VII) Executive and New Employee Compensation Issues–
An overview of some of the common questions from both founders and newly recruited early-on employees about what is the proper way to be compensated.
A) Hiring Process
Recruiting, Applications, & Interviews:
The main concern during the hiring process is to avoid claims for discrimination or possibly breach of contract or wrongful termination if the person is hired and something said or promised during hiring does not occur. For example, if you keep telling the person that they will be promoted to CTO within 3 months and you plan to keep them with the company for at least 2 years and you then terminate them after 5 months without promoting them to CTO, you may face a claim that there was an implied employment contract and you breached the agreement by wrongfully terminating it.
You need to take all precautions to avoid actual or perceived discrimination in hiring. Discrimination can occur when a protected class of people are discriminated against by things like not hiring due to their gender, race, or religion. There are also claims for discrimination for things like a pattern of hiring only one race and no others, or when comparing 10 equally qualified applicants and only a certain religion of people is hired. Protected classes depend upon various state and federal laws, but generally, protected classes can include: gender, martial status, sexual orientation, religion, disability, age, and race. This means that you should not include any kind of preference limitations in any advertising for the job or during the hiring process unless it is a bona fide occupational employment qualification. Also, any hiring standards must have a legally justifiable basis and meet a business-necessity test. If the hiring standard meets the business necessity test, it could be used to avoid a claim of discrimination in hiring, even if the person is in a protected class.
When interviewing candidates, you need to be cautious in what you say or imply so that it does not also show any kind of preference or discrimination against a protected class. In addition, you need to avoid any false or misleading statements about what will happen in the future, try to get them to move to the area based upon lies about the employment, or generally any statement that could be construed to be a promise that you never or don’t intend to fulfill.
One other specific caution for tech companies these days would be recruiting a candidate away from a competitor. California is generally pretty liberal in allowing employees the right to change employers whenever they feel like it, unless there is a valid employment agreement that says otherwise. If you recruit a competitor’s developer in order to gain access and use their knowledge of the inner workings of the competitor, that could be viewed as trade secret misappropriation. Also, if you try to persuade a competitor’s employee to leave and work for you and you know that would break their employment agreement, your company could face liability for inducing a breach of contract.
In general, you cannot use hiring standards or qualifications such as: age, national origin, US citizenship, lawful alien, or refugee status. You cannot refuse to hire someone simply because they have a bankruptcy, are in a alcohol or drug rehab program, or were in a rehab program. You can refuse to hire based upon current drug or alcohol use, impose dress and personal appearance standards, or place a requirement to speak English if job related.
When questioning the applicant during the interview process, you can ask whether they are eligible to work in the US, but most questions about age, marital status, mental or physical disability, pregnancy, or religion. When it comes to crimes, you can ask about criminal convictions, felony convictions, criminal charges or arrests that are still pending. You can’t ask about marijuana-related offenses more than 2 years old, arrests without a conviction, or participation in a drug or alcohol diversion program.
References or Background Checks
When many companies look into an applicant, they want to know as much about their other recent job performance as possible. In most cases, the employer is allowed to ask various questions related to the applicant’s prior job performance, with or without express permission to contact references. Most of the time, it is tough to get much information because former employers are aware that if they give negative information and the person isn’t hired, the former employee could try to claim defamation that resulted in them not getting the job. Most employers have policies where they will only confirm that the person worked there and their dates of employment.
If the company wants to run a credit check, they need to comply with various fair credit reporting requirements. If they want to run a background check, they also need to comply with certain laws and notice requirements, so properly prepared notice in writing given to the employee need to be used.
B) “Independent Contractor” versus “Employee”
One major issue faced by business, small or large, is the battle with whether someone is an employee or an independent contractor. This can have various major and minor implications on the company and the hired individual. Many people think that they can just call someone an independent contractor or a “1099” and that assures they are not an employee. That is not the case and there are specific tests used to determine someone really is an employee.
If the employer hires someone as a 1099 and pays them without taking out tax withholdings, but they turn out to qualify as an employee, they can face serious monetary and other problems down the road. In addition to tax issues, they also might suddenly be subject to laws covering things like minimum wage, required rest periods during a workday, workers compensation requirements, and overtime pay.
In California, the Employment Development Department (EDD) and IRS generally set out the tests for determining if someone is independent or an employee. Generally, they look at the following items:
- Who controls or directs the person on how to perform the work?
- Does anyone provide training on how to perform the work?
- Does the contractor have their own established business and do they have their own tools or specific training? Can they perform the work anywhere or do they have to come into an office for set hours?
- Does the worker contract out with other employers or hold himself out to the market as able to work for others?
- Is there an opportunity to profit or lose from the relationship and are they paid on a per project basis or hourly/salary?
- Does the company retain the right to terminate the person?
Companies need to resist the temptation to simply call someone a 1099 worker without examining the factors that can affect it down the road.
Even if you hire independent contractors and they are not considered employees, you should still put together an independent contractor agreement in writing that sets specific terms of what you are hiring them for, how they get paid, how long it should take, and confidentiality terms to clarify the relationship and avoid future disputes.
