Business Compensation Article

Compensation Planning and Strategies for Start Up and Growth Companies

This article will be organized in three sections:

1) Venture/ Small Business Compensation Program Building Blocks

2) Performance Reviews

3) Employee Moral

Understanding how Performance Reviews and Employee Moral figure into Company Compensation Programs is a vital component of a Business’ Success.

I. Compensation Program Building Blocks for Start-Up Ventures and Small Businesses

A. Ownership

1. Founders Stock Strategy

a. Issue convertible preferred stock to outside investors and reserve common stock for founders and key employees.

i. Convertible Stock should have a liquidation preference large enough to eliminate the book value of the Company, and in subsequent funding rounds the liquidation preference of each stock class should be increased to cover the current

ii. The Convertible Preferred Stock should have Senior Dividend, Preemptive and Redemptive Rights; registration rights and rights of co-sale.

iii. Holders of Common Stock own only the remaining Shareholders’ Equity after the convertible stock preferences has been satisfied.

iv. The Goal: The superior rights of the Convertible Stock, when combined with the probable profit loss of a new venture, will substantially reduce the taxable fair market value of the Common Stock. Founders and Key Employees can obtain Common Stock at significantly reduced prices and tax liabilities than paid by outside investors.

Note: For more information regarding Convertible Preferred and Common Stock, along with more details on stock dividends, rights redemptions, liquidations and anti-dilution provisions, pre-emptive rights and so forth, please visit ABC Business Consulting’s Article on Funding Sources for Your Business.

2. Stock Options Incentives

a. An Incentive Stock Option Plan (ISO) provides employees with tax preferable stock acquisition.

b. There are many rules, conditions and tax implications for an ISO, so the ISO Designer should be knowledgeable with factors the IRS considers instrumental to a fair market stock valuation. Penalties can be severe for miscalculations.

c. A Qualified Stock Plan is a fantastic way to attract and keep talent, as long as, the design and use of the program understands potential issues, such as the Alternative Minimum Tax, Sequential Exercise Rule, Loans, Holding Period Requirements, ISO Exercise Conditions, Stock Exchange and Fair Market Valuation.

3. Non-Qualified Stock Options

a. Maybe good to mix with ISO plans for certain employees to balance tax implications.

b. Excellent vehicle if want to grant an option to an Outside Director, Consultant, Adviser, or Supplier.

c. Issues to consider when utilizing a Non-Qualified Stock Option Plan include Inadvertent ISO Qualification; Institute withholding, Shareholder’s Grants, Loans and Valuation Methods.

d. Considerations: In some situations a Non-Qualified Option can be more advantageous over an ISO; however, an ISO has a lower tax burden at exercise, and the time value of money is superior. Also, long-term capital gain implications are often better tempered through an ISO. Again, it is very important to hire experts in this area to fully explore Qualified and Non-Qualified Stock Option Plans.

4. Subordinated Common Stock

a. Junior Stock can allow key employees of startup firms or high growth companies to acquire a subordinate class of Common Stock at a fraction of the value of regular class Common Stock.

b. Have an option to possibly convert into the regular Common Stock.

c. This stock structure awards key employees from substantial improvements in the Company’s Sales and Earnings.

d. The associated rights of Junior Stock conveys inferior rights to those of regular Common Stock, such as, reduced voting and dividend rights, and inferior liquidation preferences.

e. However, if the Company achieves specified Strategic Goals in Sales and Net Income, the Junior shares convert to regular shares on a one to one basis.

f. Junior Stock Plans should restrict ownership of shares to continuing company employees and include transfer limitations, repurchase provisions and rights of first refusal.

g. Junior Stock can be offered through an ISO or Non-Qualified Stock Options.

i. There can be certain tax preferences to a Junior Stock Option Employee when purchased through a Qualified Plan, yet issues of Valuation, Lapsing Restrictions and Conversion should be considered by a tax professional.

h. Goal: Junior Common Stock Plans is a very economical compensation structure for a Key Employee; yet clearly incentivizes Employees to contribute to the overall success of the Company. While Convertible Preferred Stock and Junior Common Stock have many common features, the goals of each are opposite:

i. Convertible Preferred goal is to depress value of regular class stock into which a secondary class will convert.

ii. Junior Common Stock’s goal is to depress value of the secondary stock class which will be converted to regular class.

B. Harvesting Value: Rule 144 Implications

1. Founder’s Stock is subject to Rule 144 Restrictions, which sets standards and procedures by which restricted and control stock can be sold. The rule specifies when, how and how much restricted stock and control stock may be sold in the public market place by private company owners and is subject to the SEC’s Securities Act registration rules.

