(Editor’s note: Caine Moss is a corporate and securities partner at Wilson Sonsini Goodrich & Rosati. He submitted this column to VentureBeat.)
In our startup practice, we see a number of common mistakes entrepreneurs make as they establish and grow their companies. Not surprisingly, many of these are made in the course of compensating employees and other service providers, which is a key area of activity early in a company’s life cycle.
Compensation-related pitfalls can be easily avoided if you know what to look out for. Once made, though, these five mistakes can put your company in a thorny legal predicament that can be difficult and costly to resolve.
Wage Deferral. One of the most common mistakes an early-stage startup makes is deferring founder wages and other compensation to save costs prior to raising a financing round. Unfortunately, this can lead to significant legal and tax liability.
Under California (and other) state laws, employees generally need to be paid at least minimum wage and must receive payment at least semi-monthly. No one – not even the owner – can exempt themselves from these requirements.
In our practice, we frequently deal with the fall-out from this problem, usually after an employee working for “sweat equity” gets fired, becomes disgruntled, talks to a lawyer, and then brings a wage and hour claim against the company.
One viable work-around for the wage issue is to pay employees minimum wage prior to funding, then increase their compensation (and give them a hefty bonus) when you secure funding.
Misclassification. To avoid having to pay wages to employees, some startups will classify service providers working full-time for the company as “consultants” and only issue them options, with the promise that they will become salaried employees once the company is funded. This is risky, as the IRS and state employment agencies are aware of this practice and have recently been investigating companies that are suspected of such “misclassification.”
Many startups are being audited over this issue, and end up paying very significant penalties and fines. There can also be misdemeanor criminal liability for willful failure to pay wages, so be very careful about the employee/consultant designation.
Premature Option Grants. Granting options to employees or other service providers before they start working for the company is another common mistake. Because granting options requires board approval – and because a startup’s board typically meets quarterly or monthly – companies will often seek board approval for option grants ahead of an employee’s start date to make things easier on an administrative level.
This can create a number of legal issues, though. Stock plans usually only allow option grants to be made to current service providers of the company as of the date of grant (i.e., date of board approval). Prospective service providers are not eligible until they join the company. As a result: To be valid, these premature grants must be characterized as having been made “outside of the stock plan.”
Grants outside the plan are not eligible for many commonly used securities law exemptions, and can therefore violate securities laws. They can also irritate investors who are forced to suffer ownership dilution beyond what they have agreed to under the stock plan.
Because premature stock grants often go unnoticed for long periods, there is no easy fix for them, such as re-granting the option on the same economic terms. They also have a tendency to be discovered in due diligence during a financing or company sale, adding delay and complication to the transaction.
Post-Termination Option Acceleration. Companies occasionally try to accelerate unvested options for employees after they have left the company to sweeten the terms of a severance offer and obtain a release of claims. Simply stated, this cannot be done.
At the time an employee leaves a company, his or her unvested options are immediately returned to the option pool and are no longer eligible for acceleration. To get the options to the terminated employee, the company has to approve a new fully-vested option grant for the number of unvested options that would have been accelerated and re-hire the former employer (at least for a temporary period) as an employee or consultant. Few boards are willing to jump through these hoops for someone they just let go.
The easy fix here is for a company to accelerate options before a person is let go or quits.
83(b) Elections. Although many entrepreneurs are sensitized to the need to make an 83(b) election for tax reasons, it’s surprising how frequently entrepreneurs miss the filing deadline.
An 83(b) election allows a startup founder to recognize income, if any, on the difference between the purchase price of his or her restricted stock and its fair market value. Generally, there is no income recognized at that time because, for founder’s stock, the purchase price is equal to the fair market value. Making an 83(b) election offers founders the benefit of starting the one year capital gains holding period for their stock at the time of purchase.
In order to get the tax benefit of the 83(b) election, however, it must be made with the IRS within 30 calendar days of the stock purchase, without exception. Miss it and you’ll have to recognize income at each vesting event based on the value at that time, without necessarily having any corresponding liquidity to pay for taxes due.
If the shares appreciate in value over time, this income can be significant. The lesson to founders: Be religious about filing your 83(b) election as soon as possible after you sign your restricted stock purchase agreement.
Dan Green, a senior associate at WSGR, contributed to this column.