Equity-based compensation valuable, if done correctly from the beginning
Fertilab’s legal sponsors warn of the tax and regulatory pitfalls all startups must avoid to ensure equity-based compensation brings employers and employees mutual benefit.
David Brabender and Katherine Moyer of Endeavor Law Group believe equity-based compensation is a useful approach for startups that don’t have much cash today, but are poised for fast growth in the future.
“Paying with ownership in the company can make up the difference when a startup can’t pay full market rate at the beginning,” says Moyer.
Which form of incentive?
Two forms of equity-based compensation give recipients (employees and other service providers) an incentive to help drive the startup to a point where it can take off.
- In an outright grant, the recipient receives immediate ownership in the company.
- In a stock option, the recipient receives the right to buy equity at some time in the future at today’s (cheaper) market rate.
If you are compensating only a couple of recipients, the two forms are equally easy to set up. More important is avoiding the pitfalls that can make an equity compensation plan backfire.
Avoiding the regulatory traps
Moyer points to three areas where you must be in compliance:
- Ensure that you stay within state and federal overtime and minimum wage laws.
Equity-based comp cannot be 100% of an employee’s compensation.
- Register with state and federal securities regulators—or structure the arrangement to comply with the requirements for an exemption from registration.
Most in-state startups in Oregon will have an exemption if they structure the arrangement properly.
- Provide written disclosures to ensure the recipient understands the deal.
Moyer says the disclosure must help the recipient decide: “Do I want to provide service in exchange for equity in this company?”
Why early regulatory compliance matters
- Disgruntled employees might get you in trouble with the SEC and other regulators.
- Very disgruntled employees might sue you for lack of disclosure.
- Future investors might be wary of a startup that cannot provide evidence of full regulatory compliance.
“If you do it right in the early go,” says Moyer, “you will be well set up for future investors.”
Avoiding the tax traps
Typically, the transfer of equity is a taxable event, but not for the employer. Brabender, the tax expert on the team, says: “All the bad tax news is to the recipient.”
Therefore, Brabender recommends that employers take pains to structure the plan so that recipients have a good tax day when they receive equity. If you don’t, recipients may get a tax bill that makes them regret getting involved with your startup.
There are many strategies for avoiding this problem, but all involve two questions:
- When is the equity valued for taxation?
In general, you want the valuation to be early, before company growth.
- When does the long-term capital gain period start?
In general, you want this to start a soon as possible, so the lower long term capital gain tax rate will apply sooner.
When to get advice
Brabender and Moyer recommend startup employers get advice tailored to their needs before setting up an equity-based compensation plan. While “one size fits all” solutions are available from outfits like LegalZoom and Nolo Press, such solutions can miss some aspect unique to your startup’s situation.
Also, a do-it-yourself approach can be risky. Brabender cautions, “Mistakes in this area are hard to fix after the fact.” Moyer add, “There are some do-it-yourself areas in the law. This is not one of them.”