Upside Compensation
Purpose: Identify the best vehicle to provide freelancers equity compensation.
TLDR
(1) There are many ways to compensate people with equity. The most common methods include:
SAFE
FAST
Warrants
RSAs
Investment Rights
(2) Each of the options outlined above have their advantages and disadvantages. We focus primarily on the disadvantages because they help to guide our decisions about the best investment vehicle to use. The key issues we examine in this document are:
Founder understanding
Builder desire
Investor acceptance
Taxes
Accreditation
Agreed upon value
(3) Through my analysis of the most commonly used forms of equity compensation, the optimal solution we came to was for founders to compensate builders in restricted stock awards when a company has no valuation or Non Qualified Options when a valuation and option plan has been established.
Context
Creators are tired of investing time into projects and then seeing them take off without receiving any meaningful upside from the work they have done. The classic example of this is the Nike logo which was created by Carolyn Davidson for $35. After the company ascended to becoming one of the most successful companies of all time, Carolyn eventually received stock in Nike. If it was not for the good graces of Phil Knight, Carolyn might not have ever received anything for one of the most iconic logos of all time.
In today’s tech enabled and capital rich world, companies receive funding at early stages resulting in founders ability to protect their cap table and does not require giving out employee equity. Additionally, shorter timelines from the start of a company to the point at which it is sold means that builders are often bouncing around from position to position and the most talented often end up working for themselves as freelance consultants.
Having excess capital, while preventing freelancers from obtaining meaningful equity, has greatly increased the income of talented builders. The increase in income and the inability to access the equity they want at earlier stage companies has created a robust angel investing network among the top builders. Founders are also eager to work with these individuals because the increase in capital has created a highly skilled labor shortage.
All of these factors has created high demand for builders to invest and early stage founders to have these highly skilled builder bought into their company
Upside for All (Creative Capital)
RSAs
RSAs stand for “Restricted Stock Awards.” These awards grant the employee the right to purchase shares at FMV, at a discount, or at no cost on the grant date. Because you legally own RSA shares when they are granted to you, vesting only impacts whether the company can repurchase your shares if you leave or are terminated. Most companies have vesting schedules in place to prevent individuals from joining a company, receiving their RSA award, and leaving immediately.
Builder Implications:
Date of receipt: Minimal tax implications. The value of shares should be calculated based on par value. Builder receives common shares in the company on the date of issuance.
Date of exercise: Minimal tax implications assuming that the recipient files the form 83(b) and decides to pay taxes as of the date that the RSAs were issued rather than the date of vesting.
Founder Implications
Date of issuance: The founder would have a new investor on the cap table owning common shares in the company. These shares would be the same as the ones obtained by the founders.
Date of vesting: No change to the cap table because shares are viewed as issued on the day they were granted to the builder.
Employee Stock Options (ESO)
When a company is issuing employee stock options they have two types of options they can issue. Non-qualified options (NSO) or incentive stock options (ISO). The difference between the two is that ISOs can only be issued to employees while NSOs can be issued as compensation to anyone who has done work for the company.
Incentive Stock Options (Statutory)
From the builder's perspective you would want ISO so they can be categorized as incentive stock option (ISO) under the IRS code because they are subject to capital gains tax rather than ordinary income when sold as long as the employee exercises 2 years after the grant date and 1 year after exercise. Employees must also wait until shares fully vest before exercising the options. Additionally these options can only be granted to part time and full time employees, not contractors or other entities. Which does not make them the optimal option for a creative capital instrument.
Builder perspective
Builder only pay’s taxes when they sell their shares
Will be included in the Alternative Minimum Tax calculation
Company perspective
Less attractive because the employer is not entitled to a tax deduction when they are exercised.
Nonqualified Options (Non Statutory)
From the perspective of the startup issuing these options, you would want to have them categorized as NSOs. NSO provides the tax advantage to the company on the date that they are exercised. NSOs are less advantageous to builders because they must recognize the difference between the grant and the spread on the date of exercise rather than the date of sale as regular income instead of capital gains.
Builder pays taxes on the date of exercise.
Regardless if the builder holds the company shares they are counted as part of your earned income and taxed at your ordinary income rate.
