Equity compensation can be a powerful incentive, particularly in early-stage startups, where the upside is massive if the company is successful. Some employees might even express willingness to work solely for equity, bypassing traditional cash compensation. But is this practice as straightforward as it seems? In this article we explore the risks and legal implications of an equity-only compensation model, providing a balanced perspective to help startup founders navigate this complex issue.
Though this article will lay out the general principles, each situation varies and is impacted by state and local laws. It’s best to work with competent legal counsel to understand what’s right for your startup. If you’re looking for counsel, feel free to reach out to us here.
Employees Must Earn At Least Minimum Wage
The idea of compensating startup employees mainly or exclusively with equity may seem appealing, but it is important to understand that this practice is not legally allowed. United States federal and state laws require that employees receive at least the minimum wage for all hours worked. Moreover, if employees work more than the standard hours, they should receive overtime pay unless they are exempt employees. Click here to learn about exempt and non-exempt employees. [Link to: Exempt v Non-Exempt Employees]
After the employee has received at least the minimum wage and, if applicable, overtime pay, it may be an option to supplement their income with equity rewards. However, this approach must be thoughtfully executed to avoid any unforeseen tax legislation consequences.
Equity, depending on its form, often creates a tax obligation for the recipient. So, the company and the service providers should consider any tax and withholding obligations that may arise from such an arrangement.
While equity compensation can be an attractive addition to a compensation package, it cannot replace the legally mandated wage and overtime payment. Therefore, it is crucial for startups to navigate this area with a thorough legal and financial understanding to ensure compliance with all relevant regulations.
Contractors May Receive Equity-Only Compensation
The minimum wage regulations apply to employees but not to independent contractors. So, it is hypothetically possible to pay equity-only compensation to independent contractors.
That being said, this option opens the startup up to another legal issue: worker misclassification. Worker misclassification is when a company labels a worker an independent contractor but treats them as an employee. Employees are individuals hired by a company to perform specific duties under the company’s control and direction, usually with an ongoing, long-term commitment. They are entitled to benefits such as health insurance, paid leave and unemployment protection.
Independent contractors, on the other hand, are self-employed professionals hired to complete a specific project or task, generally without the same level of oversight or control. They are not entitled to the same benefits as employees, taking on their own tax and insurance responsibilities.
Misclassifying roles can have serious legal implications for startups. Misclassifying an employee as an independent contractor can lead to significant adverse consequences, which include:
- Back Tax Withholding. Employers might be required to pay back tax withholdings, including state, federal and Federal Insurance Contributions Act (FICA) taxes, with interest. In California, this liability typically extends back three years.
- Unpaid Minimum Wage and Overtime Compensation. Employers may have to cover unpaid wages and overtime with interest. In California, for instance, this could date back three years for non-willful violations and four years for willful violations. Some states, such as New York, have longer statutes of limitations, up to six years.
- Civil Penalties. Employers may face civil penalties for violations of employment laws. For example, California imposes penalties for not providing itemized wage statements or failing to give workers mandated meal and rest periods.
Ultimately, this option could avoid one regulatory issue — minimum wage compliance — and create another regulatory issue — worker misclassification. To learn more about worker misclassification click here. [Link to: Risks of Misclassification]
In conclusion, equity-only compensation is not a legally viable option for startup employees due to minimum wage and overtime pay regulations. However, independent contractors may receive equity-only compensation, although this approach carries the risk of worker misclassification. When properly executed, equity-based compensation can be an effective tool for attracting and retaining top talent while aligning the interests of workers with those of the company’s founders and investors. Startups should work with legal counsel to ensure compliance with relevant regulations and to design compensation structures that optimize equity allocations and protect the company’s interests.
If you’re looking for legal counsel, feel free to reach out to us here.