Starting a company has many challenges—the biggest being how to attract top talent when you are cash-strapped. Many companies solve this by offering equity for services. Not only does equity compensation conserve cash, but it aligns employees with the company’s long-term business goals. However, founders should be aware that improperly administered or ad hoc equity compensation programs carry serious securities, tax and employment consequences—to both the company and the equity recipient.
To avoid costly mistakes, consider the following:
1. Equity for services is a security. Whether you offer stock for cash or for services, it is still a security. As such, the company needs to either publicly register the stock/option or seek an exemption from registration. With proper planning, several exemptions exist for equity compensation plans and the underlying securities. Exemptions sought after the fact may not be feasible and can jeopardize the future capitalization of the company.
2. Equity grants require board and often shareholder approval. In the absence of delegation from the board (or a properly formed compensation committee), an officer or founder does not have the unilateral power and authority to grant equity. Unauthorized (or ultra vires) actions are void (or voidable) and can subject the officer/founder to personal liability. Additionally, tax incentive stock options require shareholder approval for the incentive to be available.
3. Payment in cash or in kind is still income. If you pay your employees with equity, you still need to withhold and report the value as income. If you are paying a consultant or a contractor, you still need to file a 1099. In short, paying in kind is still a taxable event and does not avoid IRS reporting requirements.
4. Equity grants must be valued at market value. The days of nominal stock and discounted options are over. Stock cannot be given away or sold for less than fair market value, as determined at the time of grant, without triggering tax consequences to the recipient of the stock and to the company. Employee options must have exercise prices set at a fair market value that is determined in compliance with the increasingly complicated rules under Internal Revenue Code section 409A. Best practices recommend securing third-party valuations, which can be expensive and time-consuming.
Even the best run companies make these kinds of mistakes, which can be costly or impossible to fix. Rest assured that even unintentional lack of vigilance and compliance will catch up with your company eventually and rear its ugly head during the due diligence process relating to a venture capital financing, acquisition or initial public offering. So, make sure you understand the administration of equity compensation before you begin promising equity for services.