HOW TO PLAN FOR BUSINESS OWNERSHIP AND COMPENSATION (PART 2)
Compensating With Stock
Giving someone ownership rights in a company is a serious decision that should receive very careful consideration. There are several things to contemplate before taking on an equity partner, be it an investor or key manager. For example, anyone brought in as an investor/shareholder or partner with the entrepreneur does not have to be an equal partner. An investor can hols whatever share of stock is warranted on the basis of what that partner will contribute to the business.
In general, one should not bring someone in as a partner. investor if that person can be hired to provide the same service, no matter how urgent the situation. The most advantageous way to hire someone for a new venture is to hire the person as an independent contractor. In addition, do not lock the company into future compensation promises such as stock options. Use cash for bonuses whenever possible.
The company should be established as the founder’s before any partners are taken on – unless, of course, the company has been founded by a team. Finally, consider having employees work for the company at least two years before they are given stock or stock options.
Founder’s Stock is stock issued to the first shareholders of the corporation or assigned to key managers as part of a compensation package. The payoff on this stock comes when the company goes public or is sold. Assuming that the company is successful, the founder’s stock at issuance is valued at probably the lowest it will ever be, relative to an investor’s stock value. Consequently, a tax problem can arise when private investors provide seed capital to the new venture. Often the value of the stock the investors hold make it very obvious that the founder’s stock was a bargain and that its price did not represent the true value of the stock.
One way to avoid this problem is to issue common stock to founders and key managers and to issue convertible preferred stock to investors. The preference upon liquidation should be high enough to cover the book value of the corporation, so the common stockholders would receive nothing. This action would effectively decrease the value of the common stock so that it would no longer appear to be a bargain for tax purposes and subject the founders to immediate tax liability.
Founder’s stock is restricted, and the SEC rules state that the restriction refers to stock that has not been registered with the SEC (private placement) and stock owned by the controlling officers and shareholders of the company (those with at least 10 per cent ownership).
If a stockholder has owned the stock for at least three years and public information about the company exists, a particular rule can be avoided in the sale of the stock. If the stockholder has held the stock for less than three years, the rules must be strictly complied with.