"More than 90% of startup companies around San Diego compensate the founders and senior staff with stock options, grants, or restricted stock" advises Mike Kinkelaar, Partner at Procopio, a San Diego Law Firm.
Mike joined three other panelists discussing "Sweat Equity" and senior management compensation at the San Diego Software Industry Council's Entrepreneur's Forum Thursday evening in San Diego (SDSIC).
Sweat equity refers to "the efforts of executives or other shareholders into a company. This does not include money that is put into a business, which is financial equity. It is the time and knowledge that an individual or a group of individuals put into a business to make a result." (BusinessFinance.Com)
The panelists represented a very diverse group including lawyers, a couple of serial entrepreneurs, and a CPA who was very familiar with assisting start up companies and their executive compensation plans. Those members were:
- Joe Perohit, serial entrepreneur and CEO of EcoLayers
- Mike Kinkelaar, partner at Procopio
- Daniel Cunningham, serial entrepreneur and CEO at DPC Corporation
- Timothy Willis, CPA at Mayer, Hoffman, and McCann P.C.
Who deserves Sweat Equity Compensation?
The panel discussed this is great detail during their panel discussion, as well as during the Q&A session following their panel remarks. After a bit of debate, the panel and attendees finally settled on the following model for sweat equity compensation (SEC):
- Those who contribute to the company in early stages who are willing to accept ownership and shares in the company rather than pure cash compensation
- Avoid SEC grants or compensation for mercenaries, or those who may leave the company as soon as their shares are vested (Joe)
- Those senior people who are already financially stable, and will be able to stick out the early phases of the company without a desperate need for cash (Mike)
- Younger people, newlyweds, new home owners, YUPPIES with expensive tastes in cars, etc., are not generally good candidates for high levels of sweat equity, as they will have a need for higher levels of cash, and will probably not be able to stay in a startup for a long period of time while waiting out the valuation of their potential stock shares
- Those who offer a very unique contribution to the startup company. This could include engineers with the intellectual property needed for the company's product, or those who are needed for the founders to go to investment bankers and the market for additional development funding
Understanding the Types of Startup Sweat Equity Compensation
The panel introduced and discussed four major types of SEC, and went into a bit of detail on the descriptions of each. While there are obviously clear legal and financial descriptions available for each category of SEC, it was refreshing to hear the panel paraphrase those categories.
- Stock/ownership grants. This is really straight ownership of the company. Each stock grant has value, and presents a voting right for the company. This should only be considered for the founders, and possibly one or two C-Level executives. Grants are considered as income to the IRS and state.
- Stock options. Given more freely to employees. Most often these are incentive grants, either allocated as a signing bonus, or as additional compensation for better performance. Vesting period is normally around 2 years, at which point the employee is eligible to purchase ownership in the company.
- Warrants. Normally only issued to financiers and banks - not recommended for employees or senior management. This is legally considered a form of stock option.
- Non-Incentive Stock Options. This is more on the line of friends and family options, and given to those who would not normally receive an option based on performance or other incentives.
Of course there are other forms of stock, ownership, and management of those forms of equity distribution, however the above are those most commonly used as tools by startup companies to provide additional ownership incentives to owners, employees, investors, and financiers.
Setting up Your Sweat Equity Compensation Plan
All panelists were in violent agreement on a few major points. The main point is to ensure you consult with a lawyer when legally setting up your SEC plan. Mike emphasized this is not a lengthy or expensive process, as all reputable law firms have this plan on the shelf.
With the number of startup companies emerging each year, law firms deal with the SEC plan as a routine part of the startup process. It is well-understood, simple if done up front in the startup process, and not difficult to understand.
Additional points made by the panel included:
- Consult with a local small business bureau. Most cities or counties have a very good group of volunteers and professionals happy to assist startup companies with their structure and compensation planning.
- Keep your legal documents as simple as possible.
- Make sure your SEC documents are complete - do not defer items to a later, this will nearly always result in unforeseen tax and legal issues.
- Set up the volume and percentages of shares allocated to grants, options, and warrants at the beginning, again even if you do not plan to allocate right away.
- Ensure the founders and early stage recipients of SEC fully understand the compensation plan, as most problems and legal disputes with ownership and options occur with founders or senior SEC recipients who leave the company, are disgruntled, or have other issues with the founders.
- Establish a qualified stock option plan as quickly as possible - even if you do not plan to use sweat equity compensation in the early stages. It is best to have this legal framework in place from the beginning.
- Do not allow accelerated vesting of shares for other than founders or C-Level executives. This may result in a potential buyer finding the cost of acquisition much more expensive due to the ownership of shares becoming a higher cost to the buyer.
Some Additional Considerations Concerning Employees
Most employees do not understand the concept of stock options, grants, and taxation. Many employees do not understand items as simple as grants being considered income, and options being considered something for which you eventually will have to pay tax.
There are many people who get hung up in the percentage of a company they will own due to grants and options. They do not understand that the only value to stock ownership percentages is when the share gives you the power of vote - and that vote is only useful when it has value within the articles of incorporation, or when it is not overruled by the board of directors.
Many people still believe that percentage ownership is the highest priority, when they should understand the only value of shares is actually when you are receiving distributions (unlikely with a startup company), when you sell your vested and common stock shares, or when an equity event (sale of the company) results in a new ownership "buy back" of your shares. The only value of shares is when you sell the shares and receive cash for those shares.
Dilution of share percentage ownership in a company is normal, and expected. This will only become more apparent as the company continues to grow, receives additional investments, is acquired, or becomes a public company. In short, control by a small group of individuals will be diluted if the company is successful.
Employees must also fully understand the tax implications of all categories of SEC. many states, including California, allow the employee to either pay for the value of an option or grant up front, or defer to a later date. Many, many young employees who do not understand the concept of stock options find themselves with huge tax liabilities when their options vest.
This should be explained and clear to employees up front so they do not both have a shock, as well as become disgruntled and ineefective if they are hit with a bad tax situation.
There were many more topics discussed, impossible to codify into a single blog. However a great panel, great audience, and a good use of a Thursday evening in Southern California.
The SDSIC is a great, Aggressive Organization Helping Entrepreneurs and the Tech Industry in San Diego
Silicon Valley - keep your eyes open to the south. San Diego is a very robust technology community, and organizations such as the SDSIC are focused on making it grow.
There are many retirees from US and international companies settling in the great communities surrounding San Diego, and many of those successful people are starting to give back to the community through organizations such as the SDSIC.
There is a great energy in the community, with very bright people being pumped out of schools such as San Diego State University and the University of California at San Diego. Both schools have robust tech programs, and both are well-respected on a national and global scale.
Another "Well Done" to the SDSIC, thanks to the panel, and we'll see you next time (check out the SDSIC schedule at http://www.sdsic.org/events.aspx
John Savageau, Long Beach