How to Compensate Sweat-Equity Players

Compensating individuals who devote skill and time (sweat) to grow a business has long been a nettlesome issue. The following letter from a reader is a case in point.

“We are starting up a technology company and want to know the right way to compensate our technicians, developers and others who will be helping us grow the business. We don’t want to give them equity at this time because we don’t know how committed they will be to the business going forward. But we do want them to share in the growth of the company if it’s successful.

“We’ve done some research online and it’s all pretty overwhelming. Can you put together a simple ‘checklist’ of the different ways we can incentivize our key players?”

You basically have five options (other than cash, of course) when compensating sweat-equity players in a startup.

Restricted stock. By giving your sweat-equity team restricted stock, you are giving them actual shares in the company but with a number of strings attached:

The shares should be nonvoting. You don’t want these people having the right to second-guess your management decisions.

The shares should be doled out over a period of time (usually three to five years), called a vesting period.

After a person’s shares have vested, you should have the right to buy them back at book value or some other highly discounted price if the sweat-equity player leaves the company for a competitor or commits an illegal or fraudulent act (this is commonly called a clawback provision).

Stock options. By granting options to your sweat-equity players, you enable them to buy stock in your company down the road at their current (much lower) value.

First, you put a value on what your company is worth today. Since you are just starting out, this will be an extremely small number, for example one penny per share. You then grant each sweat-equity player the option to purchase X number of shares — say, 10,000 shares — at that price (so, $100 in total) when the shares vest one, two or three years after the date of grant.

As the company grows in value, holders of options will exercise them by purchasing shares for the original option price ($0.01 per share). So if your company is later worth $1 per share and the option holder exercises all 10,000 of his or her options, he or she is getting $10,000 worth of stock for a purchase price of $100.

Not a bad deal, except for the IRS: Holders of stock options will be taxed at high ordinary-income rates on that $9,900 increase in value when they exercise their options (unless they have special incentive stock options defined by the IRS, in which case they will pay the tax only when they sell their shares in the company).

Phantom stock. A phantom stock plan works like a stock option except that the sweat-equity player receives cash instead of stock in the company.

In a phantom stock plan, you set up a book account giving each participant a number of credits, each credit having a value equal to one share of your company stock on the date the credit is booked. As the company grows, you value the company each year and pay to each player cash in an amount equal to the difference between the value of his credits on that date and the preceding year.

Restricted stock units. This is a hybrid of restricted stock and phantom stock in which holders of credits (called units) receive actual shares in the company at the end of an initial vesting period.

Strip rights. A strip right gives the holder the right to receive, in cash, a percentage of the net proceeds of any merger, acquisition or sale of the company in the future. Strip-right holders have no rights as owners or shareholders until the event triggering a cash payout occurs.

When considering these methods, here are the tradeoffs:

  • Restricted stock gives holders actual ownership of your company, and they are taxed when the restricted stock vests.
  • Holders of restricted stock units do become owners of your company eventually, and are taxed when the units vest and they receive actual shares.
  • Stock options defer ownership in your company to a future time, when the holders exercise their options (swap them for actual shares). Holders of stock options are taxed when they exercise their options, but they decide when they exercise and so can manage their tax liability.
  • Holders of phantom stock never become owners of your company, but you must pay someone to value your company each year and pay cash to participants in the plan.
  • Holders of strip rights never become owners of your company, but you must compensate them in cash if a merger, acquisition or other triggering event occurs. Because this will dilute investors who acquire actual shares in your company, you will need to disclose the existence of strip rights to potential investors the same as you would restricted stock, restricted stock units or stock options.

Cliff Ennico is a syndicated columnist, author and former host of the PBS television series “Money Hunt.” This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state.