Compensation Issues of VC-Backed Companies

Compensation Issues of VC-Backed Companies

I’d like to share some thoughts on compensation in VC-backed start-ups today.  According to a recent export poll by ExpertCEO of 56 CEOs from venture backed companies, the average compensation of CEOs was $330,145 in 2010, with a salary of $246,742 and a bonus of $83,403.  In 2011, CEOs expect their salaries on average to remain relatively flat at $247,950, but their bonuses to increase to $106,337, for a total average compensation of $354,287.

Given the expected increase in bonuses it seems timely to briefly talk about stock options versus restricted stock.  Restricted stock is becoming increasingly popular over stock options.  One reason is that restricted stock still has value if the stock trades below the price when the stock was granted, whereas stock options are worthless if the stock price is below the strike price that was set when the stock option was granted.

Another reason for the growing popularity of restricted stock is §409A of the IRS, which became effective on January 1, 2005.  Under this rule, compensation that is not considered deferred is subject to hefty taxes and fees.  Stock options with a strike price set below the current valuation of the company are not to be treated as deferred compensation and therefore do not comply with §409A.  For example, if the strike price is $10 and the company is valued at $12, you will have to pay an additional tax on the difference.  The costs are substantial and include an additional 20% tax, among others.

Valuation is a big question for companies that are not yet listed i.e., VC-backed companies who also often rely on stock options to retain talent.  There is no silver bullet and the IRS increasingly scrutinizes valuations presented to them.  Valuation methods applied are asset valuation, option valuation (Black Scholes), income valuation (DCF), and valuation events, to name a few.  But how do you defend a valuation of an early stage start-up that hasn’t yet generated revenues or experienced a valuation event?  Having a reputable company such as CENAK Consulting L.P. prepare a valuation analysis always helps.

One way to avoid having to deal with §409A is to grant restricted stock or Restricted Stock Units (RSUs).  These are becoming increasingly popular and warrant spending some time on before deciding which way your company wants to go.  Both restricted stock and RSUs will still have to be taxed as income and you will have to pay capital gains tax once you sell them hopefully at a profit, but you do not have the dreaded §409A-question hanging over you.  Also, at least with restricted stock you can elect to pay income tax when the stock is granted, not when it vests.  For shareholders of strong growing, VC-backed companies this is an attractive option.  RSUs do not have this feature as they are an unsecured promise by the employer to grant a set number of shares to the employee in the future upon the completion of the vesting schedule.

What does this mean for those companies that are currently exploring compensation alternatives?   You need to do your homework and include tax advisors and accountants in the decision process.  Taxation of stock options and restricted stock is one thing; accounting for them is a separate issue.  Whatever you do, get your advice from experts in the area.

This posting should not be construed as tax advice.  We simply want to make you aware of these choices you have to make that could potentially have costly and unwanted consequences down the road.

You also need to have a reputable company on your side that can help you present a defendable valuation.  If you have a valuation question or are currently considering raising funds and you wish to become a CENAK Consulting L.P.client, please submit your information to info@cenak.com.

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