Employees and contractors
Whether someone is an employee or an independent contractor depends on the actual relationship, not on what the contract calls them, and getting it wrong means back payroll taxes, penalties, unpaid overtime and benefits claims. Several tests apply and they disagree at the edges. The IRS looks at who controls how, when and where the work is done, and at the financial relationship. The Fair Labor Standards Act asks whether the worker is economically dependent on the company or in business for themselves. Some states are stricter: California's ABC test presumes a worker is an employee unless the company shows the worker is free from its control, does work outside the usual course of its business and is independently established in that trade. Under that test, a software engineer building a software company's product is almost always an employee.
A useful rule of thumb: someone who works mostly for you, on your core product, on your schedule and with your tools, for an open-ended period, is probably an employee. Contractors fit best for defined projects, outside specialties and people who serve many clients.
Employees must be paid at least the federal and state minimum wage, and most are owed overtime unless they qualify for an exemption, which for professional roles usually requires both a salary above a threshold and duties that fit. Several states, including California and New York, set their thresholds well above the federal one. You cannot pay an employee only in equity. That applies to founders too. A founder who is only a stockholder and director does not have to be paid; a founder who works as an employee generally does. Many pre-funding startups leave founders unpaid and treat them as owners only, then put them on payroll after the first financing. If you are unsure which category a founder falls into, ask an employment lawyer before it becomes a wage claim.
Each new employee needs an offer letter, a Form I-9 confirming work authorization within three business days of starting, federal and state withholding forms, registration with your state's payroll tax agency and, in nearly every state, workers' compensation insurance. A payroll provider handles most of it. Every employee and contractor should also sign a confidential information and invention assignment agreement before starting, which assigns their work to the company and protects its confidential information. Without one, a contractor in particular may own the code they wrote for you.
New hires bring obligations from old jobs: confidentiality, invention assignment, non-solicitation and, in some states, non-competes. Ask about them before you hire, and make clear in writing that they must not bring or use a former employer's confidential information. A single engineer who copies their old employer's code onto your laptop can become a lawsuit against the company. California treats most employee non-competes as void and several other states restrict them, and the law is changing state by state, so check the current rules where your people live.
Advisors and interns
Advisors help with introductions, expertise or credibility, usually a few hours a month. They typically receive a small equity grant, often between 0.1 and 1 percent, vesting monthly over one or two years without a cliff, and they sign an advisor agreement with confidentiality and invention assignment terms. The Founder Institute's FAST agreement is a widely used template. Grant advisor equity deliberately, because a cap table full of inactive advisors is a common regret and investors notice it.
Under federal law, interns at for-profit companies generally must be paid unless the internship mainly benefits the intern, which the Department of Labor judges by its "primary beneficiary" test. An intern who writes production code or does real work for a startup is almost always an employee owed at least minimum wage. Pay your interns.
Equity compensation
There are three common forms of equity for employees. Restricted stock is actual shares the employee buys, usually subject to vesting as founders' shares are, with an 83(b) election to be taxed at purchase. It works best when the price is very low, because the employee can buy the shares outright for little and start their tax holding periods at once.
Stock options give the right to buy shares later at a fixed exercise price, set at the stock's fair market value on the day of the grant. They usually vest on the same four-year schedule with a one-year cliff. The employee pays nothing to receive them and pays the exercise price only when choosing to buy. Incentive stock options can go only to employees and, if the holding requirements are met, are not subject to regular income tax at exercise, with the whole gain taxed as long-term capital gain on sale. They come with rules: an exercise price of at least fair market value (110 percent for holders of more than 10 percent of the company), a term of at most ten years, no more than $100,000 worth by grant-date value first becoming exercisable in any year, and, to keep the tax treatment, exercise within three months of leaving. Exercising them can trigger the alternative minimum tax. Nonqualified stock options can go to anyone, including advisors and contractors; when they are exercised, the difference between the stock's value and the exercise price is ordinary income, with withholding for employees.
Restricted stock units are a promise to deliver shares later at no cost, taxed as ordinary income when the shares are delivered. That is awkward when there is no market in which to sell shares to pay the tax, so private startups rarely use them until they are late-stage.
In practice most startups follow a rough sequence. The first few hires, while the stock still costs a fraction of a cent, often get restricted stock, because they can own shares outright with an 83(b) election at almost no cost. Once the price rises, usually after a SAFE round or a first 409A valuation, employees get options, because buying shares outright would cost them real money and create tax, and incentive stock options are used for employees wherever the limits allow. Advisors, contractors and anyone else who is not an employee get nonqualified options or restricted stock.
Make offers in shares and give candidates the fully diluted share count so they can work out their percentage. A percentage in an offer letter is ambiguous, because it leaves open what it is a percentage of and as of when; a share count is fixed. Typical grants vary widely by role, stage and market, and founders often benchmark against data from equity management platforms and their investors.
409A
Section 409A of the tax code governs deferred compensation, and an option with an exercise price below the stock's fair market value on the grant date counts as deferred compensation. If that happens, the employee can owe ordinary income tax on the option as it vests, plus an extra 20 percent tax and interest, and the company can face withholding penalties.
So companies set exercise prices at fair market value and establish that value with a 409A valuation. A valuation by a qualified independent appraiser gets a safe harbor, meaning the IRS must show the value was grossly unreasonable to challenge it. A 409A valuation can generally be relied on for up to 12 months, or until something material happens, such as a priced financing, a serious acquisition offer or a major change in the business. In practice, get one before your first option grant, get a new one after each priced round and at least yearly while you are granting options, and have the board approve each grant at the current 409A price. The value of common stock in a 409A report is usually well below the price investors pay for preferred, because preferred carries a liquidation preference and other rights common lacks.
Vesting acceleration
Acceleration makes unvested equity vest early when certain things happen. Single-trigger acceleration vests some or all of it when the company is acquired. It is uncommon for employees, because acquirers want to keep the team and treat accelerated equity as a cost. Double-trigger acceleration requires two events: the acquisition, and then a termination without cause, or a resignation for good reason, within a set period afterward, often 12 months. It protects people from losing unvested equity because an acquirer let them go, while still giving the acquirer a reason to keep them. Double-trigger acceleration is common for founders and senior executives, and Corply's founder stock agreement includes it. For most employees, startups grant equity without acceleration and deal with it in the acquisition negotiation.
When employees leave
When an employee leaves, unvested options are forfeited and vested options must usually be exercised within a set window, often 90 days. That is a short time for someone who would have to pay a meaningful exercise price, and perhaps tax, to keep equity in a private company, and some startups now offer windows of one to ten years. Options exercised more than three months after employment ends lose incentive stock option treatment and are taxed as nonqualified options. Give departing employees a written summary of what they hold, what has vested, the exercise price and the deadline. It costs nothing and prevents most disputes.