Common Errors of Paying Employees and Contractors in Stock

Common Errors of Paying Employees and Contractors in Stock

Early stage companies - notoriously short on cash - will often use stock to pay employees and contractors. This type of "financing" can work very well if done right. It can also be a disaster if all of the issues are not considered and addressed.

The most common errors made when paying employees and contractors with stock are:

• Ignoring Tax Issues.
• Issuing Stock without Protection for the Company.
• Giving Too Much or Too Little Stock.

Tax Issues.

Whether a firm compensates an employee in cash, with stock or using some other type of property, the compensation is earned income to the employee.

This means that when the stock is delivered to the employee, there has to be income tax withholding, and the employer and employee portions of FICA (social security and medicare) taxes must be paid.

Assume that ESV, Inc., an early stage venture, has a total enterprise value of $3MM. ESV needs a software developer, but can't pay the going salary rate. So, it hires John J. Developer, and pays him by issuing him 3% of the stock of ESV on the date he's hired.

Income Tax Withholding, FICA and Medicare Must Still Be Paid.

By issuing John the stock, ESV compensated John to the tune of $90,000 (ignoring minority and lack of marketability discounts). It is treated the same as if ESV gave John $90,000, John immediately invested the money into ESV and ESV gave John his shares.

As a result ESV must pay taxes in the same way it would have to if it gave John a pay check.

This means that paying salary in stock is not entirely cash free. Some cash must be available to pay the taxes.

Many times entrepreneurs try to get around this problem by labeling John as an "independent contractor" and pushing the tax problem over to John. Of course this will only work if John actually is an independent contractor. If he isn't, a lot of bigger problems can be caused by doing this (for more information see my September 15, 2010, blog post:  The Downside of Outsourcing Incorrectly).

Giving Stock Over Time Increases the Problem.

Many times the companies will pay employees and contractors with stock, just like a paycheck, with bi-monthly or monthly "certificates." But paying stock in increments over time is problematic because the value of that stock increases as the value of the company increases. And the work of the employee and the founders is designed to grow and increase the value of the company.

As a result, the taxes that have to be paid become greater and greater and the employee is working against his own interests.

Issuing Stock without Protection for the Company.

Blindly issuing stock to John at the outset can cause additional problems besides taxes.

Selling stock for services is very different than selling stock for cash.

Once stock is issued to a stockholder, the company can't take it back without a contractual right to do so. The stock becomes the property of the stockholder. So it is imperative to be sure the company receives the consideration or can get the stock back.

When a company sells stock for cash, it knows it received the compensation when the money is in the bank account.

What If the Services Aren't Performed Timely, Sufficiently or At All?

On the other hand services are provided over a period of time. Plus, services can vary in quality and usefulness.

If John fails to complete the services or does a horrible job, ESV needs the ability to get its stock back.

Protecting the company can be accomplished by:

1. Issuing stock to the employee at the outset.
2. Setting objective criteria that the employee must meet (deliverables and timing) over the time the services are to be rendered.
3. Having a written agreement with the employee that calls for stock to be forfeited if the objective criteria are not timely achieved.

Plus, paying with stock in this fashion allows John to decide if he wants to pay the taxes now, when the price is low, or later, after he can no longer lose the shares. The tax code gives John the right to make an election about when to pay the taxes.

Giving Too Much or Too Little Stock.

Using a forfeiture agreement protects the company from not receiving value for the stock, but how should the company determine that value? How much is each share of stock worth?

Stock Compensation Makes Employees Quasi Investors.

Before jumping into this issue, it's important to remember that, by accepting equity instead of cash John is, effectively, investing in ESV. He's making that investment each time he accepts ESV stock as compensation. As a result he should be treated like any other investor with the same expectation of return.

How Much Stock to Issue?

The first step to figuring out how much stock to pay to John is to determine the fair market value of John's services in the market.

What would ESV have to pay in cash to someone with John's experience and capabilities to perform the tasks it expects John to perform, in the time that ESV expects John to perform those tasks?

As we know, though, services are provided over time. So, John isn't making his investment on the day he starts working for ESV.

Rather, he's providing a bit of the services every week until they're completed.

Therefore, John isn't investing the value of his services immediately. Instead, he's investing a bit each week.

To reflect this weekly investment, the fair market value of the services have to be adjusted to the net present value of the services based on the time period over which they are to be rendered.

Say, again, John's salary should be $90,000 per year, but ESV can only pay him $30,000 in cash. The balance is to be paid in stock.

The fair market value of John's non-cash compensated labor is, therefore, $60,000. But the value of his "investment" in ESV is the net present value of $60,000 paid in monthly increments over a 12 month period.

Using a discount rate of 6%, the value of John's investment is $58,094.

