Getting Funded

Lauren Celano – Founder and CEO Propel Careers.

I attended the Sept 22, 2010 TCN lunch program at Wolf and Company on “Equity Compensation & the Perils of 409A”. Scott Goodwin, the head of the technology practice for Wolf and Company and Michelle Basil, with Nutter McClennen and Fish LLP led a very in-depth discussion of this important topic which is relevant to all early stage entrepreneurs. In the room were individuals from many different types of companies in different sectors leading to diverse perspectives and questions. After the meeting, I reflected on how important this issue is with respect to bringing on employees to help grow a team. For companies, a firm understanding of equity compensation and its implications is critical to attract, retain, and align employees and protect your company from legal ramifications associated with non-compliance.

One sage word of advice from both Michelle and Scott before we dove into the presentation and discussion was to always contact your lawyer before enacting a stock option plan. This seems like a very reasonable thing to do, but some companies will enact option plans without considering legal input leading to inopportune outcomes….

Goals of Stock Options Plans

The entire goal for all stock option plans is to attract and retain employees and align them with the goals of the company. There are different intricacies within each plan, but companies and employees should remember this overarching goal: if things go well and the company exits for a large payout, then everyone holding options should benefit. For many early stage companies, options provide the ability to create incentives that are not tied directly to salaries, which can help them manage their resources and still attract top talent. We all know companies whose employees have benefited greatly from options – remember Microsoft and Google – and early stage ventures count on attracting people who are want to be part of the “next Google” and are comfortable with a higher risk/higher reward equation.

In thinking about a stock option plan, many emerging companies provide options to all employees but at different levels. The company typically sets out 15-20% of the equity for an options plan. In a series A, the VC likes to see this range since it typically provides the company an appropriate number of shares to incentive, attract and retain employees.

Samples for equity distribution:

§ New CEO – 5-8% on average

§ VP’s, CXO – 1-2% on average

§ Director/BOD – 0.5%

The option pool should last for a while – sometimes founders are too eager in giving out equity to early employees in a company and this can cause problems as the company grows if too much is handed out too early. This is especially true if the time it takes to develop a technology or reach an inflection point takes longer than expected. Without enough of an options pool, the ability to provide appropriate compensation and upside potential diminishes for future employees. This could hurt the ability to hire top talent, which is crucial to reach critical milestones. Lesson Learned – be careful in giving equity out and provide incentives for individuals to earn all of it. To align incentives, vesting is preferred, typically cliff vesting for the 1^st year and quarterly after this. This ensures that individuals who stay with the company are rewarded for their time and effort. The worst thing you can do is give, for example, 10% of the company to someone with no vesting, then two months later, the person leaves to get a “real paying job”. This person is no longer contributing, and they own a large stake in the company, which limits your ability to provide compensation to people who are really helping the company grow.

As a founder, it is completely justifiable to put vesting and milestones payment structures into the plan. Ultimately, you want to do what’s best for your company and this means making sure everyone who is a part of your organization (now and in the future) is aligned and incented to perform and drive your business to the end goal. Since the options pool comes out of the original founders equity, they really need to create incentives that are tied to success, otherwise you are doing yourself and the company a disservice.

Remember, the goal of an options plan is to align goals and incent ALL employees, including founders. Also remember, many times, post outside investment, option vesting provisions are set up to retain the founding team since success is not just about the technology. Doing this helps to align the investors and the team - ultimately everyone wants the company to be successful and to be rewarded for success.

Logistics of stock option plans

The Board of directors administers the plans and the parameters needed to determine fair market value. Typically options are non-transferrable and companies will have different versions of agreements for individuals (employers, consultants, and independent contractors) associated with their companies. Many companies typically use cliff vesting for 1 year, then quarterly after that. Plans usually outlines repurchase rights for employees who leave the co, do not exercise rights, etc. Documentation is CRITICAL. If a company gets to a stage for outside investment, the investors will review and audit the forms, so the company should, ensure everything is straightforwardly outlined. There is no need to make the investors’ jobs harder and give them a reason to second-guess a possible investment just because the company did not have good documentation.

Founders shares are usually non-compensatory salary since at the time of company formation, the shares typically have no value. There is a certain time period to issue founders shares and the value of the shares is created over time. To reissue these, you need to determine if “value” has been created, and if so, they can be swapped out - options are the most common form.

In the US, there are two types of options that are typically granted:

Incentive stock options (ISOs). These have a tax benefit for employees. The options are not considered as property by the IRS and therefore not taxed. On exercise, the individual does not have to pay ordinary income tax on the difference between the exercise price and the fair market value of the shares issued. These are only available for employees. These can only be offered by corporations (C and S)

Although ISO are seen to be the “Holy Grail”, the % of ISO holders who realize ISO benefit is small. For rank and file employees, the non-qualified options seem to be better. With options, these do not lead to true dilution of equity since if people leave or don’t exercise their options, etc then the options go back into the options pool.

Non-qualified options (NQSOs or NSOs). These do not qualify for the special tax treatment. NSOs result in additional taxable income to the recipient when they are exercised, with the amount being the difference between the exercise value and the FMV on the date of issue. Employers typically prefer these since they can take the tax deduction equal to the amount the recipient is required to include in their income.

83(b). Issuing shares of stock with restrictions such as vesting can be beneficial if value is low, as with most early stage companies. Employees can do the 83(b) election that allows the employee to avoid the possibility of substantial income in the future upon the lapse of the restrictions contained in the buy-back agreement. 83b allows employees to file and pay tax now since value can increase over time. This is good if the value is low, however, if the company fails the employee would be out of luck since the tax was already paid.

409a. Section 409a, of the Internal Revenue Code, deals with the treatment of non-qualified deferred compensation given to individuals. These individuals could include employees, BOD, or in some cases, independent contractors. Companies should get a valuation of fair market value for their options. If this is not done, then an employee receiving the options could have a tax problem (instead of this being a benefit) and the tax problem could include the following: Ordinary income tax, 20% penalty withholdings, interest and penalty for late payment tax bill could be issued even before exercising. The company could also have a problem such as: being liable for misholdings, employee issues, and Potential liability for employee taxes also

Valuation Methodology. Valuations are usable for up to 12 months. Many companies do either annual or 6-month valuations. This depends upon the company and the relevant financial milestones and significant events. Typically, companies utilize the services of a valuation firm, however, an internal company representative could also do this if they meet specific requirements.

Considerations for a LLC. LLC’s would need to offer membership shares. To incent employees, a profit interest could also be given. If a LLC gives stock to an employee and the employee exercises it, then the employee becomes a member. This means that the employee would need to utilize a K1 creating tax implications for them.

Venture Fast Track Program

TCN has a Venture Fast Track Program, which is a One Day Boot Camp for VC and Angel Success on November 9, 2010. This program will go over all of these details in much more depth. See link for more details

http://www.thecapitalnetwork.org/programs.bootcamp.home.php