Equity in Lieu of Cash – a Sticky Wicket!
Jun 13th, 2007 by admin
For the overwhelming majority of start-up companies the one irrefutable truism seems to be that “cash is king.” At least in my experience, the early stages of a company’s growth call for significant investment of capital and longer periods of negative cash flow than even the most conservative business plans tend to anticipate. Whether this is because the pre-revenue development stage is more prolonged than planned or because sales of products or services have not ramped according to plan, young “pre cash-flow-positive” companies have to employ creative tactics to stretch cash to the maximum.
One of the most frequent methods employed by early stage companies is to stretch their cash by using equity in lieu of cash to pay for all or part of a founder’s, employee’s or other contractor’s services. While this tactic will certainly allow a company to conserve cash it must be carefully considered or it can result in some undesirable consequences for both the company and the recipient. Aside from the obvious disadvantage of creating additional dilution of ownership, the tax ramifications of using equity in lieu of cash present unique challenges that must be addressed.
Take for example a scenario presented in a recent hypothetical call from a talented Northwest techie named Ed. Ed was recently laid off from a large pharmatech company. He was a young entrepreneur and excited to report that he had secured a commitment for investment in his biotech start up. His pre-revenue stage company had several patent applications pending and was going to receive $1.5 Million in seed financing through a private placement of preferred stock. However, only $1 Million was in the form of “new money”, the other $500,000 was to be paid in fully-vested preferred shares to be issued to Ed as an employee of the company for his “services in-kind” provided prior to the financing.
The first thing I did was congratulate Ed on lining up $1 Million in “new money” for his company; after all “cash is king” when you’re a pre-revenue company. The second thing I did was ask him whether he was prepared to deal with the potential tax liability involved in receiving $500,000 in restricted and possibly illiquid stock in a privately held company. After an awkward moment of silence, Ed spouted out – “What!!!??”
Equity Compensation in a nutshell
(a) Equity as Income to the Recipient.
In general, if someone receives fully-vested stock for services rendered, they will have to report compensation income at the time of receipt equal to the value of the stock minus the amount that they have paid for it, if any.
The tax consequences, of course, will depend on the value of the stock, namely, the fair market value of the stock at the time of receipt. For publicly traded companies with stock traded on an established securities market, fair market value can be easily determined and typically means that stock’s value on any given day and taken as the average between the high and low selling prices on that day. For very thinly traded stocks of public companies an average taken over several trading days may be more appropriate so that the possibility of a one day swing will not unduly distort average value.
But for privately held companies, generally the price at which the shares change hands in a transaction between unrelated parties determines what the fair market value of the stock is. An actual arm’s length transaction for the stock near in time to the date of grant will provide the best indicator of its value. However, often there are no recent sales. In that event, it is more appropriate to compute a value of the shares of the company by arriving at a valuation of all of the company’s assets and dividing by all outstanding shares. At a minimum, it would seem that the company’s book value (the value of all its assets minus all of its liabilities, as shown on the company’s financial statements) would be a good starting point for determining value, however many companies have a value that far exceeds book value; for example “good will” and “first mover/first to market” or other less tangible but still compelling values need to be factored in.
In the scenario presented above, the unrelated parties (Ed and his “new investors”) have arguably set the fair market value of the fully-vested preferred shares by stating that Ed is receiving $500,000 worth of preferred stock for “services in-kind.” On its face, the stated value of the stock granted for Ed’s services is “$500,000 worth of preferred stock.” In addition, Ed has no obligation to pay anything for the preferred shares. Moreover, the financing itself necessarily required the company and the outside “new investors” to negotiate a value the company and price the preferred shares issued based upon that valuation. Certainly, there won’t be a more recent pricing of preferred shares than the financing itself. Since Ed will be receiving equivalent preferred shares to those purchased by the outside “new investors” and since his shares will be “fully vested”, Ed will be potentially facing down a tax bill on income of $500,000.
In order to avoid a potentially costly tax bill Ed, the company and investors should seek the assistance of a qualified tax professional and/or appraiser. Given that Ed’s shares (and those issued to the “new investors”) will likely have an extremely limited marketability, the financing could be restructured slightly to provide Ed with a justifiable valuation discount that could apply to the value of Ed’s preferred shares. In addition, the company might consider i) placing restrictions including “risk of forfeiture” upon Ed’s preferred shares, ii) issuing Ed “non-vested” preferred shares, or even iii) issuing Ed a lesser class of preferred stock or common stock which could reasonably be valued at a lower price per share than the class of “fully-vested” preferred stock the investors will receive. Another possibility would be to compensate Ed for his “services-in-kind” in whole or in part with stock options or warrants.
