Please see Audience to make sure it's appropriate for you.
Employees & Consultants
The people you hire to work at your startup will either be employees or independent contractors (commonly referred to as consultants by startups).
When startups hire employees, they typically have the employees sign offer letters. When startups hire consultants, they usually enter into consulting agreements (or independent contractor agreements) with the consultants.
For both employees and consultants, startups should also enter into agreements to make sure (1) the worker is bound to confidentiality and (2) the company owns the IP the worker creates. These agreements are typically called Confidential Information and Invention Assignment Agreements (CIIA Agreements) or Proprietary Information and Invention Assignment Agreements (PIIA Agreements).
At the federal level, the U.S. Department of Labor (DOL) and IRS have separate criteria for determining whether someone is an employee or consultant.
Under the DOL guidelines, whether someone is an employee or consultant typically depends on whether that person is economically dependent on the employer and whether their work follows the usual path of an employee. The DOL generally looks at several different factors to determine whether or not this is the case for a given individual and their employer, including:
- The extent to which the services rendered are an integral part of the principal's business.
- The permanency of the relationship.
- The amount of the alleged contractor's investment in facilities and equipment.
- The nature and degree of control by the principal.
- The alleged contractor's opportunities for profit and loss.
- The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
- The degree of independent business organization and operation.
The IRS looks at the degree of control and independence:1
Various states also have their own criteria as well. You should check the state where your startup is located, as well as any states where you hire people, to see what their criteria are.
Note that in most cases, the classification does not depend on the term or documents used by the startup. A government agency may classify someone as an employee even if you refer to them as a consultant and have them enter into a consulting agreement. The penalties for misclassification can be serious.
Federal law typically requires that employees be paid at least the federal minimum wage, and some states (including California) and municipalities have implemented their own higher minimum wage standards. The minimum wage is a cash standard, so companies can’t use stock or options to satisfy this requirement. This means that startups cannot legally pay employees in equity compensation alone, even though many startups still do this.
Federal law has an exception for employees that own 20% or more of a business, which can apply to many founders if certain conditions are met. However, not all states with minimum wage laws have a corresponding exception. For example, California's minimum wage laws do not have such an exception. This means that California's minimum wage applies to founders in California, even when the federal minimum wage does not.
Some people may have entered into contracts that restrict their ability to work as employees or consultants. For example, a person who is a full-time employee at one company may be contractually prohibited from working for another company at the same time.
Advisors are a type of a consultant. Startups typically enter into an advisor agreement with them, which roughly covers the same topics as a consulting agreement and CIIA agreement would.
It is almost always impractical for startups to legally have unpaid interns. Under the Fair Labor Standards Act, as interpreted by courts, unpaid interns are only permitted when the employer "derives no immediate advantage from the activities of the intern... and on occasion its operations may actually be impeded" (in addition to other requirements).2
See Internal Revenue Service, Independent Contractor (Self-Employed) or Employee?.
See Wage and Hour Division, U.S. Department of Labor, Fact Sheet #71: Internship Programs Under The Fair Labor Standards Act.
There are two primary forms of equity compensation: restricted stock and stock options.
Startups can either sell shares of restricted stock or give them to people for free. If a startup sells shares below their FMV, the recipient must include the difference between the purchase price and the FMV as taxable income. If they give the shares for free, the recipient must count the FMV of the shares as taxable income.
Some people use the term RSU, short for restricted stock unit, synonymously with restricted stock. However, RSUs are not restricted stock; instead, they are promises to issue restricted stock at a later time. RSUs are not commonly used by early-stage startups.
Stock options (also referred to simply as options) are a type of security that allows people to purchase common stock at a fixed price (known as the exercise price or strike price) in the future. People that own stock options are known as optionees.
Purchasing shares through a stock option is known as exercising a stock option. Until they exercise the stock option, the optionee does not own the shares underlying the stock option. Thus, someone who only owns a stock option and no shares is not a stockholder.
Stock options are typically subject to vesting, similar to restricted stock. Regular stock options can only be exercised to the extent the underlying shares have vested. For example, if a regular stock option is only halfway vested, the optionee can only exercise the stock option for half the shares covered by the stock option.
A special type of stock option, known as an early-exercisable stock option, allows the optionee to exercise before the underlying shares have completely vested. When an early-exercisable option is exercised early, the unvested shares sold to the optionee are subject to a right of repurchase until they have vested. You can read more about early-exercisable stock options in this blog post by Yokum Taku.
