purchase stock in the company for whom he or she is employed. Incentive stock options are accorded tax favored treatment by the Internal Revenue Code. In order to qualify as an incentive stock option, an option and the plan pursuant to which it was granted, must meet the requirements in the Code.

The principal advantage to an employee is that, apart from the alternative minimum tax, he or she will not have to recognize any income upon exercise of the incentive stock option. The employee has tax deferral until the stock is sold. In a start-up situation, the advantage to the employee is that he can exercise his option and become an owner of the company and not have to come up with the cash to pay any income taxes until he or she eventually sells his stock.

The principal disadvantages of incentive stock options are that (1) the company cannot deduct for the benefit to the employee, except in the case of a disqualifying disposition of the stock acquired through the option; (2) the spread on exercise of the option must be included as an item of tax preference for purposes of the alternative minimum tax for the employee; and (3) there are many requirements that must be met in order for an option to qualify as an incentive stock option.

Some of the requirements which apply to incentive stock options are that (1) the exercise price of an incentive stock option must be the fair market value of the stock on the date of grant; (2) the term of the option cannot exceed a period of 10 years; (3) they may only be granted to employees; (4) they must be exercised while the person is an employee or within three months after the termination of employment, except in the case of death or disability, in which case they may be exercised up to one year after the termination of employment; (5) they may not be exercisable as to more than $100,000 per year based upon the fair market value of the stock on the date of grant; (6) they are not tax effective for companies paying federal income taxes because the loss of the company deduction available on nonqualified stock options exceeds the tax benefit to the employee; and (7) the employee must pay cash or finance the purchase of the stock and bears the economic risk of the investment once it has been made

Nonqualified Stock Options

A nonqualified stock option is an option granted to an individual to purchase stock in a company which does not have to meet any requirements which apply to incentive stock options. A nonqualified stock option may be granted to anyone associated with the company. The exercise price for a nonqualified stock option is usually the fair market value of the stock on the date of grant, but it may be at a price lower than the fair market value of the stock on the date of grant. There are no requirements as to the length of the term of the option, or when it can be exercised.

The employee will not recognize any taxable income upon a grant of a nonqualified stock option. Upon exercise of a nonqualified stock option, the employee will recognize ordinary income in an amount equal to the excess of the fair market value of the stock on the date of exercise over the exercise price.

The principal advantages for nonqualified stock options are that the company will be allowed a deduction for the benefit realized by the employee; benefits to the employee are not generally an expense item for financial reporting purposes and there is substantial flexibility in prescribing the terms and conditions of nonqualified stock options.

The principal disadvantage of a nonqualified stock option is that there is no tax deferral. The employee will recognize ordinary income upon exercise of the option whether he or she has cash to pay the tax on that income or not. The employee must also pay some of the taxes currently, not at a later date, such as April 15 of the following year. Finally, the employee must pay cash or finance the purchase price.

Nonqualified Stock Option With A Tax-Offset Bonus

To solve the tax problems of nonqualified stock options, some companies grant the employee nonqualified stock options coupled with tax-offset bonuses. Companies pay a bonus to the employee to pay the taxes not only on the spread on the nonqualified stock option, but also on the bonus itself. The employee is grossed-up and all taxes upon exercise of the nonqualified stock option and the tax-offset bonuses are paid by the company. The gross-up formula is generally equal to the employee's combined marginal federal and state income tax rate divided by one minus that rate.

Thus, the company can make the employee whole and still come out with a net cash savings from the entire transaction. Of course, this assumes the company wants to pass along most of the tax savings to the employee. Some companies elect to split the tax savings with the employee, only partly reducing the employee's tax burden.

Restricted Stock

Under a restricted stock plan, a company sells stock to an employee. The purchase price is either the fair market value of the stock or some nominal value, such as the stock's par value.

The stock is subject to forfeiture upon termination of employment by the employee prior to the expiration of a specific period of time. Transfer of the stock is restricted until the expiration of that period. Upon forfeiture, the company buys the stock back from the employee at the original purchase price. The restricted stock becomes transferable after the expiration of the vesting period. The vesting is usually over a number of years in increments. The employee is the owner of the stock for all purposes, including for voting and dividend rights.

