Having now answered (to the extent I am comfortable doing so in the absence of any specific knowledge or facts of any particular case) the only question any client ever asks about advisory boards, I hasten to note that there are a lot of other – far far better – questions that could be asked about advisory boards.  Here are a couple:  What value can I reasonably expect from a member of my advisory board?  How do I get that value?  Why do I need an advisory board at all?  How do I find good advisors?

I don’t have any objective or quantifiable information around whether and how much value start-ups derive from their advisory boards.  My gut sense, based only on my law practice, is not much.  Mostly, what start-ups get is the opportunity to name a few luminaries on a slide towards the back of their deck.  The second thing they probably get is some introductions, probably to investors. 

I am sure there are some companies and entrepreneurs that have benefited greatly from advisory boards, but I have to believe this is a small number.  Below are a couple of links to blog posts on the subject of advisory boards.  The one from venture hacks seems to me to be particularly good in that it covers a lot more than just compensation, although it also covers comp.

Venture Hacks “Everything you ever wanted to know about advisors”

Ask the VC “Are Advisory Boards Helpful?”

Ask the VC “Advisory Board Compensation”

What is 409A and why do you care?

409A is a section of the Internal Revenue Code that governs the tax treatment of certain options.  409A provides that an option either (1) be an option for common stock of the employer and have a per share exercise price on the date of the grant equal to or greater than the fair market value of a share of common or (2) if the option has an exercise price of less than the fair market value of a share of common stock the recipient and the issuing company suffer some pretty draconian tax consequences.  (There are other ways to comply, but relate to less usual situations, such as options that are only exercisable on a liquidity event, and I am not going into that level of detail here and now.)

What are the draconian tax consequences?

There are three particularly nasty tax consequences:  (1) The recipient of the option will have income equal to the difference between the fair market value of a share of common stock and the exercise price of the option multiplied by the number of options, at the time the option vests, even if the recipient does not exercise the option.  (2) The recipient will get to pay a surtax of 20% over and above his or her normal income tax on the option related income.  (3) For each year for which the option remains outstanding, the recipient will suffer the same nasty tax consequences with respect to any increase in the value of the common stock. 

Why on earth would the IRS create such a rule?

Consider what could happen if the issuing company were publicly traded and was issuing options with below marked exercise prices to its execs.  Need I say more?  Unfortunately, 409A applies to all companies – not solely public ones.

What can I do to avoid the bad tax consequence?

Issue your options with an exercise price equal to or greater than the fair market value of the underlying shares.

How do I know what the fair market value of a share of my privately held technology start-up is?

Here are some ways to price your options:

(1) You can take a guess at the fair market value.  If you guess wrong you are toast.  And, by the way, your guess will be judged with 20/20 hindsight by the IRS.  So, that does not seem like a good solution.

(2) If there is a recent actual arms-length transaction in which common stock was sold, then you have price.  Note that I said “actual,” “recent,” and “arms-length.”  The fact that your lawyer took a few shares a year ago in consideration of an old invoice won’t cut it. 

(3) If you have a financially sophisticated person on your board (or as your CFO), and your company has been in business fewer than 10 years, 409A provides that such person can perform a valuation. 

(4) You can pay an outside appraiser to perform a valuation.   Most (all?), of my clients who have professional money invested in them end up doing this.  It is a toll and it is unfortunate that you have this cost, but that is you tax dollars at work. 

Like my entrepreneur friend, you can want to price options at $.03 but if you sold common stock last week  in an arms-length transaction for $.30 per share, don’t do it.

With respect to vesting, Fred has the following to say, “Vesting usually happens over a four year term, but some companies do use three year vesting.”  It is true that in the case of venture funded companies the “norm” is four year vesting with a one year cliff, but I rarely see three year vesting.  (Right now, I don’t recall ever seeing it in the context of a “normal” option grant for a venture financed company.)  I don’t mean to quibble, by I have noticed a trend to the other end.  There are at least a couple of VCs (one in Boston and one in Silicon Valley) that I know use five year vesting with a one year cliff.  Anecdotal information suggests that this practice is gaining ground. 

