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Stock In Lieu Of Cash For Employees

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I have been getting a lot of inquiries lately about what to do if you are a prospective employee of a start-up company and the owner(s) offer you stock in the company in lieu of salary.

If you are an employer-entrepreneur, my first instinct is to say: “IF AT ALL POSSIBLE, DO NOT DO THIS!” The absolutely last thing you need is a bunch of minority shareholders walking around the hallways bitching that they could run the company better than you do and deciding in the best interest of their shares they are not going to follow the direction given to them as employees.

But, if you absolutely must hire a person and pay them with stock, here is what YOU need to do:

    1. Treat him (or her) as an investor. Make sure you understand how he will integrate into your group of investors, how he will behave at shareholder meetings.
    2. Review your operating agreement (if you are an LLC) or shareholder agreement (if you are a corporation) with a fine tooth comb. Understand what rights he will have as a (presumably) minority investor. One thing you may not be able to avoid is that he will have access to your financial records. Unless you create a separate class of ownership interests (LLC membership or stock), this is a default rule. Do you really want him to know all that about your company?! Oh, I forgot, you “have to do this”.
    3. Follow standard protocols for bringing on investors. That means he must have a subscription agreement and he must sign the operating or shareholder agreement. Also make sure your operating/shareholder agreement spells out things like the vesting schedule, and whether he must remain an employee to keep his stock. A buy-sell agreement will be essential if he cannot leave the company owning a piece of it. Oh, and don’t create a separate class of stock for employees unless you really know what you are doing. This could destroy your S-Corp status for federal income tax filings (if that is something you want to have or keep).
    4. You should value the company. Do it the way your operating/shareholder agreement says to (usually using an independent valuation expert). If you don’t have an independent valuation done, make sure the employee knows that and agrees to the valuation in writing.
    5. Independently of the company valuation, determine how much you would pay him if you could pay him a salary.
    6. Use the results of items 4 and 5 above to determine how much ownership to give him.
    7. You should have an employment agreement that binds him.DON’T DO THIS EXERCISE FOR AN AT-WILL EMPLOYEE!
    8. Before proceeding, re-evaluate whether you really want to do this. There are alternatives, like phantom stock or stock appreciation rights.

If you are the employee, read and study the above-mentioned documents. If the company is organized as a pass-through (LLC with or without S-Corp, corporation as S-Corp) you want to be sure there are scheduled distributions to cover tax liabilities when the company starts making money. Finally, in addition to a lawyer, you probably should get a CPA to look over the deal.

Argent Place Law, PLLC serves businesses and business owners in matters of business,corporate and contract law, intellectual property law, and succession planning, including estate planning with wills and trusts.

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