2. Restricted Stock is stock acquired from a Company which has not been registered with the SEC through a Private Placement.

3. Control Stock is stock owned by Company Principals who control the business affairs of the stock issuing company, which would include Officers, Directors, Major Shareholders and individuals who influence Management Decision Making.

4. Changes: There have been substantial changes in Restricted Stock Transactions whereby Small Cap Venture Funds have incentives to buy into small companies. The holding and sales periods have been significantly shortened. Please confer with a Tax Professional to measure any Rule 144 implications to your Company’s Stock Structure and Plans. These changes to restricted stock holding periods have made this type of stock a lot more marketable, as a result, much easier to determine fair market value.

5. Implications: Expert counsel should be utilized when designing your Company’s Compensation Structure and Package to fully understand the extent of Rule 144 regulations, penalties and implications.

C. Returning Ownership: Termination Considerations

1. A Company needs to be protected against founders, key personnel and major shareholders departing, to include disability, termination and death.

2. Buy/ Sell Agreements help a company retain the ability to recapture the value of stock and ownership, normally through the use of insurance policies to fund the Buy/ Sell Agreement.

3. A Buy/ Sell Agreement will protect the entrepreneur’s return on his or her efforts.

4. Other forms of protection are utilized through Vesting Programs for Stock Options and profit-sharing plans. As a Company matures and achieves success, vesting plans can secure key employee loyalty while maintaining adequate incentives to excel and increase company profits.

This article is an excerpt of a Chapter from our Business Success Guide. For the rest of the Chapter, please visit:  The Business Success Guide. 

The remaining major sections of the book’s Chapter have been left below as an outline so you can get an idea of what else is contained in this Chapter of the Business Success Guide.

II. Performance Reviews

A. Overview: The Annual Employee Performance Review should be a thing of the past…

Dr. Samuel Culbert, consultant, author and professor of management at UCLA, argues that the traditional Performance Review is detrimental …

1. Two Different Mindsets:

2. Performance doesn’t Determine Pay Levels:

3. Subjective Objectivity:

4. One Size doesn’t Fit All:

5. Personal Development is Impeded:

6. Hindrance to Effective Teamwork:

7. Immorality of Justifying Corporate Improvement:

Dr. Culbert laid out 7 key areas where Performance Reviews do nothing to enhance performance…Let’s break this down into parts:

1) Two-Sided:

2) Reciprocally accountable:

3) Performance Preview:

Dr. Culbert’s reasoning behind Performance Previews makes great sense…

1) Boss’s role is to “…guide, coach, tutor, provide oversight …

2) Eradicates self-serving boss behavior …

3) It is a Pro-Active Process, not reactive…

4) Replace the one-size fits all Evaluation Check-off List with …

Ok, so what does Performance have to do with a small Company’s Compensation Strategy? … Company’s Compensation Plan, as that achieves…

1) Common goals toward achieving company success…

2) Higher individual productivity…

3) Accountability between team members and management…

4) Happier employees work harder and smarter….

5) Retain highly valuable, well trained, experienced employees as this system fosters trust…

6) Achieves the same objectives as do Stock Option Plans…

However, the question to be asked is where do benefits fit into Compensation Planning for new and growing small companies? …

Founders Stock, ISOs, Non-Qualified Stock Plans and Junior Stock Plans

Tax and SEC Regulations

Key Person Termination & Company Continuation Planning and Strategies

Performance Pre-Views

Where most companies dangle the Benefits Package, …

A Benefits Package should be comprehensive in its offering…

I highly recommend using a large Financial Services Company to package the entire Benefits Plan …

I also make the contention that Pay Scale is not very important in the overall scheme of things as long as pay is not the focal point but a part of a Progressive, Incentivized, Comprehensive, Competitive, Proactive based Compensation Plan…

III. Employee Morale

A. Overview:

“Employee X” wrote an eye opening article in the January ’09 Entrepreneur Magazine, titled “Why I Finally Quit.” Employee X, wishing to remain anonymous, …

B. Why He Took the Job

C. Why He Left the Job

D. Lesson to be Learned from this Story

IV. Conclusions

The Central Point of this article is Compensation Planning, to be effective for both the company and employees, needs to address certain key areas….

References:

• Entrepreneur Magazine, January 2009, Employee Section, “Why I Finally Quit” by Employee X (anonymous)
• Wall Street Journal, October 20, 2008, The Journal Report, Human Resources Section, “Get Rid of the Performance Review” by Samuel A. Culbert