In recent years, stories of Silicon Valley unicorns have been rife with tales of early employees who, thanks to their company's skyrocketing valuation, found themselves sitting on a gold mine. However, it's not just full-time employees who can strike gold. Remember the story of the graffiti artist David Choe, who chose to be paid partly in Facebook company stock for decorating their headquarters? His shares, once Facebook went public, were suddenly worth an estimated $200 million.
It's an extreme example, but it begs the question: Can independent contractors, like Choe, receive equity as part of their compensation, and if so, why would private companies offer stock or even choose this route?
There's a growing trend among privately-owned companies to reward contractors not just with regular cash compensation but with something potentially valuable asset—a direct financial interest in the company's success through equity-based compensation. It’s a model that has been adopted by many tech giants and startups, effectively blurring the traditional boundaries between employee and contractor. But what does this mean for independent professionals themselves and the companies that hire them?
Understanding the Basics of Equity Compensation
Equity compensation offers a unique way to motivate, reward, and retain individuals involved with a company. It’s a multidimensional tool, offering various forms that each come with its benefits and complexities. But, what does it mean for independent contractors to be offered a piece of the pie, and how does it work? To get the gist, below are the essential components that make it up:
Stock options offer the right, but not the obligation, to buy a specific number of shares at a predetermined price, known as the exercise price or strike price. There are two primary types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).
- Incentive Stock Options (ISOs): These are only available to employees, not independent contractors. They come with the economic benefit of potentially favorable tax treatment if certain conditions are met.
- Non-Qualified Stock Options (NSOs): These can be granted to employees, contractors, board members, and others. They don't come with the tax benefits of ISOs, but they're more flexible in terms of who can receive them.
Restricted Stock and Restricted Stock Units (RSUs)
These are company shares given to an individual, whether an employee or a contractor, with certain restrictions. The receiver typically cannot sell or transfer the shares until they meet specific conditions, usually a vesting period. Unlike stock options, RSUs have value even if the company's stock price does not increase, offering a degree of security.
Vesting refers to the period that the recipient must wait before they can exercise their options or sell their company stock. The typical vesting schedule spans over four years, with a one-year cliff. This means that no vesting occurs until the one-year mark, at which point a significant portion (often 25%) of the company equity grant vests.
Fair Market Value (FMV)
This is the value of a company's stock at a given time. For privately-run companies, determining the fair market value can be challenging due to the lack of a publicly traded market price. They often rely on 409A valuations to provide an estimate.
Strike Price or Exercise Price
The exercise price is the price at which the recipient can buy shares if they decide to exercise their stock options. It's usually equal to the fair market value at the time the options are granted or the grant price.
Company’s Current Valuation
The company’s worth or valuation at the time of the equity grant plays a significant role in determining the potential future value of equity-based compensation.
Exit Event or Liquidity Event
For privately-owned companies, equity often only becomes truly valuable during liquidity, such as a sale or Initial Public Offering (IPO). This is when equity holders can cash in on their shares.
Equity Involves Risk
There's always a chance that the company’s stock value may decrease or, in the worst-case scenario, become worthless if the company fails.
Understanding these key components helps contractors evaluate their stock-based compensation's potential worth and the risks involved. It forms a crucial part of the decision-making process when considering an equity offer.
Do Contractors Own Equity?
Historically, the concept of owning a company's shares was reserved for internal employees. However, as the business landscape evolves, the roles of independent contractors are becoming increasingly crucial, and so is their compensation. Enter equity compensation for contractors—a concept that seems novel, but is rapidly gaining momentum.
Equity-based compensation is no longer an exclusive club for traditional employees. As businesses recognize the immense value that independent contractors, a.k.a. gig workers, bring to the table, many are exploring the opportunity to reward them with more than just an hourly rate or a project fee. They're bringing them into the fold by granting them equity, creating a sense of partnership and joint venture in company success.
This paradigm shift is driven by several reasons and backed by legal justifications. The primary one is a straightforward acknowledgment of the contractor's contribution to a company's growth and success, similar to that of an employee. The relationship between a company and its independent contractors has moved beyond transactional exchanges; gig workers are integral players in a company's journey, and their compensation structures are evolving to reflect this fact.
