Startup Toolbox

Jay Parkhill September 4th, 2008

One of the toughest conversations I have with many startup founders is about salaries.  Founders may come from larger companies that pay them an annual salary and the idea of getting *no* cash for a significant period of time is really hard to wrap one’s mind around.  The argument goes something like this:

“I make $X currently, I know I am worth that much and I really need to get the cash.  I can defer collecting it for a little while, but I need to catch up at some point.”

My humble suggestion is always the same- don’t think about it that way.  You are building equity in a new business.  The equity is your return.  You are unlikely to see your “deferred” salary repaid in that way, so make sure you have enough stock in the business to give the upside you need and work toward making that worth something.

There are really two alternatives to this, neither of which is feasible: accruing a hypothetical salary to be repaid when some large bundle of cash hits the company’s accounts through financing or sales efforts, and taking stock in lieu of cash.

The Extra Cash Theory

The repayment on filling the coffers approach is based on the false premise that at some point there will be “extra cash” available.  This never happens.  Investors put money into a business in order to build structures that will take the business down the road.  Seeing their cash go straight through a company’s bank account is anathema- except when a founder has actually put in cash without getting stock for it.

The revenue argument is probably even worse.  Revenue is hard to come by and most businesses don’t see enough of it to justify paying back salaries on top of current ones and other business expenses.  The idea of generating enough revenue to cover accrued/deferred salaries is a fantasy in almost all cases.

Stock for Salaries

The stock-for-salary proposal is actually much worse than the extra cash idea.  What many founders don’t realize is that the IRS treats stock in that case exactly the same as cash and taxes it at the same rate.  If a founder accrues $100k in salary and collects it in stock she still has $100k in income to report.

The problem is that she has $100k worth of illiquid stock, a tax bill of $35k or so and no cash to pay the taxes.  This is not a happy situation for anyone.

No Deferral, No Salary, Just Stock

The way out of the dilemma is to give up on the idea of taking much cash out of the business in the early going.  Buy your founder stock (for cash!) at a very low price when you start the business.  That is what you get instead of a salary, so be mindful of unnecessary dilution (no “advisory” options to friends and relatives) and work on making that stock as valuable as you possibly can.  You may not see much cash for a couple of years or more, but if you are lucky the stock will more than compensate for the sacrifices made in the early days.

• Startups , Taxation , capitalization , founders
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Jay Parkhill March 6th, 2007

The California Department of Corporations seems likely to adopt a new set of rules affecting compensatory benefit plans by the end of March. The rules cover a variety of plan types, but stock option plans are the most commonly used type of plan.

Vesting Terms Reflect Real Life
The new rules generally conform California law to IRS rules. California has a few requirements that aren’t covered by the IRS, so the changes will help to avoid a few different “gotchas”. Some of them are basically stenographic, such as the (soon to be former) requirement that options vest at least 20% per year. I have not yet worked with a company that used a 5 year or longer vesting period, so the issue was moot for all practical purposes, but the language still needed to be in the plan. It always makes me happy when I cut language out of a document, so this is a nice step.

2/3 Shareholder Voting to be (Mostly) Eliminated
The other notable “gotcha” is the funny rule that companies can not have options outstanding to purchase shares in excess of 30% of the company’s capitalization without 2/3 shareholder approval. The new rules would eliminate the 2/3 voting requirement (majority vote for option plans is still required for favorable tax treatment) if the plan otherwise complies with IRS rules.

It is the rare company that *needs* that many options outstanding, but I have once or twice encountered a situation in which it made sense, esp. the “late co-founder” situation where a person comes in after the stock price has risen and assumes such a critical role that s/he should be treated as a de facto co-founder for equity purposes.

In those cases, it may be too expensive for him/her to buy founder’s stock and an option is the simplest way to get a substantial equity share to the person. Once or twice I have worked with companies where it has made sense to authorize options in this situation, pushing it up to the 30% of outstanding capital limit. Shareholder voting would not be required to issue stock outright to the person, so it is nice to see that the voting requirement has been eliminated if the equity comes as an option as well.

California Steps into Line
All in all, the new rules aren’t particularly momentous, but that is really the point. California is such outlier on so many issues, with its own special rules, that it is nice to see it simply come into line with “standards”.

• Securities , Startups , Taxation
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Jay Parkhill October 30th, 2006

This is a fascinating area opening up in the frequently mundane area of tax law. Given the sophistication of online games and communities and the relative stability of the markets in those environments, should tax authorities have jurisdicition over virtual transactions?

Reuters reports (through Second Life correspondent Adam Reuters, of course) that the US Congress’s Joint Economic Committee has taken notice of the question and is presently rolling around the various permutations. Wagner James Au also gives the scoop on Gigaom.

It is an established fact that if one makes Linden Dollars in Second Life and sells them in the real world for US Dollars, the IRS wants to know about it.

What makes things interesting is that “virtual” markets have become so stable and robust that virtual gains and losses may start to take on attributes that would be considered taxable in the real world. In other words, if a suit of Elven mail from World of Warcraft could be sold for near-equivalent value to numerous buyers at different times, should that armor be deemed an asset for tax purposes?

The IRS’s barter rules show just how deep this particular rabbit hole might go. Under barter rules, goods received through trade or game winnings have value when they change hands, not merely when sold.

Even further, items obtained as prizes could be subject to taxation as, you guessed it, prize earnings. Does this mean that every gold piece won from every slain orc would have to be declared?

And a moral/legal fun question: if my WoW avatar is a thief, do I need to declare to the IRS my ill-gotten gains? On what tax return schedule should these earnings be presented?

I agree with Au that Congress is likely to spend a long time looking at these questions and probably far longer working with the IRS to come up with a set of rules, if it ever gets that far.

If, however, Congress and the IRS do move to tax these assets, the landscape of game development and hosting may be in for a major jolt. Game publishers might be required to 1099 each subscriber every year for “gains” made. If that happens, Linden Labs will look prescient. By sticking to its policy of providing the environment alone and leaving it to users to build and manage just about everything inside, it strikes me that they will stand the best chance of escaping the administrative nightmare that scenario presents.

• Taxation
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