Equity Compensation Archives - Randel Law, Inc., Your Business and Succession Planning Lawyer as well as Corporate Transparency Compliance

How to Attract and Retain Talent

November 1, 2016 By Rick Randel

My friends at Breakaway Funding invited me to present a webinar on Equity Compensation for Start-ups & Small businesses. Check out the webinar after Breakaway Funding’s introduction.

Equity Compensation for Startups and Small Businesses from Breakaway Funding on Vimeo.

This video is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter. You are encouraged to seek competent legal and tax counsel before proceeding with any transaction involving any of the matters discussed above.

Building the Business through Ownership Expansion

October 4, 2014 By Rick Randel

Business owners often hesitate to give away a piece of the pie when it comes to sharing ownership of their business. But if they wind up with a smaller piece of a bigger pie, they come out ahead. Sharing ownership (also known as giving equity) can create a bigger pie by helping to attract, retain and incentivize personnel, whether it’s senior team members at the top, or all employees. This is especially true when getting equity convinces key rainmakers to stay with the firm, rather than bolting to start a competing firm and take customers with them.

Ownership Expansion Benefits

Equity simply means an ownership stake in the business (for example, shares of stock in a corporation, or membership interests in an LLC). Expanding ownership offers business owners a number of benefits, including:

Incentivizing key employees to contribute to the bottom line.
Incentivizing “rainmakers” to bring in more business and decreasing the likelihood that they will take customers to a competing firm.
Increasing employee retention, which reduces turnover and training costs, improves customer satisfaction, and increases productivity.
Providing cash to the owner, if the tool selected involves the owner selling some of his/her shares.
Providing for continuity of the business and liquidity to the owner(s) upon retirement, when used as a component of an ownership succession plan.

Ownership Expansion Tools

Methods for expanding ownership vary depending on the owner’s objectives, the party or parties receiving the equity, tax factors, etc. The following alternatives represent some of the tools in our kit for expanding ownership in corporations:

Restricted Stock. This is probably the simplest method, involving just the grant or sale of actual shares to the individual. Typically, the company has the right to repurchase the stock if the recipient leaves within a certain period (hence the term “restricted”). Note, if the person doesn’t pay full value for the shares, the shares will be treated as compensation and therefore taxed. There are ways to help the person pay the taxes. One arguable downside of restricted stock is that the recipients are true shareholders with the right to vote, receive information, call meetings, and be paid dividends (if any are declared).

Restricted Stock Units (RSUs). A variation on restricted stock, RSUs grant the shares to the individual at the end of the vesting period instead of the beginning. The downside for recipients is they don’t have the option of being taxed at the beginning, when the value is low (as they can with restricted stock). They are taxed at the end, when the value is (hopefully) higher. RSUs are similar to options; the difference being that with RSUs, there is no “exercise” – the stock is simply issued (and an exercise price is not required).

Stock Options. If the tax hit to the recipient is too great to use restricted stock and the company can’t afford to pay it for him/her, we sometimes select stock options as the most effective tool. If the recipients are employees, they get favorable tax treatment (generally, no tax upon receipt or exercise of the options; taxed as capital gain upon sale, assuming certain conditions are satisfied). This is also a common way to get stock into the hands of numerous “rank and file” employees, rather than just one or two key individuals.

Ownership Transition Plan (OTP). Sometimes referred to as a “management buy-out,” this tool involves key senior team members gradually purchasing shares over several years, coupled with gradual “sell-downs” by the owners. After a designated time period, the owners own little or no stock and retire. If the owners are too young for this, the other alternative is an “ownership expansion plan” that does not include the “sell-down” part (or provides that the sell-down will occur at a future date). This works best for service companies where the owners (including the new owners receiving equity) have business development responsibilities, and where the owners want the company to continue indefinitely, rather than be acquired or go public.

Employee Stock Ownership Plan (ESOP). Although the mechanics can vary, in the typical ESOP, the corporation contributes money to a trust (a deductible expense), and the trust uses the money to purchase shares from the founder(s). The founder(s) pay no capital gains tax, if the business is a C corp. The trust holds the shares on behalf of eligible employees, and when employees leave they get paid for their “shares.” An ESOP makes sense for companies that are consistently profitable, (b) have a fairly large payroll, and can afford significant up-front expenses plus annual valuation and maintenance expenses.

Phantom Stock and Stock Appreciation Rights (SARs). Although technically not equity (they are basically a promise to pay a bonus in the future), both allow the recipients to benefit from increases in the company’s value, so they are generally included when talking about sharing equity. People use these terms differently and the differences can become blurred. However, in both cases, the recipient (usually an employee) is allocated a certain number of imaginary “shares” that go into his/her account. The number of shares is often increased each year. When phantom stock vests or the employee leaves, he/she is paid the full value of the shares. With SARs, he/she is paid only the increase in value since the grant date. A benefit to the owners and the company is that recipients do not have the same rights as shareholders, such as voting rights. The company is not obligated to pay dividends, but in many cases, the plan includes “dividend equivalents.”

Employee Stock Purchase Plan (ESPP). A “qualified” ESPP must be offered to all employees and requires extensive “jumping through hoops” specified in the tax laws. Assuming an ESPP meets all the tests, employees receive favorable tax treatment. Qualified ESPPs are generally only adopted by large publicly traded companies. Unqualified ESPPs take many forms: some are similar to qualified ESPPs without the tax benefits, others are basically grants of restricted stock (see above) that are implemented under an actual “plan” document adopted by the board of directors. These are typically awarded to a broader base of employees, rather than straight restricted stock with no plan.