C) Employment Agreements, Confidentiality Agreements & Other Initial Documents
There are a number of documents that the company needs to fill out or have on file to comply with state and federal laws. This is a best practices list that includes both required and non-required items:
- Employment offer letter (not required)
- Employment contract (not required)
- Employment application (not required)
- Job description (not required)
- Consent to background check or other requested testing (only need to obtain if you utilize that qualification)
- INS Form I-9 (required and you need to verify the documents listed such as passport, driver license, or social security card; it is also best to make a copy of each of these)
- IRS Form W-4 (required)
- Employee handbook with company policies and procedures, can include or separately have what is called an employee proprietary information and inventions agreement (covered below, essentially a confidentiality and non-disclosure IP protection)
- Insurance or other benefit paperwork (401k, stock option plan, payroll direct deposit)
California, like many other states, is a presumptive “at will” employment state. This means that employees you hire are presumed to be at will and either the employer or the employee can terminate employment at any time, generally for any reason, although there are some discriminatory practices that could get the company in hot water. Ways to change the relationship to more of an employment for a specific term or under certain conditions is to have a written employment agreement or, in some cases, an employment agreement can be inferred from actions and statements prior to and during the course of employment, so employers need to be cautious in making bold statements about someone’s long term future with the company.
Most often when hiring the top management for the company or other key personnel, such as a top engineer or developer, many companies will use written employment agreements. The employment agreement can set a specific length of employment or it can also include a clause that employment is still “at-will” and can be terminated at any time. It can be useful to define the specifics of that person’s employment and avoid litigation down the road because of ambiguity in some term of employment.
Some of the items that generally may be included in an employment agreement are:
- Specifically define who the two parties are to the agreement
- Length of employment or whether it is at-will
- Specific reasons that the employer or employee could terminate employment and what happens upon termination
- Place of employment where the work will be performed
- Specific Duties and Authority of the Employee (tries to limit what the employee may be able to say to bind the company as an agent of the company)
- Compensation- both cash, incentives, benefits, deferred compensation
- How business expenses are handled
- What happens to the employee if the company goes public, gets acquired, or some other major event (used mostly by top personnel to keep their job with the company or get some form of bonus to get the company to that level and walk away)
- Generic contract terms for dispute resolution, choice of law, etc.
- Confidentiality- covered next
Employee Proprietary Information and Inventions Agreements (EPIIA)
EPIIAs or sometimes referred to in other names like confidentiality agreement, non-disclosure, or otherwise, are used to protect both the company and the employee related to intellectual property. The point is to set in writing the following to avoid disputes:
- What are the employee’s obligations to try to protect confidential information
- What information is confidential
- Define who owns what IP going into the employment relationship- For example, if you developed 3 apps and filed 10 patents on your own prior to employment, it would set out an explanation of those items and that they remain your property, not the company’s
- Define what happens to inventions or developments made during the employment relationship
- Define what happens to the IP after the relationship terminates
A company needs to have similar confidentiality agreements to use for independent contractors, business service providers, and other hired businesses to be sure that they protect their intellectual property.
D) Forms of Compensation
Cash- Salary or Hourly
There are a variety of compensation forms that a company can use to pay its employees, such as cash in the form of hourly or a salary, stock grants or purchase rights, deferred compensation, stock options, and benefits. The concern when it comes to compensation in a new or small company is that you must comply with both state and federal law on issues such as minimum wage, overtime, and breaks. There are specific rules on paying at least minimum wage, even in many cases to interns. The rules also cover payment of an increased overtime wage if the person works more than 40 hours. The employee must also be provided with certain breaks and rest periods depending upon how much they work. There are certain exemptions from these wage and hour requirements for certain executive, administrative, or professionals at the company, IT workers, outside salespeople, and more.
Minimum wage & overtime issues
One problem when it comes to a startup is the possible violations of minimum wage or overtime when the person is only paid in stock, stock options, or a combination of both. The minimum wage and overtime laws generally will apply to require payment of cash for at least the minimum wage, even if they are getting lots of equity in the company. That is not to say that the company many not be able to avoid those requirements if the employee does qualify as exempt.
Other benefits- insurance, retirement
Other benefits such as sick time, vacation time, health insurance, retirement plans, and leaves of absence are generally up to the employer if they want to provide them, so most startups avoid these benefits due to the record keeping and administrative setup time involved, not to mention the costs. The company is required by law to provide time off for certain events, such as pregnancy, certain disability or medical leaves, voting, and serving as a juror or witness in court. In most cases, though, the company is not required to pay the employee while they are off, but they may be eligible for certain state or federal leave payments.
The new laws relating to health care are still in implementation, so issues related to what requirements the employer may have to provide health care can change depending upon factors like the size of the company.
In California, all employees are required to be provided workers compensation benefits. Also, the employer is responsible for things like their portion of any employer payroll tax and withholding, disability insurance requirements, or other similar public benefit programs.