The amount of stock to be issued to John is based on the ratio of the value of John's "investment" in ESV to the total value of ESV, and the number of issued and outstanding shares of ESV at that time.

(For information on valuing a pre-investment early stage company for investment purposes, go to:  How to Value an Emerging Business to Raise Venture Capital).

This method should also be used among founders when there are cash founders and sweat equity founders, or when founders interest in the company is based on post formation obligations to the company.

Using these techniques, early stage companies can limit and deal with potential tax problems, be assured that they'll get value for the stock that was issued, and make sure the right amount of shares are issued for the services.

What You Don’t Know Can Hurt You When it Comes to Raising Money for Your Business.

My experience suggests that many, if not most, entrepreneurs and small business owners don’t fully appreciate the requirements and the risks of violating securities laws when raising capital for a business.

State and federal securities laws regulate offers and sales of securities and require companies (as well as others) who sell securities to meet certain requirements for registration or disclosure as well as other criteria.  These laws also contain stringent anti-fraud provisions.

Securities are more than Shares of Stock.

First, entrepreneurs often don’t know that a security is more than just shares of stock. 

Securities include promissory notes (whether convertible or not) and profit participation arrangements as well as any other arrangement where an investor provides money and expects a greater return through no effort on their part.

One business owner (not a client) strenuously claims he did not have to follow the securities laws because all he was selling was 1% of the profits of his company.  Unfortunately for him, that’s not correct.

Likewise for promissory notes – secured or unsecured – sold to individuals and certain entities.

Securities Fraud Isn’t Your Grandfather’s Fraud.

They also don’t fully appreciate the stringent anti-fraud requirements.  Where business owners correctly think of fraud as an overt act, securities fraud has a much lower threshold.  In the securities context failing to say enough can rise to the level of a fraud.

This is a particular problem for passionate entrepreneurs.  As you can imagine, when you’re committed to making the business work, it’s difficult to see the warts.

But, it’s critical to disclose everything – the good, the bad and the ugly –about the business in writing when raising capital.  The worst thing that can happen is for an investor to say “If I only knew” and for you not to be able to point to a written disclosure to that investor.

Ramifications of Violating Securities Laws.

Failure to follow the securities laws has a significant downside.  Investors could have the right to rescind their purchase – meaning the company has to return the money (possibly with interest).  Of course, no one asks for their money back if things are going well.  So, its usually the case that the company doesn’t have the money to pay.

It might also mean the company isn’t able to attract additional investors.  They won’t provide additional capital because of the prior mess and because they see the prior mess as being the proverbial tip of the iceberg.  ‘What other skeletons are in the closet?’ they usually wonder.

Violating the securities laws can also mean personal liability for the founders.  In these deals founders are almost always the ones promoting the securities to prospective investors.  The founders are certainly always involved in negotiating and dealing with the investors.

As a result, the corporate limited liability veil doesn’t protect them.  They can be held personally liable for the investors’ damages.

Of course, depending on the infraction, there can be criminal penalties, as well.

Every entrepreneur looking to raise capital for a business must understand and comply with securities laws to ensure her company gets the full benefit of the investment and she doesn’t end up personally liable for the investors’ money.

If you’d like to raise capital for your business and need to know where to begin, we may be able to help.  Give me a call at 407-649-7777.

Insights from Successful Entrepreneur Pete McAlindon

In this blog I return to a video format, with a conversation with Dr. Pete McAlindon, the founder and CEO of Blue Orb, Inc. (more below).

 [CLICK ON VIDEO]

Pete’s a successful Orlando area entrepreneur.  He founded Blue Orb in 1997 and since then has raised more than $4MM in angel investor capital and built a successful business.

During our talk Pete discusses:

• the keys to his success in raising over $4MM
• entrepreneurial lessons he’s learned (school of hard knocks)
• how to find and approach possible investors
• why it’s critical to talk to other entrepreneurs.

This information is invaluable for anyone building a high growth business.

To add even more value, Pete and I also discuss a new TechStars network accelerator that’s coming to Winter Park and the Orlando Entrepreneurial EcoSystem. 

TechStars is a highly successful accelerator from Boulder, Colorado with networked accelerators in New York, Seattle and other major U.S. cities.

One warning.  At 12 plus minutes, the video is longer than a normal blog video.  Here’s the problem: Pete and I talked for about 45 minutes and Pete is a literal fountain of experience.  So, to get it to any reasonable length I had to cut a lot of great stuff.  What’s in the video is truly the cream of the interview and definitely worth your time. 

Please be sure to leave your comments.

How One Entrepreneur Decided on an Early Exit Instead of Raising Equity Capital

Over the past couple of weeks I've been discussing early exits for high growth scalable entreprenurial ventures - that is selling earlier with a lower overall acquisition price, but a high likelihood of a good outcome.  Last week I discussed a method for properly assessing entrepreneurial risk.

