1. SWEAT EQUITY ISSUES IN EARLY STAGE BUSINESS RUTH JIN, ESQ. rjin@jinlex.com June 19, 2015 rjin@jinlex.com © The JIn Law Group, PLLC All Rights Reserved. www.jinlex.com 1

2. INTRODUCTION Table of Contents: What is “Sweat Equity”? Page 3 Designing Equity Compensation Page 5 Restricted Stock Page 6 Options or Warrants Page 9 Phantom Stock and SARs Page 14 Performance Stock Page 15 Profits Interests Page 16 Choice of Entity Page 17 Founders’ as Employees Page 20 © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 2

3. WHAT IS “SWEAT EQUITY”? SCENARIO: Adam and Betty decided to start a business together. Adam will contribute $100,000, but Betty has no money but will work 20 hours/day and is the heart and soul of the business. Adam and Betty hope to own NewCo 50/50. PROBLEM WITH “SWEAT EQUITY”: Upon receiving 50% of NewCo, Betty has taxable income $100k. Calculation: Adam gets 50% of NewCo in exchange of $100k  NewCo’s Value x 50% = 100k  NewCo’s Value = $200k  Betty gets $100k value of security upon receiving 50% of NewCo. Future Services is not a contributable asset under Code Section 83(a)  Betty pays 35% ordinary income tax. There is no such thing as “Founders’ Stock”. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 3

4. WHAT IS “SWEAT EQUITY”? SOLUTION: 1.Issue “Grid” Notes: Adam put $1k and loan NewCo $99K payable in 7yrs or convertible to equity; or 2.Issue Restricted Stock to Betty (subject to forfeiture) if Betty is willing. PARTNER #3 or Employee #1 Comes Along: In year 2, NewCo is worth $500k but no profit yet. David, IT expert, wants to join NewCo as COO, and Adam and Betty wants to give David 10% of NewCo (=$50k at the time of grant). David doesn’t want to pay taxes on $50k, and A/B don’t want to pay David’s tax liability.. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 4

5. DESIGNING EQUITY COMPENSATION Equity Compensation Options: 1.Restricted Stock 2.Options or Warrants with vesting schedule 3.“Phantom” Stock Plan 4.Stock Appreciation Rights (SARs) 5.Performance Stock Companies often use equity compensation as a retention tool by requiring the holder to continue to provide services to the company through each vesting date. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com. 5

6. DESIGNING EQUITY COMPENSATION RESTRICTED STOCK: Pro: Shares of restricted stock are actual equity of the company that carry restrictions on transfer and sale that lapse over a specified vesting period or upon the achievement of specified vesting conditions. Retention and incentive tool. Designing Restricted Stock:  First, the Restricted Stock must be created by NewCo’s governing documents, equity compensation plan or award agreement.  The vesting of restricted stock can be accelerated upon a change- in-control event (Ex: sale of company).  Vesting can also be accelerated upon termination without cause or termination due to death or disability.  NewCo can award shares of restricted stock outright or it can require holders to pay a purchase price for the stock. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 6

7. DESIGNING EQUITY COMPENSATION RESTRICTED STOCK:  The plan or award agreement should specify the holder’s rights as shareholders with respect to unvested shares of restricted stock. Unless otherwise provided, the default rule is that because shares of restricted stock are considered actually issued upon grant, holders generally have same dividend rights and voting rights as other shareholders. o Can create non-voting class with different dividend rights. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 7

8. DESIGNING EQUITY COMPENSATION RESTRICTED STOCK: How Is It Taxed?  Restricted Stock is not taxed on grant. Holder recognizes taxable income on vesting (only when there’s no substantial risk of forfeiture).  Taxable income = FMV of shares upon vesting – purchase price  Holder can elect to recognize taxable income in the year of grant. Then taxable income = FMV of shares upon grant – purchase price  Such Section 83(b) election must be filed with the IRS and NewCo within 30 days of the grant date.  After making the election and paying initial taxes, Holder pays no more taxes on the subsequent vesting.  If Holder later sells the vested shares, any appreciation in value is subject to 15% capital gain’s tax and not 30% ordinary income.  Disadvantage: If Holder filed 83(b) election and his stock is forfeited before vesting, can’t get the paid tax refunded -> could end up with nothing. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 8

