New year, new stock plan – 10 pitfalls to avoid

The festive season is almost upon us, which means that the new year is just around the corner. While the coming days will first and foremost be about catching up with loved ones, it is also a time when many of us will be thinking about making positive changes once the calendar flips to January. The same is true for companies looking at ways to improve engagement and retention. One such strategy can be to embrace employee equity compensation. Many positive outcomes can arise from introducing a stock plan in the workforce, but avoidable missteps in the early going can undermine your efforts. With that in mind, here are 10 potential pitfalls to avoid…

#1 – Employees not signing up:

Even the best offering can be undermined if you don’t get the message out clearly. Failure to inform people on a) what’s being proposed, b) how it will benefit them and c) what’s required of them can lead to any number of unwanted scenarios, including poor engagement from the target audience, missed deadlines and a lack of comprehension at key moments, e.g., vesting.

How to avoid: Consider your target audience and their needs. Framing your communications strategy at least in part as an educational tool and customizing it accordingly can help to bridge the knowledge gap.

#2 – Overselling the potential benefits:

Don’t let the desire for your equity compensation plan to succeed tempt you into wearing rose-tinted glasses when promoting it to employees. Yes, everyone involved will hope for a positive outcome, but if there are no guarantees you need to make this clear. Where participants feel they were led to believe a windfall was a near certainty, they may become disgruntled if that fails to materialize.

How to avoid: Be frank and open with employees in the run up to and during the registration period. Emphasize the potential benefits, but make it clear that there may be some measure of risk involved, even if the terms on offer are attractive.

#3 – Shares over-valued pre-IPO:

This could lead to a bruising experience for stockholders should share prices plummet after flotation, perhaps dashing their hopes that shares granted while the company was still private would prove lucrative once openly traded.

How to avoid: It can be difficult to second-guess how the market will react to a flotation but when the share price falls significantly post-IPO it suggests that the market did not agree with the company on how valuable its stock was. Seeking out additional outside opinions and professional input may help to temper pre-IPO expectations.

#4 – Not understanding tax implications:

AKA who pays tax and when? This can vary at different points in the process dependent on plan type. Consider for example how NSOs are taxed at exercise, whereas ISOs are not. Failure to understand and abide by the rules could land participants with an unexpected tax bill, which is about as far removed from “happy new year” as you can get.

How to avoid: Know the rules and follow them. Speaking to an experienced equity compensation plan provider is a good way to get an understanding of what the tax implications for different plan types are.

Bonus tip: Be aware that changes to your employees’ status, e.g., going from full-time to contract, can impact their rewards.

#5 – Granting stock options without an up-to-date 409A valuation report:

A 409A needs to be updated regularly over time to ensure that the exercise price linked to newly granted options is based on the fair market value (FMV) of stock at that time. If the IRS inspects the details of your plan and concludes that you have not complied with 409A, then this can potentially have a range of adverse consequences, such as a tax bill and reputational damage.

How to avoid: Stay on top of your 409A obligations, e.g., have a fresh valuation conducted every 12 months or sooner if there has been a material change in your circumstances.

#6 – Issues arising from SEC Rule 701:

All securities issued to employees must be registered with the SEC unless deemed exempt. Rule 701 sets out the terms under which companies can avail of exemptions. Generally, the key considerations pertain to the annual value of grants staying within specified limits, but if a company exceeds these limits certain disclosure obligations kick in. Crucially, there is a retroactive element involved for the required disclosures as opposed to from that point onwards, with companies liable to fines or other sanctions if they can’t produce the necessary documentation.

How to avoid: Maintaining up-to-date records and having systems in place that will give you advance warning on if you are likely to break through any limits.

#7 – Not tracking terminations and vesting:

Typically experienced by start-ups but relevant to companies of all sizes. If you’re handling admin in-house, it’s almost inevitable that over time human error will creep in. One common area is not staying on top of departures. If not recorded properly an individual’s options may continue to vest beyond the point that they should. This could lead to a scenario in which a company might find itself needing to repurchase those shares. Also, errors of this nature can have tax implications and may impact adversely on cap table accuracy.

How to avoid: Ditching the spreadsheets and partnering with an equity compensation software administration provider, such as J.P. Morgan Workplace Solutions, can help prevent this.

#8 – Keeping it all in-house rather than outsourcing as your company grows:

For a busy founder or CFO administrating an employee equity compensation plan might be fine on Day 1 and maybe even on Day 100, but what about Day 1,000? What if you decide to launch a second plan at some point? As time passes and more and more data accumulate a workload that may have been manageable will inevitably become increasingly difficult.

How to avoid: Updating your tech stack with equity compensation plan administration software can help. You wouldn’t expect your payroll department to run everything on a spreadsheet, so why should your equity compensation management be any different?

#9 – Awarding the ‘wrong’ type of equity:

Not every compensation type is going to suit your company’s goals or meet your needs. If you opt for a form of equity that isn’t the ideal fit for you and your employees, it may not prove to be a full-on flop, but at the very least it could mean that your plan doesn’t achieve as much as it might had you made a different choice.

How to avoid: Do your research. Know what you want to achieve and what equity compensation vehicle is most likely to help you get there.

Bonus tip: Stock options tend to be a good fit for startups with genuine future growth expectations, restricted stock plans are commonly seen in both publicly traded companies and startups, while restricted stock units (RSUs) are often favored by established companies, both public and private.

#10 – No secondary market:

When private company employees are deciding whether to sign-up to an equity compensation plan, they may have questions on how to sell any shares they have exercised while the company is still pre-IPO. If you decide to not allow shares to be sold on a secondary market and do not make it clear how employees can instead cash in their awards the prospect of possible complications on this front might dissuade some employees from signing-up at all.

How to avoid: Before introducing a plan it should be made clear how employees can sell shares while the company remains private.

These pitfalls have the potential to undermine your efforts to make employee equity compensation a success in your company, but all are avoidable. As you develop your own strategy, it is worth remembering that sometimes the best way to handle an error is to not make it in the first place.

At J.P. Morgan Workplace Solutions, our experienced professionals are available to assist in all facets of employee equity compensation, from planning, to design, implementation, ongoing administration and more. Contact us today and speak to our dedicated, experienced personnel.

All companies referenced are shown for illustrative purposes only, and are not intended as a recommendation or endorsement by J.P. Morgan in this context.

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