The reason for this trend, if it is a trend, is that VCs want to more precisely align the payoff to the option holder with the liquidity event (exit) for the VC.  As it turns out, many very high quality venture funds have average holding periods for investments of north of 8 years.  That is to say that, on average, it can be 8 years (or more) from the closing of the first investment to the exit.  During that period, many employees can vest large piles of options, and (at least in theory, and to be fair, often in practice) leave the company, exercise their options and take their talents elsewhere.  Top re-incentivize these employees, it may become necessary to “reload” option packages from time to time.  This practice, of course, can be expensive.  And, if the employee leaves and has to be replaced, the replacement will need an option package.

I understand this thinking, but I am not a big fan of five year vesting.  Although, I don’t think there is a principled reason to pick 3, 4 or 5 (or any other time frame for that matter), here are is a reason why I don’t like it.  First, in the tech world five years is an eternity – hell four years is an eternity.  It makes the brass ring harder to see and less tangible.  In effect it diminishes the incentive value. 

Many employees are great for different stages of a company’s development.  So, the guy who did product development at the start and was great with a team of two engineers can’t run a team of twenty.  He added great value for a period in the company’s development and then had to be replaced.  Only a few employees will really make every transition (admittedly some will). 

The compensation, including the incentive compensation, needs to dovetail with the expected performance not with the VC investment horizon.  (Just to make an exaggerated point, if vesting were to be keyed to the investment horizon, then the early employees might be looking at 8 year vesting and the later ones 2 year vesting.)  I can hear VCs saying we expect everyone to grow with the company etc. anyway how do we know we only want Harry for four years when we hire him but we want Sally for five?  What signal would varying vesting schedules send?  And so on.  We need a one size fits all solution…

So why 4 years?  Well, this amount of time seems to represent a compromise of sorts between wanting the liquidity to be consistent with liquidity and wanting it to be consistent with the relevant term of the services provided.  It seems to work in most cases.  So, before you buck the trend, you should have a good reason because if you go for a longer period you will undermine the value of your options to your employees and will make it harder to hire and keep them.  If you go for too short a period, you run the risk of undermining the incentive to stay.

In response to a comment from me the effect that vesting should be more keyed around expected milestones than arbitrary time frames, he notes that this is what employees get a salary for. Here is the quote:

Employees get paid salaries to deliver results and cash or stock bonuses help focus on milestones. Stock options are really about earning into equity ownership over time. That equity value is only really realized at exit.

I gave this some thought and I agree and disagree. Options, like money and everything else, have a time value and are only motivating if the option holder really thinks she has a decent chance of actually realizing on their value in this lifetime.

Here is a comment to Jeff Busgang’s post from Healy Jones,

Jeff, this is crazy talk! Keep your hands off my vesting schedule; it seems really long to me as is. ;)

Many of the early employees are not likely to be there in 6, let alone 8, years. (No doubt some will.) Many people who are highly suited for the early stage environment and can (and do) make significant contributions are not well suited for the middle or later stage environments.   A classic example is the first CEO. Let’s be honest, a lot of these folks make a real contribution then get moved on. 

Another point is that many people take employment with start-ups for the equity and not for the salary. My sense is that start-ups don’t pay what IBM or Google pay for the same resumes. The equity is an important (perhaps critical) part of the compensation for the day to day work (for which they are being underpaid in the sense that they could get more cash from Microsoft).

So, my point is that pure time based vesting (whether it is slow or fast) does not make sense because it does not compensate for the work done and the contribution made. I have noted this before from the point of view of founders with co-founders or employees that do not perform.

Milestone vesting may not make sense because milestones can sometimes be hard to define and they can be all over the place. 

So, perhaps some amount of time that makes sense in terms of the horizon in which the employee is expected to make a material contribution is a sensible compromise. Whether that should be 2 years, 4 years or 8 years, perhaps depends. 

Jeff is probably right to point out that the industry seems to have settled on 4 because it reflected some sense of historical time to exit.  That does not mean that we have to live with the logic and change the time frames. 

