HOW TO PAY PEOPLE IN A STARTUP
Founders ask me about how people get paid all of the time. It's just another one of those topics that no one bothers to explain to them.
So let's go.
Table of Contents of How to Pay People in a Startup
A. Paying People in a Startup Basics
1. C-Corps
2. How taxes work
B. How to pay founders
1. Salary and wages
2. Dividends
3. Regarding Equity
C. How to pay investors
D. How to pay employees
1. Salary and Wages for Employees
2. Equity for Employees
E. What Action to Take
A. Paying People in a Startup Basics
1. C-CORPS
There are a few ways to pay people in a startup set up as a C-Corp:
1. Salary or wages- compensation for work
2. Dividends- a distribution, usually of profits
3. Equity- giving ownership shares of the company as a form of compensation
Your startup needs to be a C-Corp. It could be an LLC. But LLCs get more complicated with guaranteed payments and distributive shares tied with LLC net income and all of that.
Don't worry that right now. This is about C-Corp compensation.
2. HOW TAXES WORK
There are a lot of nitty-gritty details regarding compensation, especially regarding the tax side of compensation. An accountant/payroll software is essential in helping with these issues. You do NOT want to mess this up. The goal is not to know how to do this all yourself. The goal is to have a big picture understanding of how all of this works.
When it comes to paying people in a C-Corp, these are the big areas concerning tax that you will deal with:
a. Income taxes
b. Payroll taxes
c. Investment income taxes
This covers federal taxes. Keep in mind that you may have to deal with state taxes as well.
a. Income taxes
The recipient of compensation will pay an income tax on their taxable income (such as their salary) at their ordinary income tax rate. The ordinary income tax rate ranges from 10% to 39.6%.
b. Payroll taxes
Payroll taxes concerns social security and medicare tax. The social security tax is 12.4% on your first $118,500 of income (that number changes every year.) Basically, the employer pays half and the employee pays half. So 6.2% the employer pays. 6.2% the employee pays. Medicare tax is 2.9%. Employer pays half (1.45%) and the employee pays the other half (1.45%)
c. Investment income taxes
This concerns taxes on investments, dividends, etc. For example, when you hold stock and sell it, you will have a type of investment income that you will be taxed on. Most investments will be taxed at the capital gains tax rate. There are two types of capital gains: short term (for investments held for a year or less) and long term (for investments held for longer than a year.) Short term mimics the rate of ordinary income. Long term tax rate is between 0-20% with most falling at the 15% rate.
Dividends are taxed at ordinary income rates; qualified dividends are those that satisfy certain holding requirements and are taxed at long term capital gains rates.
B. How to Pay Founders
I mentioned the three ways to pay people in a company is via salary/wages, dividends, and equity. Here I go through each one in the context of paying founders.
1. SALARY AND WAGES
Founders do work for the company and the company compensates the founder for these services rendered in the form of salary and wages.
You, the founder, will pay income tax at the individual income tax rate on wages paid to you by the company. The company can take a business deduction for this payment.
a. What Salary Should Founders Get?
First, you need to realize that the big benefit of being a founder is not the salary you make. It's from the potential upside of your company doing well. Value comes from the equity (stock) that you hold that will hopefully increase over time. The goal is that you can sell some of that eventually and cash in on some level. This is why your salary will not be as high as if you worked elsewhere and had a similar type of position.
"Yeah, okay, I get that. Can we talk actual amounts?"
The fact of the matter is that many founders don't pay themselves anything.
That's pretty normal for startups that have not raised money. Yes, the big benefit is not in the salary, but in having equity. Of course, that is not to say that, as a founder, you should be hung out to dry until the company is sold. You can use a rule of thumb of 10% of how much you've raised to set your salary. But this is if the amount you have raised is not substantial. So for example, if you've raised $500k, then a 50k salary (CEO) can be reasonable. $1M raise, then 100k salary. Of course, this is just to give you a general idea. The concept breaks down when the amount raised is higher than $1M. For example, If you've raised $5M, you would not have a salary of $500k.
b. How Much Salary Should Low-Equity Founders Get?