This week I received my October issue of Entrepreneur Magazine.  The "Money" column (which won't be available online until September 29) combines the two topics to show a real life example of how one entrepreneur decided to sell his company for $500,000 rather than take $500K in equity capital investment to continue to grow the business.

In making this evaluation, the entrepreneur applied the risk assessment method discussed last week by multiplying the successful exist rate of venture financed businesses (20% according to the column) by the likely exit value based on his plan ($2.5MM) to arrive at a risk adjusted value of his company of $500K.

When he was offered $500K for the company or the opportunity to continue to build the company, the risk analysis showed that selling earlier was his best alternative. 

I'll update this post with a link to the column once it becomes available online.

What's the Right Risk?

What’s the Right Risk?

I despise books that characterize entrepreneurs as “risk takers.”  It’s total bunk and dangerous to boot.

Sure, being an entrepreneur is about taking risk.  But, the characterization makes business owners seem like gamblers.  Strategic risk taking and gambling are completely different.

In reality successful entrepreneurs take appropriate risks.

An appropriate risk is where:

The Best Outcome,

Multiplied by the likelihood the best outcome will occur, is

much greater than

The Worst Case Outcome

Multiplied by the likelihood of the worst case outcome will occur.

This analysis is exemplified by the risk–reward ratio.  Where the likelihood of a bad outcome – the loss of investment principal for example - increases, the benefit –the return on investment - must increase to offset that risk.

Take, for example, a lottery ticket.

According to the Florida Lottery website, the chances of winning Florida Lotto are one in 22,957,480.  In other words, you’re not going to win; the likelihood of a negative outcome is almost a certainty.

And the downside risk ($1.00 for the ticket) is extremely low and known.

The best case scenario is that you win millions or tens of million of dollars.  So, although the likelihood of winning is extremely low, the beneficial outcome is high. 

As a result, many believe playing the lottery is a reasonable risk to take.  (I’m also certain that most who play don’t actually consider any of this.)

It also seems to me that the Florida Lottery knows that most people consider the price of the ticket lost.  This is why they add a “good cause” to the benefit side of the equation by highlighting the money contributed by the lottery to Florida education. 

The purchaser gets the added benefit of doing good by buying the ticket.  Even if there’s no win, there’s still a benefit to the community.

What if, on the other hand, each lottery ticket cost $100.  At this point the downside risk would become material and the risk would not be palatable for a much larger group, even with the additional “good cause” benefit.

In fact, because the negative outcome is a virtual certainty, its only when the best case outcome becomes in the high tens or hundreds of millions of dollars that most people are willing to play.

How does this apply to your business?

First, as long as you accurately assess the likelihood of each outcome, the formula can help you arrive at a go / no-go decision.  You can’t be overly optimistic or overly pessimistic.

Jim’s software development business entered a license agreement where the other party refused to pay.  This licensee owed Jim’s business $20,000 in unpaid licensee fees.  After he consulted with litigation counsel, Jim determined it would cost about $10,000 in attorney’s fees and costs to get a judgment against the licensee.

Jim shouldn’t file suit unless:

• the license agreement permits him to recover his attorneys fees from the licensee;
• the licensee’s liability is almost certain; and
• Jim knows the licensee has more than enough assets to satisfy the judgment, interest and the costs of levying on assets.

If the licensee only has $30,000 in assets, Jim should not take the risk of suing the customer because:

• the best outcome is $30,000;
• there is a low likelihood that Jim could actually net $30,000 by levying on the licensee’s assets;
• the downside is paying an additional $10,000; and
• the likelihood of not being able to collect at all is very high.

Second, in the business realm the likelihood of either a positive or negative outcome can be manipulated by reducing and shifting the risk.

You can decrease the likelihood of a negative outcome through:

• investigating how the other party operated in the past;
• investigating the other party’s assets;
• having specific written rights and obligations of the parties; and
• getting a security interest in assets.

There’s no way to eliminate all risk. 

Unfortunately, this is what many lawyers try to do.  They try to push all the risk on to the other party and, in the process, kill the deal. 

Or, even if the other side signs a lopsided agreement because they “have to,” the deal doesn’t survive long because the other side won’t abide by the unreasonable deal terms.

It’s also important to remember that, without any risk, there’s usually no gain – no upside.  Consider an investment in government securities.  While there’s very low risk of a negative outcome – you’re virtually guaranteed to get the return of your principal – the benefit is also very low – a low return on investment.

Taking appropriate business risks won’t guarantee success.  But, it will avoid bad outcomes that did not have corresponding potential benefits.

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Clients in the News:

Here’s a link to Assessing the Damage, a Gulf Coast Business Review article about GeoCove, Inc., a developer of geographic information system software for disaster assessment (and Entrepreneurship Law Firm client).

Thanks for reading,

Ed