Equity & Related Comp
Many people wonder how much of a startup they should get in stock or options. First answer is that the company doesn’t have a duty to give you anything, much less a specific percentage. Now most people weight the risks of a startup folding by how much equity or options they get in sweat equity. It is really up to the company through the board of directors or through a equity or option incentive plan. If the board authorizes the plan or the grant, it is generally okay. The company needs to realize that they have to recognize compensation expense on their books for equity and option grants, not just cash paid out. Most of the time for startups, it doesn’t really matter since they are in the red anyway. It is always best to come up with company-wide policies, even in a small startup. These can give guidelines for how much in grants can be given out and what factors go into making those decisions. The policies can be put together with a formal written plan of incentives that the board can authorize management to offer to new employees or existing employees essentially as bonuses for good work. One major issue is that existing, or sometimes future, investors will want to know how much dilution they will face when option or equity grants come down. Also, management needs to report to the board and then to shareholders ultimately in terms of the reasonableness of grants. The other thing that helps with a more formal policy is that it can help avoid the rumor-mill going around that someone got more equity than another. The other item for the company to recognize is compliance with SEC Rule 701 discussed below.
Rule 701- When it comes to stock or stock option incentives, SEC Rule 701 deals with equity compensation to employees to non-reporting companies, i.e. private companies small or large. Those benefits are technically sales of securities since you are giving stock or a stock option (both securities) in exchange for services rendered versus actual cash for them. Rule 701 provides an exemption from having to register those securities issued under an equity incentive plan as long as they fall within certain limits in a 12 month period. The company does need to provide the employee or consultant with a copy of the written benefits/incentive plan or other contract within which the stock or option is being granted. The benefit is normally to be provided to an employee, but there are provisions to allow the exemption of Rule 701 to apply to certain independent consultants who are similar to employees.
This is a potentially huge area in dealing with issues such as taxes. Many incentives or benefits can be classified as deferred compensation, even if someone doesn’t think that they would. For a startup with little money, accruing (keeping accounting records to document and add up) and deferring compensation is often a necessary tool to get early employees paid for their time before the company has the cash to pay them. They do take a risk in accepting deferred compensation since the company may never be in a position to pay it. That is not to say that you can found a company and starting accruing as CEO a $400,000 salary because most investors are not wanting a large part of their money going towards your prior salary, especially if you have substantial equity or option rights.
The biggest issue for deferred compensation, usually in the context of deferred salary or other benefits for executives, is the tax treatment for the individual under IRS Code Sections 409A and 83. If the deferred compensation is fully earned and not at substantial risk of forfeiture, it is treated as current income for the employee/executive when earned, not when paid to the employee. Section 409A allows for an exemption from that current income tax treatment. There are certain rules for electing deferred compensation and treatment depending upon whether the deferred compensation is qualified or non-qualified. The whole process involves examining several issues beyond just 409A, such as the constructive receipt doctrine, the economic benefit doctrine, and IRS Code Section 83. This topic is too complex to discuss in detail in this article, but needs to be addressed or at least considered when it comes to compensation issues, especially since stock grants to employees or founders can be considered deferred compensation. If the benefit plan is structured properly, you can avoid those immediate income tax issues for the employee or executive.
Also, a 83(b) election often needs to be made with the IRS quickly (generally within 30 days after issuance), even for founders, to potentially avoid negative tax consequences from immediately recognized income. BE SURE TO FILE YOUR 83(b) ELECTION RIGHT AWAY TO AVOID DISASTROUS POSSIBLE TAX CONSEQUENCES.
If you fail to make a 83(b) election timely, the IRS is not going to let you go back and make it after the fact. Also, once you make the election, the IRS makes it extremely difficult to revoke the election as discussed in this IRS bulletin:
The fact that in most startup companies income from stock grants is so minimal due to how its calculated, it is almost advisable to file the 83(b) election as soon as you are granted the stock (“receive the property” in IRS terms) and avoid taxes down the road that could be substantial.
Resources for Recruiting Founder, Co-founder, and Technical Talent:
When looking to recruit top talent, of course, the usual suspects are good to search through like Craigslist, Twitter, Facebook, and LinkedIn, especially within some of the groups. I will list some of the other startup related recruiting websites, but the best source for good talent is through people. When attending networking conferences, events, and joining various groups, look for ways to get the message out that you are looking to join forces or bring someone on. If you get VC or angel money, they can be potential sources for where to look, as well as attorneys, bankers, and HR professionals that work in your specific area. Think back to most of the jobs you have gotten and you will probably learn that most of them came through a referral or some other connection that you knew or someone you knew knew, and so on (Think of the idea behind LinkedIn’s 3 levels/degrees of connection).
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Legal Disclaimer: All answers and discussions in this article are meant to be general and educational in nature only and should not be relied upon as legal, business, or tax advice for your specific situation. Most discussions refer to laws and regulations as applied to a California corporation and these can vary by location, as can other factors in certain situations within California, so it is always best to consult with a licensed local attorney with experience in these matters. Use of, or any discussion as a result of these articles does not create an attorney-client relationship and is not governed by rules on confidentiality.