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The Startup Employee Compensation Conundrum

June 18, 2012

Alexander, Ed, www.inc.com “The Startup Employee Compensation Conundrum.” http://www.orlandobusinesslawyer.com Posted: June 13th, 2011. Retrieved June 18th, 2012.

Hiring those first few non-founder employees for a startup is critical to making the venture a success. 

Founders often get hung up by compensation issues and, as a result, settle for a team that isn’t the best.  This article highlights the essential conundrum, the problems it causes and a method for compensating key employees when you can’t pay them a market rate salary.

The Conundrum.

Many founders encounter a big problem (or, should I say, perceived problem) when hiring the first key employees for the startup.  With little cash, the founders can’t compensate these employees at market rates.

As a result, many founders decide to hire family members, inexperienced employees or those without the skills needed to make the company a success, thinking they can train these employees or get them on the cheap.

This is a huge mistake.

Family Member Employees

First, family member employees rarely work out.  The familial relationship interferes with the business relationship.  Unless the family member is an expert in the field and you have an up front serious heart-to-heart, this is how it’s going to work conversation, don’t do it.

Newbies

Founders don’t have enough time in the day to get everything done, that’s why employees are hired.  They certainly don’t have the time to train an inexperienced employee. 

Plus, most founders I’ve encountered don’t have a teaching style.  They’ve usually figured things out on their own and expect others to do the same with a little push in the right direction.

Competitive Advantage.

Time and training aren’t the only issues.

There are a lot of advantages that large businesses have over small and early stage companies – access to capital and depth of management being two.

However, the law of large numbers provides that as a pool of employees approaches a large number – hundreds or thousands – the typical employee will be average.

When, on the other hand, you’re only hiring a small team, you can select the best and have a team that is above average overall. 

This is a key advantage that early stage companies have over their large business counterparts and should be exploited.

The Conundrum Cure

Founders should always hire “full buckets” – employees who have experience and the necessary skill set to be productive from day one.  Even if it takes a bit longer to find this person, it will be time well spent.

That’s all good, you say, but what about the money?

The Fundamental Misconception

The decision to hire family or inexperienced or limited skills employees comes from the fundamental misconception that all workers are looking for money as their primary compensation.  I assure you they’re not.

Many employees, however, are looking for an environment that only an early stage company can provide.  They want to be part of something bigger than themselves.  They want to grow a business, but don’t have the skills to do it themselves.  They want to feel the entrepreneurial spirit in action. 

These are the people you need to find and they’re in your resume pool.

Of course, competitive advantage and great environment are all well and good, but you’ve got to compensate employees – the food store doesn’t accept smiles as payment.

This is where the typical startup turns to stock.

Avoiding the Tax Quagmire

The problem is that giving away stock is a big tax nightmare.  The IRS treats the stock as the equivalent of a check equal to the fair market value of the shares.  When an employee receives a paycheck, it’s a taxable event for both the employee and the employer.

The employee has to pay income tax on the value of the shares and the employer must pay the employer portions of FICA and Medicare.  (Of course, the best way to kill your company fast is to mess with the IRS and not pay your taxes.)

Plus, as the value of the shares (check) go up over time, the tax problem becomes bigger and bigger.  Each grant of shares is worth more, so there are more taxes due.

Employee Stock Options

This is where an employee stock option plan is appropriate.

Each stock option gives the employee the right to buy one share of stock at a set price over a long period of time – usually between 5 and 10 years.

The employee can hold the option and exercise it (i.e., buy the stock) just before the exit event, thereby participating in the exit and receiving part of the buyout price, but not having any cash at risk.

When set up in accordance with the requirements of the tax code, the grant of options to the employee isn’t taxable income.  Yet the employee is compensated by participating in the upside potential of the business.

Just How Many Options Should You Grant an Employee?

Deciding how many options to grant an employee is similar to the process of deciding how much equity to give a sweat equity founder.  It’s all about the value that is effectively being contributed to the company by the under-compensated employee and the value of the company at that time.

What is the Employee’s ‘Effective’ Contribution?

To determine the employee’s effective contribution, take the difference between the fair market salary of the employee and the amount the company will actually pay the employee (until it pays her a fair market salary) and divide it by the number of pay periods over that time.  This is the effective contribution of the employee for each pay period.

Because employee’s contribution is made at each pay date (when the company doesn’t have to pay that money to the employee), today’s value of that contribution is the present value of those payments from hiring until the time she’s paid a fair market salary.

Calculating the Number of Options to Grant for Reduced Salary

The starting point for the amount of options to be issued the employee (as a percentage of the issued and outstanding stock) is:

Present Value of the Effective Contribution

(Present Value of the Effective Contribution + Today’s Company Value)

Example.

Online Widgetz, Inc., just completed a seed round of funding with a post-money valuation of $1.5MM.  Company management believes its cost of capital is 8%.

Online Widgetz wants to hire John, a developer, at $50,000 per year for one year until the A Round of financing is completed when it will adjust his salary to a market rate of $100,000 per year.

Therefore, the value of John’s effective contribution at the date he’s hired (using the present value analysis described above and an 8% discount rate) is $47,981.42.

Using the above formula, a starting point for John’s options is:

$47,981.42

$1,547,981.42.

Therefore, John should be granted options to purchase approximately 3.1% of the issued and outstanding shares of stock of Online Widgetz as of the date he’s hired.

There are limitations with this method that should be addressed through adjustments, including:

  • Different values of preferred shares and common stock based on rights and privileges.
  • Tax code restrictions on pricing for certain highly compensated individuals. 

Plus the calculation does not include incentive shares that would normally be granted a key employee.  It only addresses compensation for a below market salary.

Of course, as with any time there is more than one shareholder of a corporation, there must be a shareholders agreement and that agreement must give the company the option to repurchase the shares of a former employee.  And the requirements of employment laws, including the Fair Labor Standards Act, must be complied with.

Overall, though, this process provides a means to approximate the correct number of options to grant an employee who is not being compensated at fair market rates.

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