LEGAL ADVICE BY ARTHUR L. WEISS, ATTORNEY Dear Art: I have this great idea for a tech company! I also have the resources, talent and funds to make it happen. But before I get started, I want to ensure I've protected myself from a legal standpoint. What do I need to do?
Just about every technology startup has two things in common: (1) it needs highly skilled and visionary employees and (2) it lacks the funds to pay them. Hence the rise of equity compensation, the use of corporate stock or options to make up for the financial shortfall. The concept seems easy, pay what you can afford and issue some company stock to make up the difference. This serves two complementary purposes, it saves whatever money the company has in the bank and it aligns the interests of the founder with those of the employees. It should be pretty simple to do, an entry in a spreadsheet or a capitalization table, maybe issuing a pretty stock certificate for the shares. Unfortunately, the IRS sees things differently. Relying on their basic principle – why make things simple when you can make them complicated? – the IRS has rules, exceptions to the rules and exceptions to the exceptions. It is a veritable alphabet soup of choices (ISO, NSO, RSU, RSA, NQDF) each with its own rules, tax postures and traps. What is common to each of these choices is the need for a well-drafted, comprehensive plan. If you are planning on only issuing stock as compensation then the plan need not address all the other types of equity compensation. However, if you are planning now or in the future to issue options, stock, warrants, etc, then you should bite the bullet upfront and have an “omnibus” plan drafted to cover all the bases.
For now, let’s limit the discussion to the plan to issue corporate stock as compensation. In its book Selected Issues in Equity Compensation, the National Center for Employee Ownership (www.nceo.org) suggests you use the plan to establish both policies and procedures for the stock issue. Policies should establish the objectives of the issue and address the administrative mechanisms needed to efficiently oversee the project. This plan will serve as a roadmap for the Board of Directors (I know right now your corporation is just you and your friend Darryl, but that is going to change) to determine who will be eligible for a stock award, how much the award should be and the attributes of the stock issued to the lucky few. For example, will the stock be issued outright or will it vest over time? If vesting, what will the schedule be? What voting rights will go along with the unvested shares? What dividend rights will go with the unvested shares. It is not common for unvested shares to have either voting or dividend rights, but that could be a matter of negotiation in your company. Clarifying that issue in the plan of stock issuance closes off negotiation. You get to decide.
The plan should also cover the procedures the company will use to issue the shares, valuation of the shares and tax withholding as necessary. Obviously, this very short list is not exhaustive. As your company grows, the administrative burden of tracking all of these transactions, vesting, additional issues, updating the capitalization table, will increase dramatically. It is important to remember that the founders’ skills are usually not aligned perfectly with these onerous tasks. The procedural aspect of the overall plan will address who and how the company will distribute the administrative workload to ensure it is done in accordance with good corporate governance and in compliance with the Securities and Exchange Commission rules and federal tax law. Running afoul of either of these is not a good result.
It is the Board of Directors that establishes an award, who gets the award and how much the award will be. It usually does this at a regular meeting of the Board where the corporate secretary is present and taking the minutes of the meeting, which will include the stock issuance as an agenda item, what Board members were present, who voted on it and how they voted. Once approved by the Board members, the minutes become a permanent part of the record. The mechanism for accomplishing these important tasks will be spelled out in the plan. As an aside and as an attorney who has handled corporate clients for decades I recommend you purchase a “Corporate Book” to keep track of the many documents that will memorialize your growth from a startup with a great idea to a multinational technology firm. It is worth the $100 at the beginning.
Having started many companies myself, some with good results, others not, I know that the objective of the company is to be successful, fulfilling and financially rewarding. There is another goal that is equally important – staying out of court, meaning you will not have to sue anyone and no one is going to sue you. Litigation is expensive, time-consuming and emotionally draining. It is also an unwanted distraction from the operations of the business. A well-drafted plan of equity compensation should reduce and hopefully eliminate the possibility of hurt feelings, unmet expectations, disgruntled employees and threats of “I’ll sue!!” The costs of drafting the plan will be well worth it if it lets management, staff and front-line employees know the rules of the game up front.
Final thought - I often get calls from clients asking about a particular issue of corporate governance and law. My question is usually the same – what do the by-laws say? Or, in the case of a limited liability company, “what does the Operating Agreement say?” One client responded, “Oh, that’s just a legal document.” Yes, it is, and it is a document, like the plan of stock issuance, that requires your full understanding and attention to make sure it expresses the needs and aspirations of the founders. As Benjamin Franklin wisely said – if you fail to plan, you should plan to fail. Or something like that.