(b) Company Obligation to Withhold.
In general, a company is required to withhold in situations where an employee is required to report compensation income. Withholding will be required when an employee receives a grant of vested stock based on the fair market value of the stock at the time of grant.
In Ed’s financing scenario, not only is Ed required to report his stock grant as compensation income, but because he is an employee, his company is required to pay withholdings to the IRS on the equity compensation it has granted to Ed.
If we changed the facts to provide that Ed was an independent contractor, the Company would not have to withhold, but it would still have to report income having as having been received by Ed to the IRS. Even if Ed were not an employee, he would still have to pay self employment taxes on the preferred stock grant as the IRS would treat the grant as other compensation for services.
Options as an Alternative
An option is a grant to an employee, officer, director, independent contractor or other third party of the right to purchase a company’s shares at a fixed price (the “exercise price”) and for a fixed period of time (the “option term”). Company’s granting options can also place restrictions on options including, vesting, limited transferability, limits upon when exercisable and lock up of shares purchased upon exercise of the option.
At least in privately held “pre-revenue” and/or “pre cash-flow-positive” companies, options are probably the best alternative for providing employees, contractors or other third parties a potential for equity participation in the company. From a tax perspective, options provide the recipient both an advantage from delaying tax recognition and the ability to “wait and see” when it is in the recipient’s best interests to exercise the option to purchase stock in a privately held company.
Typically in private, non-publicly traded companies an option to purchase stock has no “readily ascertainable value” and so there is no income recognition to the recipient upon receipt of the option.
(a) Non-Qualified Options.
Non-qualified option (NQSOs) are probably the most popular form of option in use today by privately held companies. In general, the recipient of an NQSO has no income to report at the time of receipt of a non-qualified option.
When one exercises a NQSO they have to report as income the difference, if any, between the value of the stock on the date of exercise and the amount paid for the stock. If the recipient of an option is an employee of the company issuing the option, any income reportable on the exercise date is also subject to withholding as well.
When one sells stock purchased by the exercise of a NQSO, provided they have held the stock for the required holding period prior to sale, they are entitled to report a capital gain or loss. Their basis in the stock includes the amount they paid to exercise their option to purchase the stock, as well as any income that they had to report, if any, at the time of their exercise of the option.
(b) Incentive Stock Options.
Incentive stock options (ISOs) are available only to employees of the company that issues them; they cannot be issued to independent contractors, directors or consultants. ISOs are actually “qualified” stock options that must meet a number of specific requirements under the Internal Revenue Code. In general, the recipient has no income to report at the time of receipt of an ISO. ISOs provide special tax advantages to the employees that receive them, however they are more complex to administer and add some tax disadvantages to the company issuing them.
When an employee exercises an ISO they do not have to report as income the difference, if any, between the value of the stock on the date of exercise and the amount paid for the stock, however, they do have to make an alternative minimum tax (AMT) calculation factoring in the difference, and may end up having to pay a significant amount of tax in that tax year depending upon the determination of their AMT calculation.
It is also significant that the favorable tax treatment for is limited; Of the options that become exercisable in any calendar year, only options covering the firs $100,000 of stock are eligible for ISO treatment. Any options for excess over $100,000 of stock automatically receive NQSO treatment.
In addition, special holding periods apply to stock purchased through exercise of an ISO. If any employee sells stock they’ve purchased through exercise of an ISO before these holding periods elapse, then they will be required to report income at that time “a disqualifying disposition.”
If an employee sells stock that they’ve purchased through exercise of an ISO after satisfying the special holding periods, they will be able to pay report capital gain or loss at the time of sale and may be able to claim a credit for all or part of any of the AMT they paid in the year that they exercised the option.
Though there are significant tax recognition benefits that inure to employees with ISOs, Company’s are advised to seek professional legal and tax before setting up ISO plans and/or issuing any ISOs. Recent IRS regulations call for specific and detailed reporting and expensing of options.
In addition, options, regardless of whether they are ISOs or NQSOs are securities, and as such are subject to federal and state securities laws. Careful review of both federal and state “blue sky” laws are required to ensure that companies issuing options are in compliance with securities law.
This article summarizes only some of the more general aspects of equity compensation and should not be relied upon as legal advice. This article is not intended for, nor should it be interepreted in any way, to assist readers in avoiding paying taxes or penalties for tax payment. Companies desiring to use equity compensation to both stretch their cash resources and to incent employees, contractors or consultants through equity participation should seek the advice of competent and independent legal and tax counsel licensed to give such advice in their jurisdiction before proceeding.