How to Choose
Often, startups start off issuing restricted stock to avoid dealing with 409A, and then switch to issuing stock options as the FMV increases. This is because the of a startup's common stock usually starts low and grows over time. As the FMV increases, restricted stock becomes less affordable for employees and consultants. Even if startups give the shares for free, the tax burden can often be too large for people to bear.
Percentages & Shares
When offering equity compensation, startups commonly describe the offer as a percentage. For example, a startup might offer a prospective employee "0.25% of the company" (or "25 basis points"). Most attorneys recommend against this common practice (even if the offer is verbal). This is because stating equity compensation as a percentage can lead to confusion and conflict in the future, for a few reasons:
- even when everyone agrees on one method of calculation, the resulting number can change in the time between when an offer is made and when the equity is actually granted; and
- some people may not realize that their percentage ownership can be reduced by future dilution.
A startup has a fully-diluted capitalization of 10,000,000 shares on a given date. If the startup offers an employee 25,000 shares on that date, the shares would commonly be said to represent 0.25% of the company's fully-diluted capitalization as of that date.
When making an offer to a prospective employee, startups can help illustrate the value of the number of shares being offered, by providing the information necessary to calculate a percentage at a given point in time.
You would tell the prospective employee that the equity compensation component of the offer is for 25,000 shares. Then, to help the prospective employee understand the value of that number, you can tell the prospective employee that the current fully-diluted capitalization of the company is 10,000,000 shares, so the 25,000 shares would represent 0.25% of the current fully-diluted capitalization (as of that conversation).
With stock options, recipients must pay for the shares but do not need to do so until they decide to exercise the stock option. To comply with a set of tax requirements known as 409A, the exercise price of a stock option must be at least the FMV of the shares at the time the stock option is granted.
The safest way for startups to comply with 409A is to obtain a 409A valuation from a qualified independent appraiser when they are ready to issue stock options. A 409A valuation attempts to determine the FMV of the startup's common stock as of a specific date, known as the valuation date. IRS regulations provide a safe harbor for 409A valuations obtained from qualified independent appraisers — the burden of proof is on the IRS to show that they are grossly unreasonable. Without a 409A valuation, it would be up to the company to prove that the exercise price of a stock option was not grossly unreasonable.
409A valuations from independent appraisers are valid until the earlier of (1) the 1-year anniversary of the valuation date, or (2) the occurrence of an event that would materially change the value of the corporation. After a 409A valuation becomes invalid, the startup will need to obtain a new 409A valuation in order to continue issuing stock options under the 409A safe harbor.
As startups get more mature, they typically have accounting firms perform financial audits. Audit firms often require companies to get prior 409A valuations redone by new appraisers if they have doubts about the quality of the initial valuations. Thus, when selecting an independent appraiser for a 409A valuation, you should try to get a sense for how their valuations have held up under scrutiny by audit firms.
Vesting acceleration provisions enable vesting to be fast-forwarded when certain conditions are met. There are two broad categories of vesting acceleration: double-trigger and single-trigger. The number of triggers refers to the number of events that have to occur in order for the acceleration to kick in.
If someone has double-trigger vesting acceleration (commonly referred to as double-trigger acceleration) on their stock or stock options, that typically means the vesting will accelerate if (1) the company is acquired and (2) that person is terminated in connection with or following the acquisition.3 This is the most common type of double-trigger acceleration, although there are many other possibilities. For example, some double-trigger acceleration provisions only allow for the acceleration of vesting for a certain percentage of the shares. Or, more rarely, the triggers themselves may be different.
The most common form of single-trigger vesting acceleration (commonly referred to as single-trigger acceleration) is for vesting to accelerate if the company is acquired. A far less common form of single-trigger acceleration is for the vesting to accelerate if the stockholder is terminated.
Double-trigger acceleration is standard for stock issued to founders, and is occasionally used for executive-level hires. It is not typically given to other employees or consultants, because it is viewed as undesirable by acquirers and consequently VCs. Naturally, single-trigger acceleration is viewed as even more undesirable. Single-trigger acceleration is usually only given to advisors, if at all.
Aside from double-trigger acceleration for founders, vesting acceleration is uncommon and should be used with caution. You should consult an attorney whenever you're doing something uncommon.
Double-trigger acceleration provisions usually have exceptions for if the stockholder is terminated for certain reasons, such as committing a felony, fraud, or refusing to work.