Due to some recent conversations I’ve had about compensating people with equity, I thought it would be helpful to cover some basics on this form of compensation.

Sometimes newer venture CEOs like to tell employees, consultants or board members that they will be getting equity without really knowing what they have promised.  This article only scratches the surface of the legal and tax issues related to equity compensation so PLEASE consult your attorney or accountant before making any promises of equity compensation.

First, it’s important to understand whether you are promising someone stock or stock options.  Providing stock as compensation is giving someone immediate ownership in the company.  A stock option gives the individual the “right” or option to purchase stock at a later date at a predetermined price.  So what are some important characteristics of these two types of equity compensation?

The biggest mistake made in issuing stock is not realizing that the fair market value of stock compensation is taxable as wages for employees or non-employee compensation for consultants or directors.  Sometimes companies issue the stock before they have made any cash payments of payroll and now they have to report and pay taxes on the stock compensation.  The obvious drawback to the person receiving the stock is that they have to pay taxes without ever receiving any cash to pay those taxes.

The key thing to remember with stock options is that in most cases the “strike price” i.e., the price at which the optionee can purchase the stock in the future must be the current value of the underlying stock.  The benefit to the company of issuing options is that the optionee is NOT an owner and has none of the rights of ownership until the options are exercised which normally is not until the company is sold.  The benefit of options to the optionee is that there is no taxable income when they are issued.

Traditionally stock options were used as incentive compensation on top of cash compensation.  Lately I have seen companies issue options as the only form of compensation.  The reason being the advantages explained above.  The difficulty in using this as the only compensation is in trying to determine how many options to issue since there is no real value at the time of issue.

In both cases, equity can be earned over time.  For options, a vesting schedule can be required.  When issuing stock, the same result can be achieved by requiring a repurchase agreement where the company can repurchase the stock that has not been earned.

Some final thoughts.  Issuing stock as compensation works best when issued to very early employees or contractors while the stock value is very low.  This is typically before any outside investments have been received.  Stock options work better later on when the company can pay some cash compensation with the options issued to make up for the below market cash compensation.

After many years of asking my clients for legal documents, I now simply ask them (actually beg them) to give their attorney permission to speak to me and provide any documents I request.  On many occasions I have had clients tell me some detail about their company, only to read the legal documents and find something different.  I have seen companies follow the right steps in documenting a particular transaction or agreement, and then fail to tell their accountant about it leading to incorrect financial statements or even worse, incorrect IRS reporting.

Accountants and attorneys actually have a lot in common.  They are both very detail oriented – usually more detail oriented than a CEO.  They both like to keep their clients out of trouble.  They both like to anticipate future problems with the goal of preventing them.  Finally, they both like to use big words like “assignment” and “depreciation”.  They are truly a match made in heaven.

Attorneys help accountants understand corporate structure, deal structure, and contract arrangements so that they can properly account for transactions and produce accurate financial statements

Accountants help attorneys by helping CEOs adhere to the legal agreements they have created and recommend they consult with the attorney when issues arise. 

If your accountant, financial manager, or whoever is handling your financial function is not asking to see legal documents and have access to your attorney, it is time to make a change.

I could give you some specific examples where accountants and attorneys need to be working together but that would defeat the point of this article.  The point is to make sure they talk to each other on their own and you just work on running your business.

Imagine standing on a chair and falling backwards into your accountants arms.  Could they catch you by themselves?  (They might break your fall.)  Imagine the same thing with your attorney.  Now imaging your accountant and attorney facing each other, holding each others hands ready to catch you when you need them.  That’s how they should be working together.

Although by definition venture companies are majority funded by equity, ongoing operations will offer some form of working capital either in the form of credit card debt or vendor credit. A company credit card line will always require the personal guarantee of the primary owner or officer; these are unavoidable.

At times vender credit applications will require a personal guarantee. Try to avoid these guarantees by simply not signing that part at first and see if it gets rejected. If it is rejected consider another vendor. If not signing the document is not an option, you will have to guarantee it. Secured installment loans or leases will normally require a guarantee. Always keep a copy of the guarantees or the applications that include the guarantee and an easily accessible list of all guarantees for two reasons. First, you can use this information later on when cash gets tight and you need to prioritize who to pay. You will probably want to pay the guaranteed debt forest. Second, as your ownership in the company goes down in the future or if the company is acquired, you will need the list to remove the guarantees.

If you have a co-founder who also must guarantee debt, remember that most guarantees cover all of the debt if something happens and the company can’t pay the debt. The creditor will go after both co-founders for the total amount until the debt is paid off, which may mean you pay 100% and your partner doesn’t pay anything.

In conclusion, one of the biggest challenges is determining how long you should continue to guarantee debt as your ownership percentage decreases. That is a hard call and you should be prepared to discuss this issue with your board of directors to determine what is expected of you when you become a minority.

2.  Most financial work is, or should be, done on forward-looking financial statements and financial models.  The first order of business in a start-up is to create a business plan that is supported by financial projections.  These are quite often revised as new information is learned or the business changes its priorities or focus.  Later, forecasts are necessary to determine how much cash is needed before the next round of funding.

3.  Because the company is typically growing fast and changing priorities, so too does the financial management function.  It changes when employees are hired.  It changes when the board of directors or shareholders need financial statements.  It changes when revenue starts occurring.  All result in changes to the financial management systems.