Cash Crunch? Consider Equity in Lieu of Cash for Highly Compensated Team Members

Written By: Trent Read, Principal at EP

|||Equity in Lieu of Cash to Pay Employees

The vast majority of companies, even venture-backed companies, rely heavily on revenue to help fund their business. There are development-stage companies for which the current Coronapocalypse may have little impact, but for any mature business or at least those in revenue generation mode the economic shutdown could massively impact revenue and thus create a tough equation for having the needed cash on hand. Tough times can call for tough actions. Though equity is an extremely expensive form of capital, it’s something you could offer to highly compensated team members who may have the savings to handle decreased or no pay for a period in exchange for equity compensation as they invest in the future of the business.

Offering equity can have a number of very positive impacts. When I was the CFO of a prior company, we had a major cash crunch and needed to do this. People who agree to forgo cash compensation in exchange for equity compensation are: 1) sacrificing for the business, 2) exhibiting loyalty, and 3) investing in the future of the business – further aligning their interests with the rest of the equity capital stack. At that company we made it through the cash crunch – thanks in no small part to the sacrifices of key team members and we ultimately had a reasonably good exit for everyone. It wasn’t an earth-shattering success story, but it had a happy ending when it could have easily been a Greek tragedy without those kinds of sacrifices.

In looking to equity as a tool for slowing the cash burn during global lockdown you need to consider what equity or equity derivative makes sense and for any of the available options that depends on considerations related to governance, any necessary structuring (partially governance related), tax consequences, and valuation (which is partially tax related). Below are some of the more common equity tools used and discussion on the related considerations.

Common Equity (shares or units)

In all cases, especially common shares or units, you will need to follow your specific protocol of corporate governance. That’s easy if your company is a sole proprietorship and you can do whatever you want with ownership in your company. If you have outside investors, then you likely have a board of directors that would have to approve any issuance of common shares / units. More than likely a board is going to push back on giving out shares / units and will lean heavily toward options or profits interests. Boards don’t like additional cooks in the kitchen that then have minority shareholder rights. Another governance concern is that some team members today may not be team members in the future and having them on your cap table can prove to be a pain – especially if they go to a competitor or become a competitor. So, for several governance reasons you’ll get push back. For those same reasons as an owner you should consider carefully who you might be making an owner in your business.

Structurally you could consider giving the shares / units out as restricted shares / units with a vesting schedule (often 4 years) such that you mitigate the risk of them not sticking around. Papering this or any grant of equity up should be done with advice from your legal counsel. They could help you make sure you do it correctly and that you keep your ownership table and corporate documents up to date.

From a tax standpoint if you grant shares / options or do a restricted grant the team member is still receiving something with current value, which has tax consequences. You can have a firm like ours conduct a valuation to determine the current fair market value of common equity and the team member could use that for their tax filing. If you were to grant restricted equity then the valuation should be done right away to allow them to do an 83(b) election and recognize the full gain now rather than waiting for vesting milestones and recognizing additional paper gains down the road when the equity is worth more and thus their tax consequences for a paper gain could be more painful. You may prefer a low valuation to mitigate tax consequences, but in theory that low valuation also means you’d be giving out more equity to keep the team member whole versus the pay they are agreeing to forgo. So ideally the valuation is right down the middle of the fairway, so you don’t give up too much equity and the team member isn’t hit too hard with taxes. Regardless these tax consequences can make this option less attractive than other alternatives.

Profits Interests

This option is only open to a company that has an LLC holding company. By that I mean, you would either already have or would need to form an LLC that holds your company and establish a profits interest plan within that holding company. To my knowledge you cannot have profits interests in an operating company in which the recipient works. Profits interests operate off the much debated “carried interest exemption” within the tax code. So, the recipient needs to look more like an investor in that company. From a governance standpoint you’d need your standard individuals involved in governance to have either already created or be willing to create a profits interest plan as part of your equity incentive plan. Again, your corporate structure needs to be right for this to even be an option. But if it is an option, it is a very tax efficient option.

Recipients could receive profits interests that have no tax consequence at grant and could have long-term capital gains treatment at an exit event (if a year or more from the receipt). You could even bake in a catch-up feature that operates similar to a liquidation preference for the recipient such that a grant could almost look like a standard unit in terms of the financial benefit to them at the time of an exit. This way you could give out fewer of these to still make them whole on their pay. All of this assumes the company eventually sells for something north of the current value as the profits interests have no value if the company were to sell at exactly the current value or below the current value.

