United States: Executive Compensation And Benefits Issues For Start-Ups And Emerging Companies

() Overview —

This chapter will discuss executive compensation in the start-up and emerging company space, including common market practices for start-ups that typically involve venture capital investors. When applicable, this chapter differentiates between equity in corporations (shares of stock), partnerships (partnership interests) and limited liability companies (membership units).¹ For purposes of this chapter, the Internal Revenue Code of 1986, as amended, is referred to as the "Code." Section references are to the Code unless otherwise specified. The term "emerging company" is used synonymously with "start-up."

() Introduction —

Executive compensation in the emerging company space is based fundamentally on a negotiation, either actual or expected, between company executives and/or founders on one hand and company investors on the other hand. Although there is no one-size-fits-all executive compensation structure, there are usually norms customary to particular industries and, increasingly less so, regions. These customary compensation forms and arrangements have been established over many years through negotiations between executives and outside venture capital investors and have coalesced into a "market standard" for emerging companies in particular industries and regions. While a company may structure its compensation arrangements in a variety of ways before an initial outside investment, as it enters the fundraising stage it will typically face pressure to conform its compensation arrangements to market standard as a condition to being funded. Some companies match their pre-investment compensation and benefits arrangements to market standard to make for a smoother transition to market, while others prefer to design the compensation and benefits package that works best for them and address changes required as a condition to fundraising later. In contrast with the typically passive nature of public company shareholders,² principal shareholders of start-ups (usually acting in their roles as officers, directors or shareholders' representatives) are often directly involved in establishing the company's executive compensation packages. The result is typically a close alignment of the executives' compensation with the interests of the shareholders (and later the investors).

Because of this close monitoring of executive compensation by those whom the executive compensation arrangements directly affect, there is relatively little criticism, public or private, of emerging companies' executive compensation arrangements. Executive compensation in the emerging enterprise tends not to be lavish or mysterious, although the compensation can be substantial if the company is successful. In any event, the starting point for the negotiations is typically whether the executive is a company founder or not.

Footnotes

1 For partnerships and limited liability companies (which are generally treated like partnerships for federal income tax purposes), equity is divided into either "capital interests" or "profits interests." In its simplest terms, capital interests are interests in both current and future enterprise value, whereas profits interests are interests in only future enterprise value. IRS Revenue Procedure 93-27 (1993-27 C.B. 343) (defining a capital interest as "an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership," which determination "generally is made at the time of receipt of the partnership interest," and defining a profits interest as a partnership interest other than a capital interest).

2 With notable exceptions for institutional investors and advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis, two well-known firms whose shareholder recommendations can hold substantial sway over shareholders. For example, among Russell 3000 companies who reported say on pay results in the 2016 proxy season, receiving a negative ISS recommendation on average resulted in 28 percent lower support from shareholders. Semler Brossy, 2016 Say on Pay Results 3 (Feb. 1, 2017), www.semlerbrossy.com/sayonpay.

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Originally published in Bloomberg Law's Compensation Planning Journal

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