Some founders don't have a large amount of equity in the company. They may own 10-20% of equity. While this is not necessarily a large amount to start off with, you need to realize that if your company is going to do something, it's not insignificant amount.
So many of these low-equity founders don't get paid or they get paid minimally similar to above.
But if, due to a variety of circumstances, they should be paid you can do a few things to figure out how much they should be paid.
I suggest using a variety of metrics and comparables. Compare and think about how much they would be working for the company vs. others; how much per hour they would be getting paid if compared to others of similar skill doing that type of work in that same geographic area. Supplement those numbers with the amount of equity they have. Figure out how much, if the company were sold for, would the pay-out be for these lower equity founders. These are all ballpark amounts, but if you have enough data points you should be able to come up with something reasonable that makes sense for everyone.
Just remember to always use comparables. They will tell you what is reasonable.
2. DIVIDENDS
Dividends are payments made by the corporation to its shareholders. They are profits passed on to you as a shareholder.
The corporation does not take a regular business deduction for this payment. There are two levels of tax associated with dividends. The startup gets taxed on its income at its corporate income tax rate. After that, dividends are distributed to shareholders. Shareholders pay tax on these distributions at the ordinary dividend or qualified dividend tax rate. The dividends are not subject to self-employment taxes.
Note: most startups don't pay a dividend; especially not early on. The revenue that the startup brings is used to grow the company, not to share with shareholders.
3. REGARDING EQUITY
A point of distinction: founder's equity is not about getting paid. At the very founding of the company, founders should have 100% of the issued stock (set to a vesting schedule.) Over time this will dwindle down more and more due to investors coming in and due to equity being issued to employees. Think in terms of the pie. If company equity represents a pie, the more pie that gets dished out, the less percentage of the pie the founders will have.
This dwindling of founders' ownership needs to be a controlled process. It is not unusual for founders to have 60% of the equity after going through rounds of financings, hiring, etc.
C. How to Pay Investors
The short answer is that you don't pay investors.
You don't pay the investors a salary for their role as being an investor. If a person is an investor and is also taking on some other kind of role such as a board member (i.e. someone is wearing multiple hats), then that is a slightly different scenario and they might get some kind of equity compensation.
However, the point is this: investors don't get paid like other individuals in the company.
The investors buy equity in the company. They hold that equity until they are able to sell it when, for example, the company gets acquired. That is when the big pay off occurs for investors. It's all about buying stock in the company, letting that stock become valuable over time, and then selling it. Investors get preferred stock while others get common stock. That means, among other things, that when the company does get acquired, the funds will get dished out to them before others. I cover liquidation preference elsewhere.
Note, again: Investors can also get dividends, but again, most startups don't pay out dividends so it's really not something to think much about.
D. How to Pay Employees
Keep in mind that there will be differences in amounts in various jurisdictions. What's normal here in Houston, Texas and Dallas, Texas will be different from elsewhere. Every place is different. Any way, two ways to pay employees:
1. SALARY/WAGES FOR EMPLOYEES
The salary that an employee gets is dependent on their role in the company, their expertise, the geographic location of the company, the stage of the company, and other factors. The employee will pay ordinary income tax at that individual's income tax rate on this payment. The corporation can take a business deduction for this payment. Use a payroll service/accountant to assist in dealing with W-2s, W-4s, withholdings, and other matters.
2. EQUITY FOR EMPLOYEES
You need a lawyer to help you with this. Equity given for compensation purposes is going to be for common stock. There are multiple ways to use equity to pay employees. Some methods are better than others depending on where the company is in its lifecycle and because of tax consequences.
a. The different methods of using equity to compensate someone
i. Restricted Stock Units (RSUs): not real stock. but "units" that can turn into actual stock
ii. Restricted Stock: actual stock that comes with restrictions
iii. Stock Options: the option to buy stock at a set price at some point in the future
iv. Employee Stock Purchase Plan: comprehensive subscription style plan
v. Phantom Stock: not real stock but mimics stock
b. Explanation and Comparison of these methods
i. Restricted Stock Units (RSUs)
RSUs are units that, when vest, turn into actual stock.
