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A partner and myself are developing a new software product. We've been working on it for several months now but we lack certain areas of expertise -- in particular art skills. Everything has been sweat equity and we do not know if we'll seek or receive any outside money. The key fact here... there is no money coming in, and no money being spent on salaries. We can't hire anyone nor do we have a legal entity setup as our business yet.

So I visited a school that had a career day for their students and found a number of viable candidates that are very interested to work with us. However, doing research on "unpaid interns" makes me realize that in our situation, we just won't fit the criteria no matter how creative we get. I'd rather just find a fair way to structure any sort of arrangement that outsiders can be comfortable with.

My partner and I have agreed to split everything down the middle and we both unanimously agree on major decisions such as bringing someone else on board and what we will offer them.

My thought is really just find a way to include them as sweat-equity founders where nobody gets paid until the money comes in. I think it's fair to avoid "deferred salaries" and focus on awarding restricted equity of some sort based on relative contributions. We're really only 6 months out from shipping this thing, prior to now it's been a part-time side project, but now it's serious and full-time.

Does anyone have experience in this situation and would you be able to point me to the best and safest legal way to pursue an option like this? I'm leaning towards valuing sweat equity at a premium (+25% prevailing wages for time spent to sweeten the risk of startup failure).

The way I see it, if we start with 2 people and bring in 2 more people and nobody is getting paid until money comes in, then we're not breaking any laws, right? The startup is in WA state if that helps.

I really appreciate any help :)

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5 Answers

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This is always a tricky thing because when you start out, you really have no structure to adhere to nor any money to build what you want to build.

The way I have seen this handled is as follows:

  • Founders Agreements for each Founder: Basically, this is a contract between the future founders to split founders equity when things become official. The way these are usually written is that the founder contributes something (like IP or time) to the organization for a percentage of founders equity. Since founders stock is so cheap (on the order of cents per share), the evaluation is a moot point. Also the founders agreement will state what happens to the contributed IP if the company never gets off the ground.
  • Non-Disclosure Agreements for each founder: Once your have the founders agreement in place, you then have your founders sign NDAs so that your ideas are protected. These NDAs can be multiple way to ensure it's all fair.
  • Consulting Agreements: It's best that the "other" founders sign consulting agreements that state what they create is owned by the "company". This also allows for a fair and equitable split if a potential founder decides to leave before founding. You never want the "forgotten founder" issue to get in the way.

In general, you want to be as up front as you can and get it in writing. Avoid setting a price for the shares of any equity. Rather, deal with percentage of founders equity based on some milestones the company needs to achieve. That way, it's clear who is doing what and who contributed what.

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Okay, I like your ideas. I'm going to take a deeper look into this. I'll report back any new findings or additional questions. – Startup Advice Mar 27 '10 at 21:03
Thanks. Good luck sorting it out. – Jarie Bolander Mar 27 '10 at 22:35
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You're correct that just unpaid labor is illegal. Of course labor for equity is legal, and you can use any level of compensation you want since it's impossible to value the stock.

In general "25% extra for the risk" is way too low. Do you really think the chance of that stock being worth $X is that good? You probably need more like 2x or 4x.

However if you put that into writing, you've just valued your stock, which has tax implications both now and later. Now because handing out stock means the recipient has to pay taxes on the agreed-upon value, and later because it affects everyone's basis value when you sell it or if you raise money.

Typically the way to avoid the stock tax issue is to give out options, but setting up an option plan is expensive both one-time and periodic (long story there too which an accountant can detail).

In the end, deferred salary is probably the easiest way. If you want to involve stock, add that to the deferred salary.

Finally, you're still 6 months from shipping anything? Unless you're building a rocketship it probably shouldn't take that long with 2+ full-time people working on it...

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I feel the 25% premium on top of "how much I would earn at a real job" is fine. I totally agree that doesn't compensate for the risk -- that's not the goal here. I've got a pool of students that would love to work on our project and would be willing to do so for free just so they can get work experience and recommendation in this dismal economy. But I'm not out to exploit anyone and wish to pay them for there time, contingent on the project succeeding and bringing in revenue. I agree that deferred salary is probably the way to go, but I read that VC's hate that so it may only work without it. – Startup Advice Mar 27 '10 at 15:22
Deferred salary approach also appears to have some issues with it... smallbusiness.yahoo.com/…. In particular, it talks about phantom income and the IRS may come after you for it, even if you don't pay the salary, you'll still be on the hook for taxes. Any way to word an agreement around that? I'm just looking for the most reasonable approach to bring in outside help -- seems like everything is illegal. – Startup Advice Mar 27 '10 at 15:34
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If it's students who don't care about compensation, why not just pay minimum wage now and be done with it? – Jason Mar 29 '10 at 1:34
+1 for Jason's comment above. What's wrong with using 'volunteers'? Surely the definition of a volunteer is that they are unpaid. The students are getting experience out of it. Don't over-complicate things. – Susan Jones Dec 23 '10 at 11:38
up vote 2 down vote

Well I've been doing some deeper research, and it does look like the best way to go about this would be to form a C Corporation. With a C-Corp founded very early long before any capital investment takes place, you offer vested restricted stocks (aka founder stock) for purchase as founders invest in the initial business.

Forgive my potential naivety with sample numbers, I'm just trying to illustrate an example. For example, we could create 1 million shares of RSUs, split them 49/49/1/1 vesting over 4 years at a total initial value of $100. The 1% would be offered to each of our "unpaid interns" requiring them to put in $1 each, while the two main founders would pay $49 each with a higher upfront vested value (like 50-60% with rest vesting over 4 years). Not much tax implications on a $100 corporation.

Then the way I see it, we're all forming this company ourselves and putting in our own sweat equity avoiding all labor and tax liability issues. Either we make it to market and bring in revenues, or attract venture capital in which case our $100 company becomes worth much more and introduces the tax liabilities. It seems pretty clean and simple.

It also deals with poor performance and firing someone that doesn't contribute. With the vesting in place, we would have to pay the value of the stock upon departure. If funding comes into the picture, that $1 could be far more.

Does anyone have experience with this? Does it work? Did I really mess this up? What am I missing?

Some resources I uncovered:

Btw, once money starts to come in, the idea would be to determine salaries and additional grants, but highly dependent on performance and commitment of individuals involved. Don't think we'd be worried about determining that upfront, unless we bring on other senior experienced individuals. Even in that case, I believe we would simply negotiate a fair deal. Haven't really thought this part of it through yet? Can it be pre-determined without creating tax liabilities on sweat equity?

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up vote 1 down vote

I am also looking into hiring unpaid talent for my start-up but I was wondering why you can't do this?

You said: However, doing research on "unpaid interns" makes me realize that in our situation, we just won't fit the criteria no matter how creative we get.

Could you explain?

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Well I've been doing a series of google searches. What got me thinking about this initially was about a recent article in an Entrepreneur called "The full-time non-employee" which was about how to hire unpaid interns and it was actually rather positive. But other articles such as blog.marketplace.nwsource.com/careercenter/… references some dangerous things... of the 6 criteria, 3 and 4 are ones we don't feel we can try to circumvent. – Startup Advice Mar 27 '10 at 15:17
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Unpaid interns are illegal unless you fit an exception such as being a non-profit organization or a civic organization. Even if they agree to it, you will be fined if the state finds out.

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