Jason Graham and Michael Hough are managing directors at tax, valuation, and finance advisory WTAS’ Private Client Services practices.

Jill and Carl Hardwork were in the final stages of negotiating the sale of their company. For 10 years they worked tirelessly to build their business from a bright spark in their minds to a successful, profitable company. Being a small fish in a big pond, their success drew notice from the “big boys” and now this deal was about to close. We were introduced to them to talk about how to plan for their tax bills relating to the impending sale.

Carl, the CTO of the company, handled the bulk of the couple’s finances. He outlined the economics of the deal to us, specifically as it related to their personal take. He explained that they were expecting to get about $20 million of cash proceeds. Although that represented a nice chunk of the entire deal, it became immediately clear that the founders’ stock portion of their proceeds would be miniscule.

“Yeah,” Jill, the CEO explained ruefully, “we had to raise so much money over the years that our founders’ shares represent less than 1% of our final take. But the investors were smart; they knew they needed us to stay motivated so most of our equity is nonqualified stock options now. Of course, we are also going to get an equity package as part of our new compensation arrangement with the buyer.”

We were astounded. To get so heavily diluted was one thing—sometimes you need to do that if you are going to make the dream come true—but to end up with stock options as the solution was a real shame. The income tax bite would cut their net cash nearly in half! The new equity they receive as part of their new deal, in reality, should not count. THAT should be their entitlement to the value they create in the future for the work they do after the deal.

Here is how the tax economics work: Selling founder’s stock, after owning it for 10 years, would generate a maximum federal income tax bite of 15% (in 2012). However, cashing out their stock options will cost them about 36.5% in federal taxes. Exercising and selling or simply cashing out these options (they were basically all nonqualified options) generates the same answer for Carl and Jill: a huge incremental tax bill.

This was no surprise to them.  As Jill explained, “We looked at other options like stock grants or loans. We were advised they wouldn’t work because our valuation kept increasing. So we were stuck with stock options.”

That advice cost these founders millions of dollars.

Many emerging companies and their founders get seriously diluted through rounds of venture capital financing. They give away stake in the company in order to secure the essential funding they need to make that company successful. Like the entrepreneurs in this example, many do this by granting stock options. What entrepreneurs don’t realize is that with this approach they are setting themselves up for an ugly tax situation down the road. If you are in this kind of situation, there are other options to evaluate before caving in on a really bad tax answer.

In today’s world, the name of the game for key founders, executives, and other talent should be equity compensation in the form of stock. Not options. Stock. This is because stock, after it is owned for a year, can be sold and taxed at the lowest possible tax rates — anywhere from zero to 15% in 2012. Starting in 2013, the range will begin at least at 3.8% and could run as high as 23.8% depending on what games the politicians play. Contrast that with a stock option where an exercise and sale in connection with an exit will be taxed at the highest possible federal tax rate — next year potentially over 40%.

Here are some practical approaches to operating a company when dilution is a fact of life  — they assume some basic knowledge of how most venture financing works.

Boston Common Stock – A New Twist for this Old Problem
When a company raises a round of financing, it will typically issue preferred stock. In most cases, the company and the VCs horse-trade for the best terms, but in the end they come to agreement on a basic enterprise value. When you strip away the value of the preferred stock, there remains inherent value in the common stock and that value often increases as successive rounds value the company higher. It is one thing to grant executives stock at 10 cents. It is quite another to try at $10. Grants of stock may be taxable on the day of the grant, so large value shares are a real tax problem for the recipient. Companies solve this problem — or think they do — by granting employees stock options instead. To meet the current tax and accounting rules, the option strike price must equal the current fair value of a share. As a result, the employee only gets value to the extent the stock increases in worth over time.

The Boston Common Stock solution is very simple. On the day of the latest round (or other valuation point), do not just issue preferred stock to the new investors. Also, convert your existing common stock into Boston Common Stock. This stock looks and feels just like the most junior preferred stock in the cap table. Its terms are designed to soak up as much of the remaining value (after the investors’ preferred stock) of the company as possible. Next, issue new, common stock to your executive group. Since the bulk of the value has been plugged into the Boston Common, the new stock grants can be very nominally valued.

Here is an example:  Melinda and Kellie founded NewIdea three years ago. Their latest round of venture financing is about to value the company at $20 million. When the round closes, their founders’ stock will represent 2% of the company on a fully diluted basis. All other employees are option holders whose stakes represent another 3% in total. Let’s pause here for a moment. Translated, this all means that if the company closes up shop tomorrow, the investors get $19 million and the founders get 40% of $1 million, and so forth. OK, now press “Play”:  The investors agree that the founders need a total of 10% equity in order to be properly incented to continue to perform. If they follow the traditional model that Jill and Carl used to get an extra 8% equity stake (even though it is only on the upside, not the total value), the company will grant stock options to Melinda and Kellie. The 409A valuation sets the value of a 1% ownership stake at $100,000. So their grant gives them eight percentage points more and their strike price will be $800,000.

Here is the Boston Common variation. Simultaneous with the financing, create a new class of stock — Boston Common. Convert the existing $1 million of common value into that class. Issue brand new common stock to Melinda and Kellie to top them off at 10%. Pause: This means that if the company liquidates tomorrow, Melinda and Kellie get nil for their new stock. They DO participate in the value of their just converted/issued Boston Common at $400,000. Play: If essentially 100% of the value of the company is embedded in the terms of the preferred and the Boston Common, the regular common stock issued to Kellie and Melinda will be worth very little — presumably pennies on the dollar. This could mean that instead of a valuation requiring an option strike price of $800,000 they could receive an outright grant for a small fraction of that value.

Of course, you need to work hand in glove with your valuation specialists in order to avoid accounting and 409A problems. The Boston Common Stock can have normal vesting and other employment oriented restrictions. Importantly, for the recipients, it can give them the ability to start their capital gains clock ticking and cut their eventual tax cost in half or more.

“Cost-Less” Stock Grants
It is not commonly understood that a profitable company can afford to grant employees free stock and it could cost everyone nothing. This is true even if the stock is worth a lot of money now. Here’s how you do it:

Assume you want to grant an employee $100 worth of stock (or, add as many zeroes as you like). Grant the employee the stock free AND pay her a bonus of $66 cash. For purposes of this illustration, let’s assume her tax rate and the company’s is 40%. From the employee’s perspective, she has $166 of income and owes $66 in tax. The cash bonus covers that, so she is out of pocket zero and now owns the stock. On the company’s side, it gets a tax deduction for $166 but is out of pocket only $66 in cash. The profitable company’s tax refund as a result of the deduction is $66. That covers the entire cash outlay. Yes, the company needs to take a P/L charge, but in the right circumstances and with savvy investors, this shouldn’t be a roadblock. Free stock. Good deal!

Bonuses, Loans and Other Fun Things
Private businesses have much more flexibility than public companies in arranging employee financing. A private company is allowed to loan its employees the money they may need to, for example, purchase stock from the company. There are tax rules that need to be followed, but there is usually ample opportunity for employers to help their key people get skin in the game. Planning for eventual repayment or bonuses to handle repayment is important, but the long term benefits to the employees can be substantial. This can represent substantial savings to an employee when combined with something like Boston Common.

The bottom line here is that there are solutions to dilution. Companies and their investors are typically NOT looking to their key employees to raise capital. Rather, they use equity to attract, retain and motivate. Enlightened companies will be sensitive to the enormous tax burden an employee could face if their equity is poorly structured and they will take cost effective steps to help.

[Top image credit: Sergej Khakimullin/Shutterstock]