By: Kat Zhao
If you are an early-stage startup with non-founder members on the team, they are most likely working for you as independent contractors. Unlike employees, independent contractors are not covered under federal or state employment laws (e.g., the minimum wage laws). This, however, does not mean that startups can avoid paying independent contractors. In fact, there are plenty of non-legal reasons why startups should properly compensate their consultants or advisors for contributing to the business. The questions that often arise are whether to pay in cash or equity (or both) and how much to pay.
The majority of startups begin by bootstrapping. Understandably, the lack of working capital and cash flow constrains your startup’s ability to adequately compensate your consultants. To make matters more complicated, your consultant may be a good friend or colleague who has a valuable skill and has agreed to help your startup on the side. The work likely will require a decent number of hours and result in something that will become part of your end product. Your friend or colleague has agreed to sign your standard PIIA. You know that the hourly rate you are able to offer (if you are paying at all) is a far cry from the market rate. What should you do?
Equity v. Cash
Many founders in this situation may be incentivized to offer equity as compensation to consultants when they are unable to provide adequate cash compensation. But for most early-stage startups, this is an issue of putting the cart before the horse. While offering equity or the promise of a future stake in the company seems like an impressive commitment, it assumes that the company will reach a point of success when that stake becomes something of significant value. Currently the business is likely worth close to nothing. If it ends up as a dud, the offer of equity becomes meaningless.
So, rather than using equity as a stopgap, founders should carefully consider the value of a consultant’s contribution to the startup’s lifecycle as a whole when deciding whether to give the consultant equity and, if so, how much. Founders should also be prepared to have a frank conversation with the consultant early on. Although the cash compensation may be insufficient, it is still much better than an empty promise. Depending on the scope of the consultant’s work and whether the consultant has a continuing relationship with the startup, it may be in both parties’ interests to hold off on an equity offer until the startup has seen more significant growth.
If the founders do decide to give a consultant equity in the company, the amount of equity should be based on a combination of factors. It is undoubtedly difficult to quantify an individual’s value to a company, particularly a startup that is undergoing rapid changes. Nevertheless, founders can base their decision on the consultant’s role at the startup, whether the work is a discrete project or of a continuous nature, the timing of when he/she joined, and his/her seniority relative to team members in similar positions.
Types of Equity
A startup may offer equity compensation to independent contractors in one of two forms: a grant of restricted stock or a stock option.
Equity compensation to consultants and advisors are subject to legal restrictions. The SEC provides a safe harbor exemption under Rule 701 allowing non-reporting companies to issue equity in the company as compensation to employees, consultants, and advisors. Of course, this exemption comes with certain limitations, with some limitations being more salient for early-stage startups than others.
First, the exemption is not available to any company that is already subject to the reporting requirements—which is unlikely to be the case for young startups.
Second, any consultant or advisor receiving equity under Rule 701 must be a natural person providing “bona fides services” to the company. In other words, the independent contractor must be an individual (i.e., not an entity) who is providing actual services or producing work for the startup (i.e., not a passive investor). A consultant or advisor no longer with the company can only receive equity under Rule 701 if he/she was offered the equity while still working for the company.
Third, the equity compensation arrangement must be detailed in a written compensation agreement (e.g., a restricted stock agreement).
Fourth, the amount of equity compensation in any consecutive 12-month period cannot exceed the greatest of $1 million, 15% of the company’s total assets, or 15% of the outstanding amount in the class of securities given.