The Perils of Accepting Stock Compensation in a Startup Company

Insider's tips to negotiating compensation with cash-strapped startup companies and small businesses

Q.   I am considering doing some moonlighting work for a startup company which has no money to pay me a salary. Should I lend my services to the company with the understanding that first investors pay back the debt or just ask for stock?

A.   There is one thing that is a sure bet for startup entrepreneurs. In business discussions with friends and family members they will hear the dreary, almost bankerly warning that startups are risky.

Practical entrepreneurs pay attention and take steps to reduce potential peril while others adopt an arrogant "bring it on" bravado. This is understandable too. Afterall, many startup entrepreneurs leave corporate jobs just to get away from cubicle lives that seem too confining and boring. But not every person who works for a startup can embrace this same level of unpredictability especially when it comes to compensation.

I hate to say it, but if you "loan" your services to a startup that has ambitious fundraising and growth plans, I doubt you will receive any hard cash, certainly not in the near term. Here's why I'm pessimistic.

First, individual investors or "angels" and venture funds don't like to invest their money to pay-off existing liabilities. Rather, they want their money to go to projects that enhance the future value of a business. Some of these expenses can include product development, patent filings and marketing. Investors also like to see that company founders and first employees have "skin in the game." From an investor's perspective it's not a bad thing to invest in management teams that as investors say, "can't afford to lose."

The real deal is early stage company investors typically force any debt due to company founders and first employees to roll into equity. Some exceptions can be made for out-of-pocket travel expenses for hardship case employees, but not often.

A second problem with many types of deferred compensation is the Internal Revenue Service. As long as you "earn" income for services rendered to a business, even if you have not yet seen the cash benefit of the income, consider the IRS as your business partner. The IRS will insist you pay taxes even if you are unable to convert the stock compensation into ready to spend cash. This is called "phantom income" tax hits. Even though you don't see the cash, the IRS will demand its share of your income That's nasty! Your accountant can also evaluate any exposure for social security taxes too.

In general, employees of early stage companies tend to opt for compensation in the form of stock options rather than common stock. With stock options that are priced at the company's current market value at the time of grant to employees, taxes are generally delayed until the date of sale. Stock options also provide the advantage of being taxed at the lower capital gains tax rates rather than income tax rates.

Of course, nothing is ever perfect. The primary risk to startup company employees is that their stock options can expire before they have an opportunity to realize any meaningful value from the options. For this reason, I encourage startup company employees to negotiate the longest terms possible for stock option awards. A stock option award in a startup company with a term of 5 to 10 years is more likely to deliver some profitable reward to first employees than stock options with a term of 2 to 4 years.

The amount of equity (in stock or stock options) you ask for should be based on the value of your work to the startup organization. If, for example, you are the driving force behind the startup's technology design then a 10% to 25% equity stake in the enterprise may not be unreasonable. Remember however, that your equity stake will shrink as the company issues more shares to investors or other new employees.

Here's one last tip. Working for an exciting startup should not be financially draining beyond reason. Determine an end date to your non-cash compensation agreement and stick to it. Your time is worth good money.

Do you want to find reliable investors for your business? Write to Susan at susan@takecommand.org for great funding references and tips designed especially for startup entrepreneurs, sole proprietors and fast growth companies.

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