Equity compensation is often a significant component of the total compensation paid to employees and other service providers. While some provisions of private company equity plans mirror the provisions in public company plans, in the private company context, equity compensation raises special concerns. Existing shareholders want to retain control over management and seek protections against outside parties. Private companies therefore generally place transfer restrictions on company shares and may require employees to sell their shares back to the company in certain circumstances (for example, termination of employment).

Because private company stock is generally illiquid, employees often have concerns regarding how they will ultimately realize any gain as a shareholder and may seek assurance from the company that it will repurchase their shares if their employment is terminated or if a liquidity event does not occur within a certain period of time. Special provisions addressing these and other issues may be included in a shareholders' agreement or each individual's award agreement.

When drafting an equity incentive plan, private companies should consider several issues, including:

The following are select portions from Practice Note, Drafting an Equity Incentive Plan for a Private Company. See the full Practice Note for more helpful guidance.

Because an equity plan will likely be used for several years, the company should estimate the number of shares that will be needed to cover future grants. Private companies typically have only one or a small number of controlling shareholders and therefore can obtain the necessary shareholder approval to amend the plan to increase the share reserve at any time. Nevertheless, most private companies typically reserve enough shares for three years' worth of grants for administrative convenience (for example, to minimize the number of regulatory filings that may be required by any applicable Blue Sky laws when the plan is amended to increase the share reserve).

Private companies rarely provide for a default or minimum vesting schedule in their equity plans. Rather, companies include provisions in their plans that contemplate vesting but provide flexibility for the plan administrator to set vesting schedules in individual award agreements when grants are made.

Most plans give the plan administrator authority to accelerate the vesting of awards in connection with certain events such as a change in control.

While private companies do grant awards that vest over time based on the provision of services to the company or on the achievement of performance goals such as EBITDA vesting targets, private companies that are owned by private equity funds often also grant awards that vest only when a liquidity event occurs (generally a change in control or IPO of the company) where the portion of the award that will vest when the liquidity event occurs is determined based on the return in investment realized by the private equity sponsor through the date of the liquidity event. For example, a plan may provide that 33% of the award vests if the internal rate of return (IRR) realized equals 25% and 100% of the award vests if the IRR equals or exceeds 30%, with the percentage that vests if the IRR exceeds 25% but is less than 30% determined by linear interpolation between 33% and 100%.

A private company will generally want to place restrictions on the transfer of fully vested shares, and also provide for certain rights that would make it easier for majority shareholders to sell the company. These rights are typically contained in either an individual shareholder's agreement or a shareholders' agreement that all individuals must become a party to when they acquire shares. Alternatively, the relevant provisions can be built into the applicable award agreement for each participant. Below is a brief summary of the provisions typically set forth in a shareholders' agreement that are most relevant to holders of equity awards.

Although private companies are not subject to the clawback requirements of either the Sarbanes-Oxley Act or the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, they should consider including a broad provision in the plan authorizing the company to recover gains on equity awards if it was determined that the gains resulted from:

Similarly, a company may wish to include a provision in the plan that causes an employee to forfeit equity awards (including vested awards) in the event of a termination for cause. Without a specific forfeiture provision in the plan or award agreement, courts may be reluctant to enforce this action at a later date.

For more information on drafting a private company equity incentive plan, see Practice Note, Drafting an Equity Incentive Plan for a Private Company. This Practice Note was contributed by Tristan Brown and Jennifer M. Wolff, Simpson Thacher & Bartlett, LLP, with PLC Employee Benefits & Executive Compensation.