Offering equity as a form of compensation provides contractors with a personal stake in the company. It's not just about completing a project anymore; it's about sharing the fruits of company success. Equity-based compensation aligns the contractor's interests with those of the company, cultivating a sense of shared commitment and motivation to achieve business goals.
Moreover, offering equity is a strategic financial decision for many companies. It reduces the immediate cash outflow needed to pay contractors, easing the company's financial burden. It's a savvy way of paying contractors without putting undue strain on the company's current financial resources.
Equity-based compensation also helps companies attract and retain top tier contractors. In a competitive market, a chance to own a piece of a promising company can be a significant draw. It signals to gig workers and contractors that they are valued contributors to the business, not just outsiders brought in for a specific task.
So do contractors get ownership stakes through equity grants? Yes, and not only can gig workers own equity, but they're also increasingly being offered the opportunity to do so. The lines between employee and contractor are becoming blurred, and in many ways, that's a win-win situation for everyone involved.
Why Private Companies Offer Contractors Equity
Privately-run companies are increasingly looking at equity-based compensation as a viable form of payment for their gig workers or contractors. This strategic move is guided by several advantages, including but not limited to the following:
1. Reduced Cash Outflow
Paying contractors with equity rather than cash helps manage a company's liquidity. By reducing the immediate cash outflow required to compensate independent contractors, companies can allocate these resources toward other business expenses or growth strategies.
2. Attracting Talent
Offering equity can help attract top tier contractors. In a fiercely competitive market, where skillful contractors are in high demand, a chance to own a piece of a promising company can be an attractive proposition.
3. Retention and Motivation
Equity gives contractors a personal stake in the company's success. This "skin in the game" aims to encourage contractors to perform their best, as their financial future is directly tied to the company's performance. It also fosters long-term relationships with contractors, promoting stability and continuity.
4. Aligning Interests
Equity aligns the interests of the independent contractor with the company. When contractors have a direct financial interest in the company, their objectives become intertwined with the company’s objectives. This alignment promotes a unified vision and mission, enhancing productivity and efficiency.
5. Favorable Tax Treatment or Tax Benefits
Equity-based compensation can also offer certain tax advantages to companies, as opposed to ordinary income. Equity-based payments can sometimes be classified as capital gains, which may be taxed at a lower rate.
6. Positive Signal to the Market
When gig workers accept equity as part of their compensation, it signals confidence in company growth potential to investors and stakeholders. This positive sentiment can, in turn, enhance the company's reputation and market value.
7. Conserving Equity
Privately-owned companies can also use various mechanisms such as stock option grants, which allow contractors to buy equity at a discounted price, rather than offering outright stock grants. This approach conserves the company's equity while still providing the potential for significant upside to contractors.
Fair warning, though: like any strategic decision, offering contractors equity-based compensation is a plan that must be considered carefully and implemented judiciously.
Risks of Giving Equity to Independent Contractors
While granting equity incentives to contractors can offer several benefits, it's not a decision to be taken lightly. Several risks and potential drawbacks need to be considered:
Dilution of Ownership
Every piece of equity you offer to an independent contractor dilutes the ownership of the existing shareholders. This reduction may not be significant if the company has a large amount of equity to distribute, but for early-stage startups, it can potentially dilute the ownership stakes of the founding members.
Managing equity involves risk and additional complexities, particularly when you bring gig workers or contractors into the mix. There's a need to maintain an accurate and updated cap table, handle vesting schedules, manage potential legal issues, and more.
Unlike employees, contractors might not have as many incentives to perform at their best once they've received equity. If contractors underperform or leave early, it could lead to unfavorable outcomes for the company that offers equity incentives.
Impact on Future Funding
Investors often consider a company's equity structure during funding rounds. Offering too much equity to contractors might discourage potential investors who prefer equity to be concentrated among full-time employees and founders.
Equity is Irrevocable
Once granted stock options are documented, equity can't be taken back. If the independent contractor's performance isn't up to par or they decide to part ways with the company, they still retain the equity granted, which might not align with the company's interest.