9. DESIGNING EQUITY COMPENSATION OPTIONS: What is Stock Option?  It gives the holder the right to buy shares of company stock at specified price.  NewCo can grant the option fully vested or with a vesting period specified in the grant notice.  Retention and Incentive Tool  Ex: NewCo grants David options to buy 200 shares of Company Stock to be vested in 4 equal installments on each anniversary of grant date or to be vested in full upon certain achievement or trigger events.  NewCo can put acceleration clause for change-in-control or termination without cause or termination due to death or disability. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 9

10. DESIGNING EQUITY COMPENSATION OPTIONS: How Is It Taxed? 1.Incentive Stock Options (ISOs)  ISOs are not taxed on grant, vesting or exercise.  Holder has taxable income or deductible loss when s/he sells the shares after exercising the options.  If Holder has held them more than 1 yr after exercise and 2 yrs after grant, he pays capital gain’s tax.  If not, it will be treated as NSO.  To qualify, the options must satisfy several requirements of Code Section 422 a)Company may only grant ISOs to employees. Directors and consultants are not eligible. b)ISOs must be exercisable while employed or no later than 3 months after termination (exception: death (expiration) & disability (1yr)) © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 10

11. DESIGNING EQUITY COMPENSATION OPTIONS: How Is It Taxed? 1.Incentive Stock Options (ISOs) c) ISOs must only be granted pursuant to a written plan approved by shareholders within 12 months before or after the plan’s adoption (# of shares and employee classification/eligibility). d) Grant ISOs within 10 yr from plan adoption; expire in 10 yrs. e) Exercise price must be no less than the FMV of the underlying share as of Grant Date. Exception: if Grantee owns more than 10% of all outstanding stock, 110% of the FMV. f) Plan or Award Agreement must provide that ISOs can only be transferred by will or the laws of descent and must be exercisable by the Holder during his lifetime. g) For each employee, the aggregate FMV of shares thru exercising ISOs (at the time of grant) that are exercisable for the first time in any calendar year cannot exceed $100k. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 11

12. DESIGNING EQUITY COMPENSATION OPTIONS: How Is It Taxed? 2. Non-statutory Stock Options (NSOs)  More flexible than ISOs and can be issued to all types of service providers (employees, directors, independent contractors).  Do not have to issue them at FMV  Are not subject to holding period restrictions.  Taxed at ordinary income tax rate on exercise price – FMV How to Be Exempt from Section 409(A)  Exercise price at least the FMV at grant date.  Issued as service recipient stock.  Contains no deferral features. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 12

13. DESIGNING EQUITY COMPENSATION PHANTOM STOCK ; STOCK APPRECIATION RIGHTS (SARs); PERFORMANCE STOCK When They Are Appropriate? 1)Founders don’t want to give out equity and voting rights, but only share the economic value of company’s equity. 2)Company already has an equity compensation plan, but wants to provide additional equity incentives without providing stock. 3)The company is a division of another company, but can create a measurement of its equity value and wants employees to have a share in that even though there is no actual stock. 4)Company is a nonprofit (meaning, no shares of company stock) © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 13

14. DESIGNING EQUITY COMPENSATION Phantom Stock:  NewCo sets “bench mark” at $1m and David gets 10% of actual increase in value above $1m, in cash.  David is taxed only upon payment; but no voting right or deductible loss. SARs 1)Holder has right to receive the excess of the FMV of equity – exercise price. 2)Similar to options but no actual purchase of shares upon exercising. 3)Typically has a vesting based on time and/or performance. 4)Company can pay out either in cash or stock. 5)Company can offer acceleration upon death/disability/termination without cause or change-in-control). 6)Taxed like NSOs. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 14

15. DESIGNING EQUITY COMPENSATION Performance Stocks:  Company agrees to issue a # of shares to David based on achievement of specified performance milestones after a measurement period.  Ex: In 3 years, if ABC happen, issue up to 100 shares (target share)  If in 3 yrs, only AB happened, issue 2/3 of the target number of shares  If in 3 yrs, more than ABC happened, issue 150% of target number.  Or “or or nothing” approach: If all of ABC don’t happen in 3 yrs, zero shares.  Different from Restricted stock: 1)Company doesn’t actually issue performance shares until it vests v. Company issues restricted shares on grant date.. 2)Company issues restricted stock as a flat number of shares, but issues performance shares with up-side or down-side possibility.  How Is It Taxed:  It’s not taxed upon grant.  Taxed at ordinary income tax rate upon actual issuance of shares. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 15