Advantageous to the company because Nonqualified dividends are included in payroll tax and can therefore be deducted from income.
In addition to understanding the type of option the company has created we must assess if the nonqualified option has a readily determinable market.
Readily determined market: Taxable on the date of the grant
Non-Readily determined market: Non Taxable
In most instances, a startup company option will not have a readily determinable market as defined and outlined below.
The FMV of an option that isn't traded on an established market can be readily determined only if all of the following conditions exist.
You can transfer the option.
You can exercise the option immediately in full.
The option or the property subject to the option isn't subject to any condition or restriction (other than a condition to secure payment of the purchase price) that has a significant effect on the FMV of the option.
The FMV of the option privilege can be readily determined.
The fair value of an equity security is readily determinable if sales prices or bid-and-asked quotations are currently available on a securities exchange registered with the U.S. Securities and Exchange Commission (SEC) or in the over-the-counter market, provided that those prices or quotations for the over-the-counter market are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by OTC Markets Group Inc. Restricted stock meets that definition if the restriction terminates within one year.
Resources
Difference between incentive options and non qualified options
Discussion around defined markets
ALL OPTIONS COSIDERED
The SAFE was originally created by Y-Combinator as a better alternative to the convertible note. The issue with the convertible note is that it is a debt instrument and therefore has interest associated with it. Similar to the convertible note, the SAFE has terms that dictate the exact equity valuation that the investor will receive an investment in the company when the investment “converts.” These terms include discount rate and valuation cap which are used to determine the price of equity the investor will be making an investment at.
Unlike the note which converts at the end of its term (if it is not paid back), the SAFE will convert at the occurrence of a specific event in the future. That event is usually some kind of financing that will be outlined in the document. SAFEs are effective for accepting an investment quickly because they have become familiar to most technology startups and investors. They are short, sweet, and cover all the topics that both parties spend time negotiating.
On the surface, the SAFE is a great investment tool. Founders and investors understand how a SAFE works and builders find it desirable as a way to obtain investment exposure in a startup. Unfortunately, there are two main problems with the SAFE being used as a creative capital tool. Cap table complexity and taxability.
First, despite understanding the SAFE, Founders are turned off from it because it makes their Cap table more complex. Some founders might not see this as an issue Second, the builder receiving a SAFE as compensation must include this illiquid asset in their taxable income calculation. Any time someone receives a SAFE, the value of the work provided is the total value that the person will be investing in the SAFE. Despite the SAFE being illiquid, this value is considered income to the builder and would be taxable upon receipt.
A FAST is a “Founder Advisor Standard Template.” The FAST is an agreement used to help streamline the negotiation process between a founder and a would-be advisor. Considering that builders are about as high impact of an advisor as a startup can get, I felt that it would be prudent to consider the FAST as a creative capital tool.
In the FAST agreement, the Founder is agreeing to compensate their advisor with either Restricted Stock Units (RSUs) or Options. We will discuss Options first.
Options are commonly used by early stage companies to incentivize employees to work at a company. Options grant the holder the right to purchase a share of company stock at a specific price the “Strike Price.” When an option vests, the holder will have the ability to obtain stock at the strike price. The option holder would then profit from the difference between the strike price and the fair market value of the asset they are purchasing.
Options are the most traditional investment vehicle we will discuss and therefore are the most well known. Options are attractive to both Founders and investors because of their minimal impact on the Cap table. They are also easy to structure and often already created as a part of a company's employee compensation package. Builders like options because they are easy to understand but do require more active participation on the part of the builder to actually execute them.
Options have both an advantage and disadvantage to how they are priced. Like other investments, receiving options as compensation would be income to the recipient. If the company issuing you the options is at an early stage, their equity would be priced at the par value of the Stock making the income to the individual minimal. The builder would pay the cost of the options.
Unfortunately, if the company is at a later stage and they have a priced round or have obtained a 409a valuation, the options would be priced at that valuation. Depending on the amount of options being received, the tax consequence of payment in options issued by a later stage company could be substantial to the builder. For these reasons, options could be a good solution for companies in earlier stages to help compensate builders.