Limited Liability Companies. Most of the above alternatives don’t work for LLCs. The most common forms of expanding ownership in LLCs are either straight grants (or sales) of membership interests (similar to restricted stock above), or grants of what are called “profits interests”. A profits interest only allows the recipient to share in appreciation in the value of the company from the grant date forward. If the company were liquidated the day after the grant, the recipient would get nothing. Profits interests are generally considered to be the LLC equivalent of stock options, especially with regard to the tax treatment of the recipient. They also resemble SARs, in that they reward the recipient for gains in company value after the interest is granted. Profits interests can be granted in specific instances, or under a broader profits interests plan.

Owners can realize many benefits by expanding ownership in their company. And they have many tools at their disposal. Many companies use a mix of these tools to get equity into the hands of their employees or other interested parties. There are many nuances and complexities to each tool, so any business owner who is thinking about adopting one or more ownership expansion tools is encouraged to seek qualified legal and tax advice before moving forward.

This article is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter. You are encouraged to seek competent legal and tax counsel before proceeding with any transaction involving any of the matters discussed above.

How to Avoid the Tax Traps of Sweat Equity

May 4, 2013 By Rick Randel

Clients frequently tell me they are planning to issue stock for no cash investment. This is generally referred to as “sweat equity”. The most common scenarios are:

Issuing stock to one founder (the “money guy”) for cash, and to the other founder (the “idea guy”) who has the idea or will be doing most of the work
Issuing stock to the founders for little or no money around the same time they issue stock to “money investors” at a high valuation
Issuing stock to contractors or employees in lieu of paying them cash

If you are a business owner or trusted advisor, it is important for you to know that this is a potential tax issue. The IRS considers any property issued in connection with the performance of services to be compensation, which is taxed as ordinary income. Stock is property (and for the purposes of this article, when I say “stock” I also include membership interests in an LLC). If someone pays money for stock, it’s an investment, not compensation. If the person pays no money, then he or she is paying with labor (hence the “sweat” part of “sweat equity”). The stock is compensation for the labor and therefore taxable.

For example, let’s say Joe is an entrepreneur with a great idea but no money. He contacts his friend Sue, who agrees Joe has a great idea. She decides to invest $20,000 for 20% of the stock, and Joe gets 80% of the stock for doing the work. Joe just received $80,000 of property, taxable as compensation for services. (We are assuming the idea is not mature enough to be considered a contribution of IP that is worth $80,000.)

Or let’s say Joe and Sue come up with the idea together but neither one can fund it. To save money they don’t form a corporation at this stage. They spend several months creating a product they think will be marketable. When they need money for proof of concept, the product is far enough along to get some investors interested. Now they have to form a corporation, because the investors need to get stock in something. The investors pony up, say, $200,000 for 20% of the company. Joe and Sue get 80%. Well, Joe and Sue just received stock worth $800,000, and the IRS will tax them on that amount at ordinary income rates.

A third example would be If Joe and Sue don’t have the expertise to do the work themselves. They might contact a friend or two, or former co-workers, and ask them to put in some time (the classic example being to develop the code for a tech product). They don’t have any cash to pay these contractors, so they offer them stock. In the early days when the valuation is minimal, this may not be a problem. But if there is a valuation event as above, the ten or twenty thousand shares these contractors receive could be valued in the tens of thousands of dollars and guess what? They’ll have to pay tax on the receipt of that stock, even though they received no cash with which to pay the tax.

Fortunately, there are several ways to avoid this problem or at least reduce the tax hit:

Form the corporation early on, when valuation is basically zero, and the founders can pay a nominal amount for their stock. In this way the few thousand dollars the founders put in will be considered valid payment for the millions (or hundreds of thousands) of shares they are issued.
In the same vein, when the valuation is this low, you can grant contractors shares and their tax bill will be so low, it doesn’t matter (the value of the shares might be, say $100 or a few hundred dollars, and either they can pay the tax on that amount, or the company can bonus them the cash to pay the tax)
If it’s too late for the above, the founders can contribute property (usually intellectual property) rather than cash; but the IP must be “mature” IP or it isn’t really property. Be careful with this, because the IRS might argue they are really contributing the time and effort to turn the alleged IP into something marketable, and the stock is compensation for that time and effort.
Just go ahead and grant sweat equity and pay the tax if it’s not too much (often the company gives the contractor or employee a “bonus” to pay the tax)
Instead of shares, grant the person stock options. If the recipient is an employee, and the business is a corporation, they can receive “incentive stock options” so that, if certain conditions are met, there is no tax until they sell the shares. If a contractor, they will get “unqualified” (or “nonstatutory”) options, in which case they pay some tax when they exercise the options plus tax on the gain when they sell the shares. If the business is an LLC, it can issue what are called “profits interests” which in many ways mimic stock options (including that they are not taxable upon grant)
If the potential problem is that shares are being issued to outside investors at a (moderately) high valuation, thereby valuing the “sweat equity” stock too high for tax purposes, it can help to issue the investors preferred stock and the sweat equity recipients common, which has a much lower valuation than preferred. This will not eliminate, but can substantially reduce, the tax owed.
There are other more esoteric methods to grant service providers a stake in the upside, such as phantom stock or revenue share arrangements, but the above are the most common.

To summarize, it’s important to remember that stock for no cash (or “sweat equity”) is generally considered compensation for services and is taxable as such. The obstacles are not insurmountable but require an awareness of the potential issue, and some good planning to avoid or reduce the tax hit.

This article is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter. You are encouraged to seek competent legal and tax counsel prior to implementing any specific transaction.