Startup Compensation: Founders, Don’t Forget to Pay Yourselves (and Others)

By Dennis Kasimov and Joe Wallin

In the early days of a startup, it is common for founders to not pay themselves any cash compensation. This approach is sometimes also applied to other service providers, who receive just stock option compensation. Despite the prevalence of this practice in the early days, as things progress it can lead to situations that put the company and its founders in a tough spot.

Startup Compensation

Here are a couple of examples showing how things can go wrong.

Example 1: A minority co-founder (say, 10%), who has not been paid any cash compensation (and is not an exempt salaried employee – see below), is not working out and is let go. If this co-founder feels aggrieved, he or she might sue the company and the other founders personally for failing to pay the minimum wage. The minority co-founder may face an uphill battle to prove his/her claim, but this situation would be a thorn in the side of any startup, with the potential to grow into a costly lawsuit. You can avoid this entire scenario by simply paying the individual at least the minimum wage in cash.

Example 2: You classify a service provider as an independent contractor, and you do not pay them cash. Instead, you pay them in vesting equity. The person works for a while, but their work is unsatisfactory so you terminate them. Their equity is unvested, and so it all reverts to the company. This person may not only sue you for failure to compensate them (a hard claim to win on maybe, but if they make it you have to deal with it), but, to add insult to injury, they might also assert that they own the IP they created while working for you, because you didn’t pay them anything for it.

It is obviously in a startup’s best interest to steer clear of these issues. So, it is important you handle paying people correctly.

What are the Rules?

For founders acting as corporate officers, it is generally difficult to escape “employee” status and the minimum wage and overtime requirements. Under the federal income tax law, an officer of a corporation is defined as a “statutory employee” (see https://www.irs.gov/irm/part4/irm_04-023-005r.html) which may hint to a similar classification under the wage and hour laws. Admittedly, the federal Fair Labor Standards Act has an exception to the minimum wage for 20% or greater equity owners, but Washington state law does not have a similar provision (c’mon legislature!). Because Washington and Seattle minimum wage levels are higher than the federal standard, these are the applicable rules to Seattle-area based startups.

The risk with not paying your employee co-founders (and if they are an officer of the company, then they are likely an employee) at least the minimum wage is that they might sue you personally if things don’t work out. Washington state has an unlawful wage statute (RCW 49.52 (http://app.leg.wa.gov/RCW/default.aspx?cite=49.52.070)) that imposes personal liability “for twice the amount of the wages unlawfully rebated or withheld” on corporate directors, officers and investor representatives on the board. This is one reason investors usually want to know if a company has severance plans in place before they invest. Failure to pay severance when a company runs out of cash is another potential source of troubles for directors and officers of the company.

But wait, you might say, how can some famous CEOs pay themselves $1 a year, as Steve Jobs did at one point? Well, for one, Steve had millions of dollars in equity incentives and retirement benefits that more than made up for a lack of payment of minimum wage to him; this type of plan is not applicable in the early startup world.

Here is the startup rule: If you are the majority founder, you are probably not going to sue the company. So, you can probably not pay yourself in the very early days. But this situation will change as your company grows, particularly when you begin to solicit investment funding. Investors are going to want to have the assurance that there is zero potential of outstanding wage claims.

For Minority Co-Founders, The Problem Can Be Especially Acute

But what about your minority co-founders at the early stages? Do you pay them at least the minimum wage?

Maybe not. If they are independent contractors (and properly classified under the law as independent contractors), then the minimum wage doesn’t apply. Accordingly, for most cash strapped startups it is important to keep as many of their workers classified as contractors as possible.

But it is not always possible to classify a co-founder as an independent contractor. As mentioned above, if the co-founder is an officer of the company, contractor status may be unattainable. Worker classification is a highly fact specific inquiry and largely depends on how much control the company has over the individual.

Usually a startup has one or two dominant founders and one or two minority founders. The minority founders might not be receiving any cash compensation, and their stock compensation is probably subject to vesting. If the company has to cut a minority founder loose, that person might sue the company and the dominant founders for failure to pay the minimum wage, and under Washington law for double damages and attorneys’ fees.

So, What Should A Startup Do?

Here are some tips:

* Every worker, regardless of whether they are an employee or an independent contractor, should sign a confidentiality and proprietary rights assignment agreement, assigning all IP they create to the company. Think of your startup as a ski mountain. You don’t let anyone ski your mountain without a lift pass. Here, the “lift pass” is a solid IP assignment and confidentiality agreement.

* Every worker should also sign a document governing the terms of their service relationship. Are they an employee? If so, have them sign an at-will offer letter. If they can properly be classified as a contractor, have them sign a well drafted Independent Contractor Agreement.

* You need to pay your minority co-founders at least the minimum wage if they are an employee (e.g., an officer) of the company. Otherwise, you are accepting a risk of lawsuit. If you don’t have any cash to pay them the minimum wage, don’t make them an officer, and treat them as an independent contractor as long as you reasonably can (and pay them a small amount of cash to make an IP assignment binding). This can work well for someone working part-time on the weekends and evenings during the company’s early days.

* Be wary of informal and unspoken agreements among friends and family (“Dont worry, I won’t sue!”). This is business and the relationship can go south quickly. Moreover, an individual can never waive their right to minimum wage, even in writing.

* Use a payroll service so that you can rest assured that all taxes are deposited with the IRS and all employment tax returns are filed. See  http://startupclass.samaltman.com/courses/lec18/.

* You may attempt to qualify a founder/employee as a salaried executive exempt from the wage and hours laws. The requirements are detailed in WAC 296-128-510. This option will not eliminate the need to compensate the individual, but it may lower the required wages to as low as $155.00/week provided that the other requirements are met as well.

As you can see, this can be a complicated area of the law. Every company should seek a trusted legal advisor. One thing is clear though: do not sweep these issues under the rug during the early stages of your company.