Hiring and compensating people using equity pose lots of questions. Do you know how to find the answers?
“I am an entrepreneur who is bringing on someone who wants to be a 10% equity partner while they also work in the business. What must I do legally, and how should I do it?”
We hear this question frequently. An entrepreneurial business needs help in some critical area. A friend or acquaintance of one of the founders wants to fill that support role, and is so enamored with the business opportunities that he wants equity.
First of all, nothing is legally REQUIRED to bring on an equity partner of this type, and the only thing required when you bring on an employee is that you must be certain they are legally allowed to work in the USA (we’ll assume that you fill out the required I-9 and we’ll leave that topic alone for now). However, it is good business practice to document every relationship with a written contract. In this case, you need two contracts: One for the shared ownership and another one to document the work responsibilities and compensation. Obviously, workers in your business don’t have to be equity partners, and likewise, not all equity partners need to work in the business. These are separate relationships, “Employee” vs “Partner,” and your two contacts will describe each of those relationships.
The employee contract is relatively straightforward. First you must decide whether the person will be a direct employee (i.e. they will receive a W-2), or an independent contractor (they will receive a 1099). There are a lot of things to consider in making that decision, but some of those considerations (both legal and business considerations) is the topic of another article.
Then you define the role, including the types of tasks the employee will be assigned, set compensation, and add other provisions around ownership and protection of intellectual property, exclusivity, term and termination, and supplemental compensation regarding equity.
Equity (Partnership) Contract
Just as the employment relationship starts with a choice between direct employee vs independent contractor, there is also a choice regarding the “form of equity” you can give a “partner.” And honestly this decision will have much more long-term impact than the employment contract.
Technically speaking, “equity” participation in a company means a relationship as a true part owner, and the rights of a true part owner are partially molded by state and federal laws about how true part owners interact.
But there is another way to give an interest in the company to the people who contribute to your company’s success. That is called “Phantom Stock,” or “Stock Appreciation Rights” (SARs).
A true part owner has rights, some of which are defined by law, in management decision making, rights to see the company’s financial records, rights and obligations regarding profits and losses, and rights to participate in the proceeds of from the sale of the company…if that ever happens. In contrast, all of the rights of a SARs owner are defined in a contract, and the focus is on the right of the SARs owner to benefit from an increase in value of the company. There typically are no management rights, no rights to profits, and maybe most importantly, no right to see the company’s financial records.
You must also decide whether the employee gets to keep the equity if their employment relationship terminates. And the answer to that may depend on how long they were an employee, what was their level of contribution in terms of ideas and activity, and the circumstances surrounding the termination of that relationship. You can even build in a sunset clause that says appreciation rights are fixed at the value of the company on the date of departure from employment, but will not be paid out until some liquidity event occurs.
A Basic Starting Framework
Okay, I have mostly introduced you to many questions, are there any answers? Well, as lawyers like to say, “that depends….”
But maybe we can agree on an approach to creating answers. Let’s start with a fundamental principle and a beginning framework.
The fundamental principle is that you (together with your existing founders) want to be in control. This guiding concern is usually paramount among entrepreneurs; even beyond wanting to make more money, entrepreneurs want to control as much of the business as possible.
Given that principle the beginning framework is this:
1. Bring the person who wants equity on as an employee if you can afford to pay them what they need in various forms of cash compensation (salary, bonus, commissions, profit sharing, etc.). You would modify this part of the basic framework if you cannot afford to pay the person as a full-time employee, and they are not willing to work as a part-time employee. But you have to understand that you give up a substantial amount of control if you treat them as an independent contractor.
2. Use SARs instead of true part ownership to keep the person who wants equity interested in the long-term growth of the business. You would modify this part of the basic framework if you value the business decision-making ability of the person who wants equity, and you want a relationship that makes it difficult for everyone to get out of.
Even within this basic framework there are a lot of variables, and much room for contract tweaking, but if you start with this as your basic approach to bringing on employee-partners, you will have a good foundation.
Entrepreneurs are going to save the world, and Argent Place Law wants to help. That’s why we are a team of entrepreneur-lawyers who provide Legal Business Counsel to Entrepreneurs just like you. Think how great will it be to have a legal team with entrepreneurial experience on your speed dial so you can call us up and ask, “I’m thinking of hiring an employee who wants equity, what should I do?” Call Argent Place Law to find out.