Published May 03, 2012
Is your company short of cash? Are you behind in payments to your office landlord or patent attorney? Are you looking for creative ways to boost employee morale but can’t afford salary increases?
If so, keep reading. Instead of parting with cash you may be able to square a bill by parting with some company stock.
Here’s how it works. Unlike investors who buy shares of a company’s common stock, employees or vendors can be “given” shares in lieu of salary or as a bonus for exceptional performance.
While handing out stock to employees and vendors can help conserve a company’s cash, the transaction does have a cost to business owners. Every stock grant to employees and other outsiders “dilutes” or reduces the size of the entrepreneur’s own equity stake in a business. Over time, entrepreneurs have to watch that they don’t lose voting control of their companies from being too generous with stock awards.
There is a cost to recipients of stock-based compensation too. With respect to stock awards, even though recipients may not receive cash today for services rendered, the IRS still likes to take its share of compensation for the year that it was "earned."
Fortunately, privately-held companies do have a degree of flexibility in estimating the fair market value for its stock to minimize tax burdens for stock recipients. If the shares are granted at the time of startup and valued at pennies per share, the tax obligation may be negligible. But, employees who receive stock that is worth thousands of dollars may be hit hard by a nasty tax bill.
Here are some other fine points of common stock grants that are useful for entrepreneurs to know.
Make no promises. Entrepreneurs should be cautious when negotiating stock compensation agreements with employees or vendors and resist making statements that can be construed as guarantees of big profit outcomes. Entrepreneurs can be optimistic about their company’s prospects but they have to stop short of providing investment advice that may violate federal and state securities laws.
Board of directors' approval. Most corporations require the board of directors to approve all issuances of securities, including common stock awards and stock options. An entrepreneur can offer shares to an employee or vendor, but the deal isn’t sealed until it is approved and documented by the company’s board of directors.
Vesting issues. Can entrepreneurs get company shares back if an employee or partner doesn’t perform? Not likely. To avoid the angst and bitterness associated with low caliber employees walking away with a big chunk of stock, entrepreneurs should give “restricted” stock awards that vest over a period of time or at the time of project completion.
If stock grants pose more tax problems than solutions, consider stock option grants as an alternative way to reward employees and other individuals for their loyalty.
Susan Schreter is a 20-year veteran of the venture finance community and a university educator in entrepreneurship. Her work is dedicated to improving startup longevity in rural, urban and suburban America. She is the founder of www.takecommand.org, a community service organization that offers the largest centralized database of startup and small business funding sources in the U.S. Follow Susan on Twitter @TakeCommand.