Becoming CEO of a Startup – Key Employment Contract and Equity Terms and Other Considerations
By Robert A. Adelson, Esq.
This article was published in CEO World Magazine on April 24, 2018.
You are a seasoned executive with a proven track record at several established companies in your industry. One day, you receive an offer to be CEO of a startup.
The startup CEO offer could be on the ground floor of a well-funded venture or perhaps to lead an up and coming startup to reach the next level.
It is an unusual opportunity, one that could put you in the driver’s seat of a market disruptor that might see rapid, even exponential growth rather than where you are now, a caretaker of an established enterprise with limited upside. It’s a challenge that can potentially be very rewarding.
Now you may be itching to join the glamour of the likes of Zuckerberg or Musk, but before you take up this intriguing offer, here are some items you should consider. These items include key contract terms, equity terms and other considerations that you might also want to include in your contract.
Vision, Mission and Resources to Succeed
When a startup hires an accomplished executive to lead the company, the investors and founders have expectations about where the company want to be in the coming years. Having a shared understanding of that vision is critical for your success.
Do you buy-in to the startup’s mission and business plan? Chances are where you start out will not be where you end up. One of the reasons for your hire is your experience and the belief of the investors that you will pivot as needed to meet the real needs of customers as you work to perfect a successful business model. But first you want to start on the same page.
Beyond plan and vision, you also need a good knowledge of the company’s current status, and what commitment the investors will make to follow-on investment. Will you have the resources to succeed?
If the company has provided you financial statements or made representations as to assets, customers, revenues, profitability, resources for your position or future strategic direction that you are relying on in taking this position, you should seek to reference those representations in writing in the offer letter.
Terms of Your Key Compensation Component: Equity
A startup is often not in a position to offer the kind of salary and bonuses that you usually demand, but if you are taking this position because you believe you can take this company to a much higher level of success, then equity can become the most important part of your CEO compensation package. Your offer letter needs to reflect that.
Taking equity in a startup carries great risk in that despite your own skills and best laid plans, the startup might well not succeed. The rate of startup failures is so high. Thus, the amount of equity you are awarded needs to offer you an upside much greater than the amount that you are giving up in cash compensation to provide at least some justification for accepting the opportunity.
Beyond the amount, the terms of the equity awarded to you need to at least mitigate in some way your risk. Your percentage of overall equity should be clear and anti-dilution protections should be sought, so that if the company does achieve a certain level of growth, you know what percentage of that growth would go to you. Additionally, you need to be clear on the rights of the investors vs your own position. If an acquisition does occur, how will the participating preferred work and what would be your share after the investors get theirs.
Equity Taxation: Choosing the Right Structure to Leverage your Risk
Finally, there is the issue of tax structuring of your equity. Your mission here is three-fold. First, to reduce your ordinary tax hit with your equity award. Second, to put off taxation of the appreciation until you sell the stock, and third, to get capital gains treatment on the equity appreciation on sale.
How to do that will depend on the stage of accomplishment of the startup, its valuation and the valuation of the stock.
If you are called in at the very early stage as the startup is being formed, then there may still be an opportunity to be issued “founder’s shares.” At this point the company is still pre-funding and the stock value is nominal. Since your shares would be restricted shares, subject to forfeiture if employment terminates within the required period (typically 4 years), you would not face taxation on the appreciation component until vesting occurs. That is not what you want. With funding and growth, at each vesting stage there would likely be appreciation for which you would be taxed at ordinary income rates with no money to pay the tax. So, an 83(b) election is made within 30 days of issue of the shares, so you take them into income now when no such appreciation has occurred. Hence little tax at this point.
On the other hand, if there has been some mileage, the startup has considerable value and you are brought in for scale-up to the next level, that requires different equity planning. In that case, you do not want the acceleration of taxation of restricted stock and an 83(b) election, but instead, RSUs – restricted stock units, alone or in combination with stock options. With RSUs, you are not taxed until vesting and the terms of the RSUs might provide sale of a portion back to the company to cover your tax hit. (See my article on RSUs.) Because the sale back will cause loss of a portion of your equity, that loss might be covered by options which offer upside though not as favorably, because typically when exercised, these may result in ordinary taxation of the appreciation.
Seeking Mutual Commitment: Meaningful Severance Terms
Taking a position with a startup has other risks, besides the biggest risk that the startup fails. That other risk is that there will be a future change in management.
You are making a major commitment to go with the company by leaving your current position, and so you should get a commitment from the new company in turn. If they choose to terminate you without cause, they should provide suitable severance.
For most CEOs, that severance compensation is at least one year’s salary. However, as said, the salary you are taking is likely much reduced. So, the severance would be as well. The important thing you want to get into your severance package is fuller realization of your equity opportunity. This can take different forms. One form is to provide an extra year of vesting on your equity. Another form can be a claw back provision that if the company is acquired or goes IPO within 24 months of your termination, you get some portion of the appreciation you would have received but for the termination.
Becoming a startup CEO is a risky endeavor that could bring substantial rewards, both financially and otherwise. To ensure that you are well compensated for your work, and protect your career, consult an experienced executive employment lawyer.
I have represented CEOs and senior executives working for companies in Massachusetts, elsewhere in New England and across the country, and I am available to answer all of your important questions. Contact me, your attorney for executive employment agreements, at email@example.com or call 617-875-8665.