Jay Parkhill January 13th, 2009
This situation comes up for me all the time and it is really hard to manage in a way that makes everyone happy.
The scenario is that founders A and B start a company and split the initial shares. Time passes, business happens. The company may or may not take on investors or issue equity to employees, but the business grows one way or another to the point that even by the most conservative valuation methodology- free cash on the balance sheet- the company can no longer justify the super-duper-low stock price the founders paid.
Person C them comes into the picture. C is an extremely high-powered executive who can bring tremendous value. A and B want to treat C as effectively a co-founder and give her a share of equity equal to theirs. The challenge is that since the company now has real value, C’s share of it can be expensive.
A, B and C come to me and say “please do your legal magic and make this all work out right”. Sadly, there is no magic here, just a bunch of unhappy compromises. There are three main intertwined issues: how much the stock costs, when to pay for it and what the tax consequences will be. Here’s my shot at acknowledging them and pointing out the options in 500 words or less.
What the Stock Costs
This is simple on its face. Per share value = company valuation / number of shares. The valuation number is the toughest variable to work out, and the methodology we use depends in part on IRS rules.
When to Pay For the Stock
Wherever possible, we want to buy the stock early. Owning stock outright starts the capital gains clock ticking and that can make a big difference when the company is sold (the SEC’s Rule 144 holding period starts at the same time). Owning a stock option does not count toward the capital gains period until the option is exercised.
What are the Tax Issues to Dodge?
The two big ones are capital gains rules, which require the stock to be held for one year before it is sold, and Section 409A, which imposes a penalty on stock or options issued as “deferred compensation” (i.e. basically any equity issued now and paid for later) if the stock or options are issued at a price deemed below fair market value (more on 409A here).
And here are the preferred ways to handle this situation, with their attendant drawbacks.
Buy the Stock
This is the cleanest option. Buying the stock outright avoids 409A issues completely and starts the capital gains clock. In my experience, though, most people do the math and decide that a year or two of sweat equity is one level of risk, but cash is something else entirely. Most people opt not to take this option, especially when the price is in the 5, 6 or 7 figure range.
This used to be everyone’s favorite way to handle this situation, and it may still be the best. If the company has real value, co-founder C could have a huge bill to get her stock. Options let her defer payment of the price until she knows the company is going to be worth something (esp. the night before the company is sold).
409A throws up one roadblock here. To avoid the 20% penalties, the company will need a valuation of its stock. This is often manageable, though no one likes paying ~$10,000 for the valuation.
The bigger drawback is that she will probably lose her shot at capital gains treatment. She would need to exercise a year before the company is sold to get into capital gains land, and if the exercise price is high that may not be feasible.
Historically, more of my clients have elected this option than any other. No one likes paying taxes, but at least this option limits the risks (assuming the 409A issue is handled well).
Back in the dot-com days this was popular. Executive buys the stock and gives the company a promissory note for the purchase price, intending that the company would either forgive repayment or Executive would repay it from sale of the stock in a merger or IPO. When the companies hit the wall, however, bankruptcy trustees seized on these notes as collectible debt and a number of very unhappy conversations followed (“you mean I got almost no salary, my stock is worthless *and* I need to pay you $200,000?!?”).
A promissory note would work for C’s purposes, but it carries a lot of risk. It is a promise to pay the company and if things don’t go as expected C can find herself not merely uncompensated for her time spent with the company, but actually owing money to it. Once in a while a situation arises where this arrangement can make sense, but it is rare.
Is That It?
That’s what A, B and C always ask me when we talk through the possibilities. Unfortunately the answer is yes. We use the most favorable valuation we can justify to bring the price down (assuming we have any flexibility there), but in the end the whole purchase price must be paid. C can pay up front or she can pay later, but there is no way to do what clients really want- which is to sneak C in at the original founder price.
The lesson? There are two, I think. (1) get in as early as possible; and (2) get your stock documented right when you arrive before the deal gets any worse.