Restricted stock is often granted in connection with the start-up of a new business where the money contributors, usually investors or venture capitalists, acquire convertible preferred stock. The value of the common stock is reduced to a low amount because most of the value of the corporation is allocated to the preferred stock. The employee is able to purchase the common stock at a low price. After a preferred return to the preferred stockholders, all the growth in the value of the company will be allocated to the common stock. The incentive to the employee is the appreciation in the value of the common stock. The benefit to the company is that the employee must remain employed to obtain the benefit of the appreciation in the company stock.

QUASI-EQUITY COMPENSATION PLANS

Quasi-equity compensation plans are similar to equity compensation plans in that they both provide for long-term incentive compensation. They differ in a number of respects. Here are some of the general differences.

• Benefits received under quasi-equity compensation plans are taxable as ordinary income, normally in the year of receipt of the benefit, whereas capital gains treatment is available under some equity compensation plans.
• Quasi-equity compensation plans generally receive less favorable accounting treatment than equity compensation plans.
• Quasi-equity plans provide an employee an opportunity to participate in a company's growth without requiring a cash outlay by the employee. Equity plans require the employee to come up with cash to purchase stock on the exercise of a stock option or receipt of restricted stock. If the employee borrows the money to purchase the stock, the interest expense on any indebtedness incurred to acquire the stock may no longer be deductible, in effect increasing the cost of the stock to the employee.
• Quasi-equity plans differ from equity plans in that the employee usually is paid in cash or at least has the option to be paid in cash under quasi-equity plans.
• Quasi-equity plans are based upon performance goals as well as stock value. Corporate performance often offers a better indication of a key employee's contribution to the company.
• Quasi-equity plans provide the company with an income tax deduction for the benefit paid to the employee, whereas most equity plans do not.

Stock Appreciation Rights

A Stock Appreciation Right (SAR) provides an employee with the right to receive the appreciated value of a share of a company's stock. The appreciation in the value of the share of stock is measured by the excess of the value of the share of stock on the date of exercise of the SAR over the value of the share of stock on the date of grant of the SAR. For a public company, the value of the stock is typically measured by the closing price of the stock on a stock exchange or NASDAQ. For a privately held company, the value is measured by the book value or some formula value. If the SAR is issued in tandem with a stock option, the value is usually the exercise price of the stock option.

Upon exercise of the SAR, the appreciation is paid to the employe in cash, stock, or a combination of stock and cash. The employee does not have to come up with any cash to exercise the SAR as he does in the case of stock options.

SARs are sometime issued in tandem with stock options to provide the employee with cash to acquire the stock upon exercise of the stock options, and in the case of nonqualified stock options, to pay the taxes on the exercise of the stock options. Upon the exercise of the SAR, the number of outstanding stock options is proportionately reduced.

SARs may be granted in tandem with nonqualified stock options. SARs may be granted in tandem with incentive stock options if the SAR is exercisable only when:

• the fair market value of the stock exceeds the exercise price of the option and the option is otherwise exercisable;
• the SAR is transferable only when the option is otherwise transferable; and
• the exercise of the SAR has the same economic and tax consequences as the exercise of the option followed by an immediate sale of the stock. Treasury Regulations state that the exercise of the SAR will not have the same economic and tax consequences if the SAR exceeds the difference between the then fair market value of the stock and the exercise price of the option.

SARs may be granted alone. In this case, the employee has the right to receive the appreciated value of the share of the company stock between the grant date and the exercise date. A stand alone SAR is similar to phantom stock except that in a phantom stock plan credit for dividends is generally given, while not so for SARs.

The principal advantage is that the employee need not make an immediate cash outlay to receive the SAR benefit. If the SAR is granted in tandem with an option, it provides the employee with cash to exercise the option and pay any related taxes.

The primary disadvantage is that the company must charge its earning for a compensation expense in each period during which the employee's services are provided and subsequently adjust the expense on a market-to-market basis upon which the company has no control.