Taxation
The recipient will have ordinary income when the units vest. Of course how much depends on the stock value. The recipient is not able to make an 83(b) election as RSUs are not actual stock. This is a downside to RSUs.
Terminology
When you come across these terms when you are doing business, be careful of how everything defined. There are times when someone says "RSU" but what they really mean is an award of restricted stock or some other type of mechanic. Other times, RSUs are really just "phantom stock."
ii. Restricted Stock
Restricted stock is actual stock that is given to an employee. It has some restrictions (e.g. shares are subject to a vesting schedule; there is a transfer restriction in place.) If the shares are subject to a vesting schedule, the unvested shares have to be given back to the company if the holder leaves the company within a certain amount of time.
Taxation
Three things can happen.
(1) If the stock is given flat out (the shares are fully vested), then the recipient is taxed on the value of the shares at the time.
(2) If the stock is given and there is no vesting schedule (fully vested on receipt), then recipient is taxed on the value of the shares when the shares vest. This can be problematic for the recipient because the shares might have gone up considerably in value over time.
(3) The preferred scenario: the stock is given and is not vested and the recipient makes an 83(b) election. The 83(b) election tells the IRS to go ahead and tax now. In that case, the recipient will be taxed on the receipt of the shares instead of being taxed when the shares actually vest and are worth more.
iii. Stock Options
As mentioned above, a stock option is the right to purchase a certain number of stock of a company at a specific price in the future. There are different types of stock options.
Taxation
Options are not taxed until exercised. What happens at exercise depends on the type of option. See the article on Stock Options for more information on taxation.
iv. Employee Stock Purchase Plan
An Employee Stock Purchase Plan (ESPP) is a program run by the company that lets an employee make periodic purchases of the stock of the company at a discount through payroll deductions.
Taxation
Not taxed at offering time start date nor stock purchase time. There are tax consequences when you sell the shares. The timing of when you sell the shares determines whether it is a qualifying or disqualifying disposition.
v. Phantom Stock
This is basically a way to give out employees "stock" and the benefits of owning stock, such as some kind of payment when there is an increase in the value of the company, but it allows the company to not actually give employees any stock. So the employees don't become shareholders. Phantom stock can be defined in many different ways.
c. When type of equity compensation to use for employees?
RSUs and Employee Stock Purchase Plans can get complicated and are better suited to larger, established companies. Phantom stock can be unnecessarily complicated. Keep things simple--especially at the beginning.
Startups should use either restricted stock or stock options.
i. Advantage of restricted stock over stock options
Restricted stock is cheaper to put into place and is less complicated. The company doesn't have to deal with configuring a stock option plan.
ii. Disadvantage of restricted stock over stock options:
The employee immediately becomes a shareholder. Being a shareholder comes with a number of voting and other rights even if the stock is restricted.
iii. Recommendation
If it's very early in the life of the startup, the employee is a key employee, then give use restricted stock. If the startup plans to make a number of hires, then institute a stock option plan and use stock options.
E. What Action to Take
- Get help. Hire an accountant/use payroll software especially when it comes to paying people.
- Founders. Early on don't pay founders much. Their big payoff will be holding and selling equity. How much they receive in salary or wages should be close to nothing if they've not raised money. If they have, then use a percentage of raised to determine salary as described in this article.
- Investors. Don't give a salary to investors. Investors don't get paid just for being an investor. They too get their payoff from holding and selling equity. Don't worry about dividends.
- Employees. Employees should get a salary depending on their role, industry norms, skills, and geography.
Use either restricted stock (if very early in the life of the company) or stock options to supplement that salary.