Category: Employees/Contractors

Best Practices for Issuing Stock Options to Startup Employees @ Paper this Deal

stock-optionsHere is a quick list a company can refer to prior to issuing stock options to its employees.  I’ve covered the basics of stock options in a previous post, as well as a more in depth pricing item related to stock options, but wanted this post to give the broad overview to founders.

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New York Qualified Emerging Technology Company (QETC) Incentives @ Paper This Deal

If your company operates in New York and meets the definition of a “qualified emerging technology company” (a “QETC”) it is eligible for New York tax credits.  Additionally if you are a New York State taxpayer and interested in investing in a QETC you may be eligible to claim a credit as well.

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Strip Rights @ Paper This Deal

In addition to the other ways we’ve discussed here (stock options, phantom stock, stock appreciation rights), another way to compensate individuals working for a startup is to give them a cash payment upon a change in control of the company, called in the industry a “strip right”.

For example if a startup company has four founders each owning 25% of the shares, and they bring on another but don’t grant him or her shares, the initial founders can agree to pay the new individual a percentage of the “net proceeds” received from a “change in control” of the corporation.   “Net proceeds” is usually defined as the gross proceeds received minus transaction costs and brokers commissions as well as some other items.   A “change in control” is defined as it normally is in these agreements, and covers if the company merges with another or sells substantially all of the company’s assets.  In such a case, the shareholders would receive cash (or assets it can sell for cash, like tradeable shares of the acquirer).  The strip right agreement would require the shareholders that granted it to pay to the holder of the strip right, either a percentage or flat fee before they received their cash for the change of control.

In the example, if the four founders grant a 10% strip right, and a couple years down the road the company is sold for one million dollars, with transaction fees of $100,000, the holder of the strip right would receive $90,000 (net proceeds of $900,000 x ten percent).    The shareholders would split the rest of the $810,000 and each receive $202,500.

One of the benefits of the granting of the strip right is that it is not taxable to the recipient.  The downside, at least to the recipient is that they are not a shareholder of the corporation and they may never receive a cent if there is never a change in control.  Due to its tenuous nature, the strip right is usually granted in connection with other compensation awards.

 

New York’s STARTUP-NY Program @ Paper This Deal

Starting at the beginning of 2014, New York’s STARTUP-NY Program went live.  Here is the official website for the initiative.  Its goals are laudable but its only available to a small niche of companies.  If your company qualifies, however, the benefits are rather nice.

In summary, the Program provides eligible companies with free office space (at certain locations) for a period of time and the employees of the company pay no state income tax on their income (at least for the first five years, with a small amount possibly paid in years 5 through ten).  The Program is attempting to lure out-of-state companies into New York, while encouraging sprouting of new startups that otherwise may not have started without these benefits.  Overall New York is looking to add more jobs in the state, and the more jobs now (even with tax breaks) the more taxes the state can collect in teh future. 

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Benefit Corporations (B-Corps) & Other “Good Vibe” Corporate Structures @ Paper this Deal

It used to be that if you wanted to start a corporation and the end goal was not to maximize shareholder value (or other typical corporate goals), you’d start a not-for-profit corporation.  That’s no longer the case. Now in New York (and at least six other states) you can form a Benefit Corporation (a “B-corp”) which has other purposes besides making money.  There are also other strategies you can use in a for-profit company to give it more of an egalitarian feel.  We’ll discuss below.

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Stock Appreciation Rights @ Paper this Deal

Another way to compensate employees of a corporation is to issue them Stock Appreciation Rights (“SARs” – not “sars – severe acute respiratory syndrome”, that’s something else).   SARs grant employees, usually higher level executives, the right to receive stock and/or cash at a future date in an amount pegged to the increase in value of the corporation’s shares of stock over a certain time period.  If the company’s share value increases, so to does the value of the SARs.   SARs often are offered along with traditional stock options, although they are granted seperately (if done with stock options, sometimes you will see them called “Tandem SARs”).

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Pricing Stock Options – IRS Code 409A Treatment @ Paper this Deal

We’ve covered the bare basics of stock options on this blog before.  Here we will look into something that is all important when issuing stock options – that is the option’s exercise price.  The exercise price is the amount an option holder needs to pay in order to exercise the option to receive the share of underlying stock.  Most option holders will not exercise their options until the price of the underlying stock has risen higher than the exercise price, so that they can receive the shares and then sell on the open market for a profit.  The IRS got keen on the fact that a company could issue stock options with an artificially low exercise price, which would allow the option holder to immediately exercise the option to receive the shares with the greater value and sell those shares, which is in effect as if the company paid cash to the option recipient.  Hence Section 409A voted into effect in the American Jobs Creation Act of 2004.  The reason stock options can receive beneficial tax treatment is because they are treated as deferred compensation.  To get that treatment, stock options should only be granted with exercise prices at or above the fair market value (“FMV”) of the underlying shares of stock on the date of the option grant.

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Remember to make your 83 B elections! Here’s why and how to do it @ Paper this Deal

As I’ve written about in the past, founders of a startup should have their equity vested. There are times when you may not want to, but the majority of the time it is beneficial. Some investors may insist upon it, although its one of the things in the negotiations.  If the founder’s stock is vested, they should make an 83-b election.  To not do so could turn into a lot of tax due to the IRS over the years the stock will vest.  We’ll discuss how it works and how to make the election here.

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Granting LLC Profits Interests @ Paper this Deal

In a startup company, its common for certain employees to be compensated with some form of equity.  When you incorporate, you would adopt a stock option plan and then issue options to the corporation’s employees to compensate them for their past services and to incentivize them to stay and keep up the hard work – make sure you vest!

With LLCs becoming ever more common, the owners of a startup organized as an LLC want to be able to compensate and motivate their employees and contractors in the same manner.  They can do so by granting employees LLC profits interests.

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Vesting the Founder’s Stock

This is a very important topic to ensure that your startup continues to be controlled by founders dedicated to its cause.    What you want to avoid is a situation where a group of founders form a startup and each hold a similar percentage of the issued shares – without any restrictions on such shares.   If only one or two of the original founders continue working for the corporation, and the rest stop, and either get other full-time jobs, move away, leave the country, etc., then the founders that are still around can be stuck and essentially handcuffed from making certain corporate decisions.  If the corporation, as most due, requires the majority of the issued shares to take certain actions, and the corporation brings in other people from the outside as shareholders and/or directors (usually investors), then the founders who have stuck around will have essentially less of a say in major corporate actions.  And if there is a liquidation event, then the founders who have left will get paid without having to put in the hard work.

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