Phantom Stock Plans

Under a phantom stock plan, phantom shares, usually called units, are granted to the employees of the company. Typically, one unit will correspond to one share of the company's stock on the date the unit is granted. The units are reflected as book entries credited to the employee's account, and are not shares of stock in the company. The units usually carry dividend equivalent rights, such that an amount equal to the company's dividend per share is credited to the employe's account, for each unit he owns upon the issuance of a cash dividend. The dividend rights can be payable in cash currently to the employe, deferred to and added to his account, or converted into additional shares of phantom stock units. Sometimes the plans provide that interest is credited to the employee's account if the payment of the dividend is deferred.

The key feature of the plan is that the employee is given the appreciation in the value of the stock corresponding to the units owned by the individual. The appreciation in value is measured by fair market value, book value, formula price, or some other similar means, depending on whether the company is public or private. The units are usually awarded for a specific time period, which sometimes includes the duration of employment of the employee. The plans also sometimes provide that the units vest over a period of time, for example, 25 percent of the units granted vest after each year of employment of the employee for the first four years after grant.

Benefits are usually paid in cash, company stock, or a combination of both, and are paid in a lump sum or installments. Plans also usually have anti-dilution provisions.

Phantom stock plans have sometimes been attacked on the grounds that they are a waste of corporate assets or do not represent reasonable compensation. The directors of a company should insure that the corporation receives adequate consideration for the payments to be made under the phantom stock plan and that there is a reasonable relationship between the value of the services rendered by the employee and the amounts paid to the employee under the plan.

Phantom stock units or shares are not stock for purpose of Subchapter S of the Internal Revenue Code.

The principal advantage to the employee is that he does not have to make a cash outlay to receive a benefit. The disadvantage is that the employee does not have voting rights. With respect to the company, a phantom stock arrangement avoids the problems of re-purchasing stock from an employee that retires or otherwise terminates his employment. A disadvantage is the accounting treatment which is like that of an SAR.

Performance Unit Plans

Under a performance unit plan, performance units (defined in dollars and not tied to the value of the company's stock) are granted to an employee contingent upon the attainment by the company of an earnings or performance goal measured over a certain period of time, usually called a performance cycle. For example, units would be granted to the employee to the extent that the earning per share of the company's common stock certain levels, or the company's common stock book value increased to certain levels.

The performance cycle varies, but typically is as long as three to five years. When the performance goals are met, the units are earned by the employee and paid to the employee in cash at the end of the cycle. Under some plans, the employee may convert the cash into stock. Payments are usually made in a lump sum but sometime are made in installments. Performance unit plans are usually designed for key employee who should have direct impact upon the income and book value of the company.

Performance goals include a defined increase in earning per share on the common stock, a defined increase in stockholder equity, a defined increase in the gross revenues of the corporation, and a defined increase in the gross income or net income of the corporation.

A computation of awards under a performance unit plan typically provides for amendment in the case of recapitalization, changes in accounting practice or methods, or other extraordinary circumstances. Award payment is also sometimes subject to continued employment throughout the performance cycle, except in unusual circumstances, such as death, disability or retirement.

The advantage for the employee is that he need not make a cash outlay to receive the payments under the program. Another advantage is that his award is directly tied to prescribed goals rather than the value of the company stock which may be influenced by other factors upon which the key employee may have little impact. One disadvantage is that the employee may not make anything if the performance goals are only partly met. Some plans do provide for partial payment on partial achievement of performance goals, or partial payment after reaching a threshold of the performance goals.

As to the company, the advantages are that the charge to compensation expense for accounting purposes is generally fixed, rather than subject to the fluctuations of the market price of company stock like that for an SAR. There is also a direct relationship between the executive benefits and the company's performance. The disadvantage is that it may be difficult to set the performance goals and that although the compensation expense is fixed, there will be an earning charge as the earning are earned prior to the time payment is actually made.

Performance Share Plans

The performance share award plan is essentially the same as a performance unit plan except that the key employee is contingently awarded a fixed number of common shares of the company at the beginning of a performance cycle. The shares are typically referred to as performance shares, and the do not represent actual ownership of shares of stock in the company. They carry no dividend or voting rights. The performance shares are converted to company shares if the performance goals are met. The plan typically permits the employee to elect to receive cash equal to the value of the stock that he would receive upon attainment of the performance goals rather than the company's stock or some combination of stock and cash to help pay taxes on the receipt.