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Common Errors of Paying Employees and Contractors in Stock

December 16, 2011

Alexander, Ed, Entrepreneurship Law Firm, “Common Errors of Paying Employees and Contractors in Stock?” Posted December 14th, 2009. Retrieved December 16th, 2011.

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.

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