16. DESIGNING EQUITY COMPENSATION Profits Interest:  Available only for partnerships and LLCs.  The holder has the right to participate in the future income and growth in value of the awarded units. Ex: Class B can be defined as “profits interest” and David can get # of Class B Units equal to 10% of NewCo equity.  It can have vesting and forfeiture upon termination.  Profit interests are not “capital interest”  Often not taxed upon grant but taxed upon receiving the distribution (exceptions)  Often no voting; no management.  Created in the LLC operating agreement. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 16

17. WHAT ENTITY SHOULD YOU CHOOSE? Types of Entities: 1)Sole Proprietorship: a)Pro: No formation; file one tax return; no partner to compromise with; easy decision making. b)Con: Unlimited personal liability; pay self-employment tax; no transferability-lack of continuity -> difficulty retaining talents; difficulty in raising capital. 2)Partnership: a)Flexible allocation of loss and profit; wider knowledge and skill pool; attraction to employees to become partner. b)Unlimited personal liability for GP; decision making is harder. 3)C corporation a)Limited liability for all owners; unlimited life and transferability; easier to raise capital; tax free fringe benefits. b)Double taxation; harder to make decisions; higher compensation; accumulated earnings tax. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 17

18. WHAT ENTITY SHOULD YOU CHOOSE? Types of Entities: 4) S Corp: NYC doesn’t recognize S corp status 5) Limited Liability Company: a)Pro: limited liability to all owners; no double taxation; flexibility of allocating profits and losses among members; no ownership restrictions as S Corps. b)Cons: Self employment tax just like Sole Proprietorship; Medicare Tax. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 18

19. WHAT ENTITY SHOULD YOU CHOOSE? Entity Comparisons based on Taxes: $500k in Income with No Salary © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 19 C CorpLLC 34% Corporate Income tax: $500k x 34% = $170k No corporate tax Individual Owner Tax: $330k x 20% = $66k High Income Addit Med Tax: $80k x 3.8% = $ 3040 Individual Owner: Social Security tax: $117k x 12.4% = $14k Medicare Tax: $461,750 x 2.9% = $13,391 High Income Addit Med Tax: $221.750 x 0.9% = $1,906 Fed. Income Tax: $486,508 x 27.64% = $134,318 Total Tax: $239,040Total Tax: $164.123

20. WHAT ENTITY SHOULD YOU CHOOSE? Entity Comparisons based on Taxes: 2) $500k in Income With Salary of $300K: C Corp: $207K LLC: About $163K FOUNDERS AS EMPLOYEES 1.C Corporation: Betty is the CEO and Betty’s annual salary is $250K; Adam is the CFO and his annual salary is $250k. If the compensation is too high compared with equity contribution and revenue, and if it is a C corp., the IRS will characterize it as dividend. If Compensation is too high, it’s a red flag and the IRS may audit. Compensation must be “reasonable.” © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 20

21. WHAT ENTITY SHOULD YOU CHOOSE? FOUNDERS AS EMPLOYEES 2. S Corporation: Betty is the CEO and Betty’s annual salary is $10K; Adam is the CFO and his annual salary is $10k. If the compensation is too low compared with equity contribution and revenue, and if it is an S corp., the IRS will characterize it as dividend. If Compensation is too low, owners can avoid social security tax. Compensation must be “reasonable.” 3. LLCs If compensation is too low, not an issue for the owners. Social security taxes are due for partnership profits allocation and guaranteed payments alike. Two prong tests: (1) payment is reasonable in relation to services performed; AND (2) payment was intended to be compensation. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 21

22. WHAT ENTITY SHOULD YOU CHOOSE? FOUNDERS AS EMPLOYEES “Reasonableness” Standard Judicial reliance: Objective criteria such as BoD approval Disinterested shareholder approval Payroll tax treatment Deducted as salary in books and records Employee’s qualifications The nature, extent, and scope of the employee’s work The size and complexities of the business A comparison of the salaries paid with the gross income and net profit of the business. The market practice. A comparison b/w salaries and distributions to owners. Subjective Criteria: What would an independent investor do? © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 22

23. WHAT ENTITY SHOULD YOU CHOOSE? FOUNDERS AS EMPLOYEES Subjective Criteria: What would an independent investor do? If the rate of return is high, the performance of the CEO is really amazing, would an independent investor want to compensate this CEO with the same amount of salary, bonus and incentive stocks? If yes, it’s an indication that the compensation is reasonable. © The JIn Law Group, PLLC. All Rights Reserved. www.jinlex.com 23

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