By Cliff Ennico
“We are starting up a technology company and want to know the right way to compensate our technicians, developers and others who will be helping us grow the business.
We don’t want to give them equity at this time because we don’t know how committed they will be to the business going forward. But we do want them to share in the growth of the company if it’s successful.
We’ve done some research online and it’s all pretty overwhelming. Can you put together a simple ‘checklist’ of the different ways we can incentivize our key players?”
My motto has always been, “no challenge too great; no fee too low.” So here goes . . .
You have basically five options (other than cash, of course) when compensating “sweat equity” players in a startup company.
1. Restricted Stock. By giving your sweat equity team “restricted stock,” you are giving them actual shares in the company, but with a number of strings attached:
The shares must be nonvoting – you don’t want these people having the right to second guess your management decisions, or be invited to attend formal meetings of shareholders;
- The shares must “vest” over a period of up to three years; and
- Even after a person’s shares have “vested,” you must have the right to buy them back at “book value” or other some highly discounted price if the sweat equity player leaves the company after the shares have vested (this is commonly called a “clawback” provision).
2. Stock Options. By granting options to your sweat equity players, you enable them to buy stock in your company down the road at a highly discounted (bargain) price.
First, you put a value on what your company is worth today. Since you are just starting out, this will be an extremely small number, for example one penny ($.01) per share. You then grant each sweat equity player the option to purchase X number of shares – say, 10,000 shares – at that price (so $100 in total) when the shares “vest” one, two or three years after the date of grant.
As the company grows in value, holders of options will “exercise” them by purchasing shares for the original option price ($.01 per share). So if your company is now worth One Dollar ($1.00) per share, and the option holder exercises all 10,000 of his or her options, he or she is getting $10,000 worth of stock for a purchase price of $100. Not a bad deal.
The tax laws governing stock options are quite complicated; holders may have to pay income taxes on the capital gain they realize when exercising their options, or later on when they sell their shares.
3. Warrants. Warrants work exactly the same way as options, except that they are granted to outside investors in the company, not employees. While there is no law against granting “options” to investors and “warrants” to employees, it’s best to honor tradition when putting names on these things to avoid confusing people.
4. Phantom Stock. A phantom stock plan (or “phantom equity” for an LLC) works like a stock option except that the sweat equity player receives cash instead of stock in the company.
In a phantom stock plan, you set up a book account giving each participant a number of “credits,” each credit having a value equal to one share of your company’s stock on the date the “credit” is booked. As the company grows, you value the company each year, and pay to each player cash in an amount equal to the difference between the value of his “credits” on that date and the value of his “credits” the preceding year.
5. Strip Rights. A “strip right” gives the player the right to receive, in cash, a percentage of the “net proceeds” of any merger, acquisition or sale of the company in the future. “Strip right” holders have no right to dividends or distributions of cash until the event triggering a cash payout occurs.
When considering these methods, here are the trade-offs:
- “Restricted stock” gives holders actual ownership of your company – even holders of nonvoting stock have legal rights, and if things don’t work out you will have to buy back the holders’ shares;
- “Stock options” defer ownership in your company to a future time, but holders of options will eventually become shareholders if your company is successful – also, options can have negative tax consequences to the people that hold them, and you may have to indemnify option holders against those consequences;
- Holders of “phantom stock” never become owners of your company, but you must pay someone to value your company each year and pay cash to participants in the plan;
- Holders of “strip rights” never become owners of your company, but you must compensate them in cash if a merger, acquisition, or other “triggering event” occurs – because “strip rights” (usually) never expire, you may need to keep them on your books for much longer periods than options or phantom stock.
Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and host of the PBS television series ‘Money Hunt’. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com. COPYRIGHT 2014 CLIFFORD R. ENNICO. DISTRIBUTED BY CREATORS SYNDICATE, INC.