Potential Legal Implications
There are legal nuances that companies must be aware of when offering equity to contractors. For instance, if contractors are granted company stock options that are typically offered only to employees, there could be legal complications if it suggests an employer-employee relationship.
While there can be tax advantages to offering equity, it's essential to understand the tax consequences. Companies need to ensure compliance with all tax regulations when dealing with stock-based compensation agreements.
If the company's growth stagnates or if the company fails, contractors who were paid a portion in equity may feel short-changed, affecting the company’s reputation.
Thus, while offering equity to independent contractors can be an effective strategy, it's essential to weigh these risks and consult with legal, tax, and financial advisors before deciding on this form of compensation.
How to Offer Equity to Independent Contractors
When considering offering equity to independent contractors, companies should keep in mind the following steps to ensure a smooth and legal process:
1. Draft the Stock Compensation Plan
This plan should clearly state the company's policies regarding the grant of equity to different stakeholders, including independent contractors. The plan will typically specify the types of equity available (like stock options, restricted stock units, or outright grants of stock), the total number of shares available for issuance, the terms of vesting, and other key factors.
2. Determine the Amount of Equity
Companies should carefully decide how much equity they are willing to provide to independent contractors. This decision is often based on factors such as the contractor's role and contribution, the company's current valuation, and the need to conserve equity for future use.
3. Set a Vesting Schedule
Establish a vesting condition that suits both parties. This might involve a vesting period over several years, with or without a cliff. Vesting stock plans can ensure the contractor remains engaged with the company for a certain period.
4. Consult Legal and Financial Advisors
Given the potential legal and financial implications of offering equity, it's wise to involve experienced professionals. They can ensure the arrangement is compliant with laws, particularly those that differentiate between employees and independent contractors.
5. Communicate Clearly
Ensure that the independent contractor understands the terms of the stock grant, including the vesting schedule, exercise price, tax implications, and what happens in the event of a liquidity event or if the company closes down. Clear communication can help avoid misunderstandings down the line.
6. Document Everything
Have a solid agreement that clearly spells out all terms and conditions of the stock grant. A stock-based compensation agreement can provide a written record that is beneficial to both parties.
7. Revisit Periodically
Equity compensation is not a "set it and forget it" deal. It's crucial to revisit the agreement periodically, especially when major events occur such as additional funding rounds, significant changes in company valuation to ascertain unfavorable valuation, or changes in tax law.
Granted, it’s not a simple process, but when done right, it can lead to a mutually beneficial arrangement that aligns the interests of the company and the independent contractors.
Tax Considerations for Contractors with Equity Grants
Receiving stock-based compensation has tax consequences and taxable events. For ISOs and NSOs, contractors do not have to pay taxes until they exercise the option. However, the spread between the exercise price and the market price at the time of exercise is considered taxable income.
In the case of an outright stock grant, the fair market value of the stock when it vests is considered ordinary income and taxed accordingly as ordinary income tax. If contractors sell their shares at a profit later, they will be subject to long-term capital gains tax if held for over a year, at a prescribed capital gains rate.
Why Giving Contractors Equity More Preferable than Other Compensation Structures
Equity grants to contractors can be a win-win situation. From the company's perspective, equity is a way to compensate independent contractors without a significant immediate cash outflow needed. From the contractor's perspective, equity grants provide a chance to benefit directly from company growth.
Contractors may see a greater potential return from equity than they would receive from cash alone, particularly if the company does well. Furthermore, equity grants can help align the contractor's interests with those of the company, leading to a more invested and dedicated partnership.
So back to the million-dollar, albeit metaphorical, question: can contractors own equity? The answer is a resounding yes. As companies seek innovative ways to compensate their independent professionals, equity compensation is becoming a prevalent and effective strategy that similarly opens up the opportunity to own a diversified portfolio. However, like all forms of compensation, it requires careful consideration of the risks and rewards, as well as prudent financial planning, investment management, and tax management.
Want to do away with the inconvenience and complexities of offering equity? Upstock is your main man! To know more about how our innovative Restricted Stock Units (RSU) plans are changing the gig economy, one contractor at a time, send us a message here for detailed info.