RSUs
The second type of investment that could be made is an RSU investment. Restricted stock units are an unfunded promise to issue a specific number of shares at a future time once vesting conditions for the employee have been satisfied. RSUs are different from options in that they actually represent ownership of the company that is locked until a vesting period has been completed. Unlike options, RSUs are considered “full value” awards since employees never have to pay for them.
RSUs could be a good option for startups looking to issue creative capital. RSUs are a more common form of equity compensation and it is more familiar to Founders and Investors. Builders might need to educate themselves more on this form of compensation before they would be willing to accept it. From a tax perspective, builders would be taxed as the RSUs vest based on the current price of the stock they have been awarded. Unfortunately, RSUs represent shares of stock in the future not at the time of issuance and therefore a 83(b) election cannot be made. It is important to note that the builder does not need to buy this equity.
Warrants are similar to options in that they provide the holder the right but not the obligation to purchase shares of a company's stock at a certain price. The difference between warrants and options is that warrants are a dilutive equity investment meaning that when the warrants are exercised the shares that are being bought must actually be issued by the company.These shares are then given to the investor. .While the difference is nuanced, warrants are mostly used to give investors the ability to invest more into a company while options are used to incentivize employees to continue to work on a project.
The pros and cons of warrants are identical to those of options. For further analysis around the use of options as a form of creative capital, please review the options section above.
RSAs stand for “Restricted Stock Awards.” These awards grant the employee the right to purchase shares at FMV, at a discount, or at no cost on the grant date. RSAs sound a ton like RSUs but differ in that they are accounted for on a cap table. RSAs are actually shares that are issued and outstanding and included when considering the capitalization of a company. RSUs on the other hand are not because they are an agreement to provide an employee shares at a future date. Unlike RSAs, when shares are “owned” by the employee on the grant date, an RSU is a promise from the company to give an employee shares at a later date.
Because you legally own RSA shares when they are granted to you, vesting only impacts whether the company can repurchase your shares if you leave or are terminated. Most companies have vesting schedules in place to prevent individuals from joining a company, receiving their RSA award, and leaving immediately.
RSAs are great for early stage companies because valuations are low and it is easy to compensate someone without needing them to incur a tax consequence or a complex capital structure. When a builder receives RSAs they will fill out a form 83(b) and elect to pay taxes on the equity received today instead of when these shares vest. Additionally, founders, investors, and builders understand these items which makes RSA’s easy to discuss.
The downside to RSAs is that early stage companies can be hard to price. RSAs work best when a company has not raised a priced round because the price of each share of stock would be the par value. Correlating the par value to the value of the work a builder has done can be challenging and would involve coming up with a valuation that the company is going to raise at and granting the builder the equivalent number of shares to that valuation. Additionally, because the RSA is actually an issuance of stock, the company would have increased complexity on their cap table. Every time a builder works on a project they would need to include the additional builder on their cap table.
Investment Rights
Investment rights grant a holder the ability to invest in a company at a certain time in the future. In most cases, the right is granted at a specific point in the future, either through a vesting schedule or in association with a specific event such as a new round of fundraising. A common form of investment right is through an issuance known as an investment issuance. Investment issuances are usually granted to existing shareholders and do so as a way to help a company raise capital from their existing investor base. Unlike there could be advantages to acquiring the right to invest in future financing rounds.
Investment rights in future financing rounds are both easy for founders to understand and acceptable to most current investors. Founders are able to quantify what a $100k investment in their next round would look like and also guarantees that they have a supportive backer on their cap table. If investment rights were to be used these investment rights could be transferable to the builders through a fund structure. This is a more indirect method for providing equity compensation to builders but is still appealing because of the unrestricted access and exposure to investments otherwise inaccessible to them. The tax consequence to both the investors and hold co would be non-existent because we would be making an investment like any other investor.
The downside to investment rights is that in order to make such an investment, a builder would need to be accredited. Accreditation is not uncommon in the top creator community however there are some who are unaccredited. For accredited investors the fund structure works well and also allows the fund to accept capital from other investors. In an instance where the fund structure would not work the alternative option is to give builders carry in the fund. Giving builders carry is not an optimal solution but it allows the hold co to avoid issues of accreditation and taxation.