Start-up companies or struggling organizations looking to fill headcount gaps without the burden that full-time staff can bring often turn to Independent Contractors. This type of worker may not have the long-term benefits and compensation package costs, however, they many times come with a high hourly rate as a trade-off. In order to pay for the specialized skills companies cannot go without, paying contractors in part or full with stock options has become an occurrence more common in today’s business world. Is this a viable option for you?
Law firm Hanson Bridgett, explains that payment of stock options to contracted workers is a “great way to retain employees and incentivize employees to be productive.” However, many organizations might not know where to begin in order to provide this option to contractors. Aimed at supporting start-ups and emerging companies, Hanson Bridgett explains in detail what it means to offer stock options and the types of stock you might offer:
Stock options are a contractual right to purchase stock. The stock is issued to the employees pursuant to an Option Plan adopted by the company. Generally, the employees are given the right to purchase the stock at a specific price. If the stock price increases in the future, the employee may “exercise” his or her right to purchase the stock and profit from the increase. If the stock does not increase in price, the employee may elect not to “exercise” the stock option.
There are two types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).
Summary of Incentive Stock Options (ISOs)
• May only be issued to employees
• Must be issued at fair market value
• Taxed to the employee when the employee sells the stock
• Any increase in the price of the stock is taxed as capital gain
• Must be exercised, if at all, within 3 months of termination from employment
• Must be held for one year
• Not transferrable
Summary of Non-Qualified Stock Options (NSOs)
• May be issued to anyone (not just employees)
• Must be issued at fair market value
• Taxed to the holder when exercised (not when sold)
• Any increase in the price of the stock is taxed as ordinary income
While providing equity as a means to pay the bills may be a grand idea to get the ball rolling on your new venture, be aware of the ways in which this method could possibly backfire if not handled right. The Next Web offers some valuable advice and tips to keep in mind.
Pitfalls in sharing equity
While equity can be a great tool for compensating early on, the drawbacks are significant. For starters, people tend to grossly underestimate just how much record keeping is involved. Speed is often of the essence early on in the startup lifecycle, and that often means rushing into casual arrangements. The lack of proper paperwork can lead to issues down the road.
And perhaps most importantly, equity is a business’ most precious resource, and the amount you give a contractor in stock can end up being worth many, many times more in a few years. Not to mention the fact that every time you compensate with equity, you dilute your own ownership of the business. For these reasons, experts often counsel startups to only give stock to contractors, vendors, and service providers as a last resort.
Tips for compensating with equity
When it comes to structuring your startup and staff, there’s no single right answer. However, if you are thinking about compensating non-employees with equity, make sure to consider the following points:
1. Plan upfront.
Any decision to hand out stock or stock options should be made within the big picture context of your company’s valuation and the total number of shares you’ll be granting. It’s wise to create a stock options pool that includes all the employees and contractors you plan on hiring in the next 18 months and how many shares each might get. Many young tech startups reserve 15%-20% for employee stock options. Note this figure would include consultants and contractors, but wouldn’t include founders’ shares or any early employees that are working mainly for equity.
2. Put it in writing.
You never want to give out equity without proper paperwork in place, period. All too often, startups grant stock options to people based on a handshake, rather than written contract. Imagine if you grant stock options to a handful of consultants. When it comes time to sell the company or go public, you’ll need to know exactly how many shares are vested as that will impact the price per share. Without the proper paperwork, it can be a nightmare to reconcile and formalize these past arrangements.
It’s best to put together a written agreement with the help of a lawyer. Consider adding the following into the agreement to protect your interests down the road:
• Right of first refusal
• Share transfer restrictions to prevent consultants from selling their stock to others (like your competitors!)
• Terminable at will, meaning they can be cancelled at any time
3. Don’t give equity to an unproven contractor.
Whenever possible, it’s best to avoid giving equity to a contractor or consultant until you have worked with them first. Remember, your equity is your company’s most precious commodity. You don’t want to dilute your shares until you know the individual is worth it. And by making your consulting agreements terminable at will, you can terminate your relationship with a consultant if they’re not performing well. In most cases, you’ll only be losing a few months of vesting on the stock.
4. Give equity based on performance, milestones, or deliverables.
When compensation packages are tied to deliverables and milestones, it helps incentivize people to be highly effective and help grow your business. But beyond motivation, there are more pragmatic factors at play here too. By linking number of shares to hours worked or other quantifiable measures, you run the risk of establishing the price per share of your common stock or options. You don’t want the flexibility to keep your future employee price as low as possible, so you don’t want to have evidence of higher prices.
5. Don’t jeopardize your S Corporation status.
If your business is structured as an S Corporation, be aware that the IRS places certain restrictions on who can be a shareholder. All S Corp shareholders must be individuals (not LLCs or partnerships) and legal residents of the United States. Don’t jeopardize your S Corporation election (and pass-through tax status) by granting shares to a consultant or advisor that may be structured as a Corporation or partnership.
While compensating contractors, consultants, and vendors is not for everyone, it can be a useful way to get critical resources for your company when cash is tight. If you decide to take this path, be sure to consider your company’s big picture and future plans carefully.
I couldn’t have said it better myself.