Technical co-founder · Stock Options

How to attract a senior engineer for equity without scaring him/her with tax consequences?

Kodjo Hounnake

February 18th, 2016

I've bootstrapped so far and raised a small pre-seed recently. My company is about a year old now and I've been working with a developer that I want to bring on full time in return for equity. I currently employ him full time for salary. My concern is, given the company is no longer at its infancy, giving him common stock may trigger a significant tax event for him, ultimately killing the deal right out the gate. Giving him (hypothetically) 20% in options would be ridiculous, and would require going through 409A valuation. So what alternative should I consider (that doesn't involve continuing to have him on payroll). Just to be clear, my motivation is not purely to get rid of the salary, but rather to get him to have his interests aligned with that of the company 
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David Pariseau

February 18th, 2016

Well, equity is always a good incentive, but it you don't want to setup options, you could work out a bonus program.  That can be structured in a wide variety of ways, but some basic ideas are:

- based on individual performance / milestones,

- based on the company performance / milestones,

- accrued over time,

You could prepare a menu of possible compensation scenarios (from mostly salary to mostly bonus) with the bonus options of course being calculated so that if targets are met that it would amount to significantly more than straight compensation would.  So that way you can gauge the level of interest and have a dialog about what scenarios he finds most attractive.

The challenge is getting these to be fair for all parties.

Dave.

David Still Founder of Start-ups, Entrepreneur, Financier and Advisor

February 18th, 2016

Time vest a large portion of the shares over 5 years or so. Declare a ridiculously low IRS section 83(b) election for those shares based on a value that reflects the risk that the shares don't vest. This serves many purposes. See a tax lawyer for many other options.

Michael Barnathan

February 18th, 2016

Your investor stock was preferred, I'm assuming - the valuation of the company from the investors is not the same as the valuation of the company's common stock, so there's no need to invoke harsh tax consequences - the common valuation is still unset unless you've already established it through some other means. Traditionally, it's a far cry smaller than the preferred.

But if you're concerned about that, give him options, set the strike price to the current value of the company. Those grant him the *gain* over the current value, and are worth $0 at grant because the strike is equal to the last valuation. If less than $100k in value, you can grant ISOs or NQSOs; otherwise they must be NQSOs.

Lots of other ways to structure this too.

Travis Chalmers Tax Lawyer (Ontario)

February 19th, 2016

Sometimes we use "Phantom stock units" in Canada, where the employee does not receive actual shares but instead a very structured compensation designed to track the company's value. Alternatively you could have shares only vest when the company sells or goes public, at which point the employee would be pretty happy with the financial consequences.

Bill CA Managing Director, The CFO Center, Part-Time CFO, Board Member, Entrepreneur, Founder, Avid Sailor

April 15th, 2016

Michael, anyone who gets restricted is going to have to get used to being taxed at full marginal rate. its the unfortunate consequence that comes with making a lot of money:)

MICHAEL O'CONNOR MANAGING DIRECTOR at True Partners Consulting

April 15th, 2016

I agree that a phantom stock plan may be one way to go. You can track appreciation off the books, and avoid creating taxable income until a liquidity event.

Michael Barnathan

April 15th, 2016

(At which point it will all come due as short-term income taxed at the full marginal rate)

Bill CA Managing Director, The CFO Center, Part-Time CFO, Board Member, Entrepreneur, Founder, Avid Sailor

April 15th, 2016

This is a problem many founders face especially with you having raised money creating a valuation for your company. What we do with many fast growth companies is set up a restricted stock plan for early employees and advisors. We set the value in the agreement reflecting the companies realistic low value. These shares are earmarked to individuals but do not vest until exit. This is a elegant way to not need a 409a valuation yet ensure early employees do not miss out on the uptick in value from when they start working with companies. Consult your lawyers to see if a Restricted Stock Plan can work for you.