I work with a lot of very early stage companies and as among founder and very early contributors the vesting time frames vary dramatically. Very short time frames (such as one year or even less) and milestone vesting is common. The reason for this is the one I originally gave. Very early stage companies need to get work done, they can’t pay dollars so they pay equity. In this situation, vesting has to make sense in terms of expected contribution. When the contribution is made, you get your stock. 

If you want to hire W2 employees (people looking to work for a salary) and you want to keep them around, pay the salaries, provide the benefits, and vest the options at a slow rate because the options will be one more good benefit, like a 401K.

Many start-ups would like to be at the stage where this is the need. Unfortunately, the nature of the animal is that there are a lot of other phases you have to go through to get to this place. Vesting is one tool you can use to attract people to work for you for less cash than it might otherwise take. Vesting has a time value. The longer it takes the lower the value to the employee and therefore the lower value options have as a form of currency.

With respect to the true pre and post money valuation, Sim points out that Fred Wilson has an insightful post on this topic. I think I agree with what Sim and Fred say on the subject, but I also think it sounds more ominous than it is. Keep in mind that the investor is assuming you will have to spend equity to attract talent. This is analogous to having to spend money for capital expenditures. It has to be a budgeted cost and has to be "in the mix" when you negotiate your deal. Your investor will not overlook this "cost." It will be built into the investor’s valuation assumptions. You just need to look at it the same way. A company that needs to spend money to acquire and IP license is not going to get the same valuation as one that does not (all other factors being equal).

Client: “OK, you’re my lawyer, how do I do that?”

The regulations provide that whether a valuation method is reasonable, or whether an application of a method is reasonable, is a facts and circumstances test. The factors to be considered include: (i) the value of tangible and intangible assets, (ii) the present value of anticipated future cash flows, (iii) market value of stock in similar corporations engaged in a similar business, the value of which can be readily determined by objective means such as trading prices on a securities market or prices paid in an arm’s length private transaction; (iv) recent arms’ length transactions involving the stock, and (v) other relevant factors, such as control premiums and discounts for lack of marketability. The use of a value which was previously calculated under a valuation method is not reasonable as of the later date if it is more than 12 months old or if it fails to reflect information made available after the date of the calculation that may materially affect the value. 

With respect to non-publicly traded stock, the proposed regulations provide for three safe harbor valuation methods which, if used consistently for all equity based compensation arrangements, will be presumed to be reasonable unless the IRS establishes that the valuation was “grossly unreasonable”. Therefore, the burden of proof shifts to the IRS if one of these safe harbor valuation methods is used.

Method one is independent appraisal. This safe harbor requires a valuation determined by a qualified independent appraiser, made not more than 12 months prior to the relevant transaction to which the appraisal is applied.

Method two is start-up company “Appraisal Lite”.   This safe harbor is available only to start-up companies (generally, those that have been in business for less than 10 years and that do not have any class of traded securities), which at the time the valuation is applied do not have a reasonable anticipation of a change in control within 90 days or a public offering within 180 days. In order for the safe harbor to apply, the valuation must be based upon a written valuation report (made in good faith) which takes into account the factors described above with respect to a reasonable valuation method, and which is prepared by a person with significant knowledge and experience or training in performing similar valuations. Unlike the independent appraisal safe harbor, the person preparing the report need not be independent, and thus could include a Board member who meets the “significant knowledge and experience” requirement (which generally means at least 5 years of relevant experience).

Method three is using a Formula Price. This safe harbor is a non-lapse formula valuation under Code §83, provided that the formula is used for all compensatory and non-compensatory valuations of the stock, including loan covenants and issuance to and repurchases of stock from persons other than service providers.”

Client: “Gee, thanks Dave”

The dirty little secret of incentive stock options is that the holder must comply with a variety of requirements under the Internal Revenue Code to actually get capital gains treatment. Among these requirements, is a holding period requirement the effect of which is to prevent the option holder from getting capital gains treatment in almost all cases. The holding period requirement is that one must hold the stock obtained upon exercise an incentive stock option for a minimum of one year in order to get capital gains treatment. In fact, you have to hold the option and the stock for a combination of two years, but at least one year has to be after exercise.

