The start-up world is full of stories of companies using equity in the business as a way to compensate employees when there was not enough cash to pay their salary. The company would go on to be successful and those employees became millionaires. That is part of the allure of going to work for a start-up, the promise of riches. Unfortunately paying someone in stock may put you in violation of the Fair Labor Standards Act.
Cash Flow is often an issue
Cash is often in short supply when a company is starting up. To attract a badly needed employee sometimes they are offered equity in the business in return for their labor. The employee agrees to work for an equity stake until the business gets off the ground and cash starts flowing in the door. (I have written previously on cash flow as an issue here.) According to attorney Doug Haas this could be a violation of the Fair Labor Standards Act. In order for this arrangement to work the employee would have to be considered an owner and there are very specific requirements under the FLSA for someone to be considered an owner.
Definition of an owner
For someone to be considered an owner the rule is, according to Fact Sheet #17B, “Under a special rule for business owners, an employee who owns at least a bona fide 20-percent equity interest in the enterprise in which employed, regardless of the type of business organization (e.g., corporation, partnership, or other), and who is actively engaged in its management, is considered a bona fide exempt executive.”
The first big hurdle in this statement is “20%”. The equity that you are paying the employee must be at least a 20% interest for that employee to be considered exempt from the minimum salary requirement in the FLSA. If that equity is not 20% then they have to be paid at least $455 per week. That is not however the only requirement.
In addition to the 20% equity stake the employee also has to be performing management duties. These include:
“… activities such as interviewing, selecting, and training of employees; setting and adjusting their rates of pay and hours of work; directing the work of employees; maintaining production or sales records for use in supervision or control; appraising employees’ productivity and efficiency for the purpose of recommending promotions or other changes in status; handling employee complaints and grievances; disciplining employees; planning the work; determining the techniques to be used; apportioning the work among the employees; determining the type of materials, supplies, machinery, equipment or tools to be used or merchandise to be bought, stocked and sold; controlling the flow and distribution of materials or merchandise and supplies; providing for the safety and security of the employees or the property; planning and controlling the budget; and monitoring or implementing legal compliance measures.” (29 CFR 541.102)
Attorney Hass points out in his article that at least this management duty does not have to be the employee’s primary duty as is required of someone who is exempt under the Executive exemption as defined in Fact Sheet #17B.
Haas and also Carl Crosby Lehmann point out that not all states recognize this provision of the FLSA, California and New York in particular. In those states you cannot pay someone with equity. There may also be some local jurisdiction issues that will be important to check on before starting to pay people in equity.
By the way, in case you are wondering, even if an employee says it is ok with them that they don’t get paid it doesn’t matter. You are violating the law. So make sure you have enough money in the bank to pay people minimum wage. That is currently $7.25 per hour, but going this route means you will also have to pay overtime, and in start-ups people often work long hours. If you want to claim they are exempt from overtime the minimum wage is currently $455 per week.