You need to have a firm like ours conduct a valuation to establish a “hurdle value” to comply with Revenue Procedure 93-27 as further clarified in Revenue Procedure 2001-43.  If the company ultimately sells for less than the hurdle value, then the recipient gets nothing (somewhat like an option). If it sells for more, then they can get their pro rata portion of the upside that they help to create. If you put in place a catch up feature, they can get an extra share of anything over and above the hurdle value until they are made whole.

Recipients of profits interests will need to get K-1s for their taxes and that adds a bit of additional administrative overhead to this option. You also need to either be set up for this in the first place or get set up for it – which will cost legal fees. But if you’re in a cash pinch and the saved salary for some period of time is more than the legal fees it can be well worth it and very advantageous from a tax standpoint unless the government legislates away the carried interest exemption – something that’s possible but not probable.

Common Options

Common options can be a good way to go. From a governance standpoint the option pool may already exist or would be easy to create/approve in a board meeting. Options are standard in corporations and are easily structured in LLCs. Options should be granted with a strike price that is equal to the current fair market value of common shares. That makes quantifying the value of an option grant a bit tricky. The reason the IRS has rule 409A (at least in part) is to ensure companies don’t play games with options. The IRS does not hit the recipient with any tax consequences at the time of grant because in theory they are almost worthless at the time of grant. Certainly, there is some “option value” but with a strike price equal to fair market value of the underlying security they aren’t worth much since you would pay just as much to exercise the option as they are worth today. So if I am the team member and I am forgoing $10,000 of monthly pay and you offer me a bunch of options I’d like to know how many of them are worth roughly the equivalent of $10,000. If the strike price per a recent 409A were $1.00, for example, a grant of 10,000 options would NOT be worth $10,000.

A valuation firm, like ours, could do the 409A to establish a current strike price but that wouldn’t solve the above question. We’d need to run it through an option pricing model to come up with a present value of the option value.

All of that said, this is not a situation where it must be a dollar for dollar exchange of cash versus options. It may be that a team member would have such high confidence in the future of the company that they would take 10,000 $1.00 strike price options in exchange for forgoing $10,000 in pay. It would be wrong to represent to them that the grant is currently worth $10,000 – that’s just not the case. But ultimately that grant might end up being worth hundreds of thousands. They may also end up being worthless and team members should clearly understand the risk they are assuming.

In my prior example at my company we used options as they were already approved to be issued by our board, employees were accustomed to receiving them, and some of our employees really believed in what we could accomplish. I never did any financial analysis on whether it paid off really well on a time value of money basis for them, but it came out pretty well for sure. This is likely the easiest thing to execute against and you might be able to use your most recent 409A valuation along with some back of the napkin calculations to land on grant amounts that have everyone feeling happy. You could also enlist a firm like ours to give a more current 409A given the new lay of the land and even provide that derivative calculation on present value of options to help with your math. Even if you do have a current 409A it would be prudent to determine if the current market conditions have a “material” impact on your business and as such you may benefit from an updated 409A.

Warrants

A related tool that could help along these same lines is to issue warrants. The same kind of governance is needed to ensure stakeholders are on board. Warrants could be issued to vendors who want to be paid, but who may have confidence in the future of your business and would be open to receiving warrants in lieu of cash for services that they are offering. Warrants given to vendors aren’t subject to rule 409A or the Revenue Procedures we talked about before. The recipient may have some hoops they need you to jump through. They might need to cancel the amount owed via a credit memo instead of having the warrant issuance look like non-cash revenue. It may need to look more like an investment by them to keep their accounting clean. There could be some needed discussion around the warrant exercise price and again valuation may be needed to provide insights here. But if you have vendors who are vested in the success of your business and who believe in you then warrants to them may be one of the cleaner, easier ways to mitigate cash burn with an equity derivative.

Summary

I was asked if you can offer this to some employees and not offer it to others. The reality is that this happens all the time in granting of options or deciding to take on partners/shareholders. There is less of a statutory issue and maybe more of a cultural/team member morale issue where some might feel miffed for being left out. It would be up to you to determine who might make sense for this but using equity or equity derivatives can definitely be an effective tool at getting you through a tight cash crunch. You’ll need to consider the related governance, tax, structure, and valuation implications of any chosen path. You’ll also want to be careful about what you are signaling to team members or vendors. It’s better to live to fight another day than to die with your pride, but you always want to signal a bright future day after a current tough spot, that way recipients fight to make that bright future day come to pass and everyone can benefit together. Our team members really stepped up when we did this, and most people do tend to rise to the occasion when they are asked to sacrifice for the common good. Giving out equity or equity derivatives does align future interests and show someone they are a valued part of the company. I would encourage those facing tough times to give this option a hard look but be smart in choosing what works for you and doing it in a clean way with help from legal counsel and valuation professionals.

2020-04-02T15:43:39+00:00