One thing to consider that can mitigate this problem is to ask for restricted stock or to exercise your options (as soon as they have vested) and start the holding period. In the case of option exercises, you will have to pay the exercise price of $.20 per share (in our example). This means you would be out of pocket $20,000 and you would be taking the risk that the company will never have a liquidity event. In addition, the spread at the time of exercise (the difference between the exercise price and the value of the stock received) is a preference item for purposes of the Alternative Minimum Tax, which means that you end up paying AMT tax for the year of exercise.  In the alternative, you might obtain a grant of restricted stock, file an 83(b) election, take the value of the stock into income in the current year, and start your holding period. In our example, if $.20 is the fair market value of a share, you would have income of $20,000 on which you would pay income tax ($7,000 in our example), and absent a liquidity event, you might never recover this amount. Now, these numbers seem small, but if you are looking at stock with a valuation of $1.00 or some other high number, then the cost of exercising options or paying tax on a grant of restricted stock could be prohibitive. Your individual circumstances will have a significant effect on what will work best for you.

We structure our option plans to accommodate incentive stock options, non-qualified options and restricted stock. While everyone may want an incentive stock option, you should recognize that it is very unlikely that you will get the favorable captial gain tax treatement and think about any  different choices that you might have.

You may want to incent employees by giving them stock. Here is an example. Easy Company decides to incentivize one of its employees by giving her a stake in the company. It then grants to Jane 100,000 shares (assume for the purposes of this example that the shares have a fair market value of $.01 per share). Two things follow. First, Jane owns the stock and, in our example, has no particular incentive to stay of the sort associated with vesting. Second, Jane has income equal to the value of the shares of stock she has been given. In this example she has income of $1,000. Easy Company must report (and withhold taxes for) this income on Jane’s Form W-2  for the year in which she was given the stock, and Jane must pay tax on that income. Now, $1,000 of income does not seem like much, but if the stock had a fair market value of $1.00 per share, Jane would have $100,000 of income on which she would owe tax. If her marginal tax rate is 40%, then she has to pay $40,000 of tax to the feds.

This arrangement is great, except that it creates a new tax problem. Under the tax code, if Jane does not make an 83(b) election (which we will get to shortly), Jane must take the value of the stock she has been granted into income at the time that the company’s right to repurchase it has lapsed. As a result, Jane will have income equal to the fair market value of 6,250 shares each quarter.

So, let’s assume that on the date of the initial grant the per share value of the stock is $.01 but that at the first anniversary of the grant, the company has developed its business and finds an angel investor who pays $.10 per share and furthermore, let’s assume that on the second anniversary the company has further developed its business and finds an angel investor who pays $1.00 per share. As the shares increase in value, the company has increasing amounts of income to report on Jane’s W-2, for which she has to pay taxes. What was once $1,000 of income, could now be much much more. If the company is really successful, Jane will owe more in tax than she can reasonably pay, and at a time when there is no public market for the stock so she can’t sell shares to raise the money to pay the taxes.  (And keep in mind that all of the income we have been talking about to date is taxed as ordinary income, not capital gains.)

Having said all that, the IRS permits Jane to take all the stock into income (even if it is subject to the company’s right to buy it back) in the year in which it is given to her if she makes an 83(b) election. This election involves filing a form with the government and sending a copy to the company. This form must be filed within 30 days of the grant. In our example, Jane would make the election at the time of the stock grant and would recognize $1000 of income, representing all 100,000 multiplied by their then fair market value of $.01 per share. If Jane expects that the value of the stock of Easy Company will rise, then this is a no brainer. She takes the stock value into income and pays the ordinary income tax on the $1000 of income. This way she begins the capital gains holding period and gets capital gains treatment (on any subsequent increase in value) when she eventually sells the stock in a liquidity event.

This is all well and good, but what happens when two years pass and the stock is now worth $1.00 per share and the company wants to make another grant? The same analysis applies, only now there would be $100,000 of income at the time of grant – assuming Jane made an 83(b) election. At this point stock grants no longer look so desirable. As a result, the company should start using stock options, which do not result in taxable income at the time of grant.