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Anthony Nassar, Founder & Principal, Venture Momentum,
Inc. |
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In This Issue |
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Dear Reader,
There’s been a lot of talk
recently about IRS section 409A. Given the significant
impact, both financial and compensatory, this law has on
US start-ups, I asked Anne Senti-Willis, attorney with
Thoits,
Love, Hershberger & McLean, to provide a general
overview of 409A in this issue, along with some other
recent labor laws which are likely to affect the way you
operate.
In
today’s article, HR expert Josiane Kristensen and I put
our thoughts together on the subject of processing new
hires keeping HR practices, the law, finance and due
diligence in mind.
In
this issue, I’ve added a new section featuring websites
worth visiting. You’ll find two sites,
Karavans,
and A
Sound Match, which aim to have a positive impact on
the lives of their visitors. More on these sites after the
article.
To
YOUR Venture’s success,
Anthony Nassar
Founder & Principal
Venture Momentum, Inc.
415-897-0195
http://www.venturemomentum.com
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Anne Senti-Willis
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Anthony: Can you describe
the IRS rules under section 409A, and what brought about
their adoption?
Anne: Section 409A is a tax
law which, by its name, deals with non-qualified deferred
compensation plans. Traditionally, these plans were set up
to benefit select groups of employees, usually top
executives. Generally, the plans allowed executives to
defer a portion of their compensation each year, to be
paid at some future time. To avoid tax on the deferred
compensation, the employee could not receive it, and the
funds had to remain subject to the claims of a company’s
general creditors. However, Congress perceived that the
plans were being abused when companies started
transferring funds offshore, so they would effectively be
immune from creditor claims, or when payment times were
accelerated as companies started to experience financial
difficulties. This law was effectively another response to
the Enron and other corporate financial crises just a few
years ago.
Section 409A was passed in October of 2004. It went
into effect on January 1, 2005. As part of the law, the
Internal Revenue Service was required to issue guidance on
how the law would be interpreted. As required, the IRS
issued some initial guidance in December 2005, but it left
a lot of questions unanswered. In October 2005, the IRS
proposed some regulations interpreting Section 409A (the
“Proposed Regulations”). The Proposed Regulations have not
been formally adopted yet, but companies are permitted to
and should rely on the guidance in those proposed
regulations.
If Section 409A were limited to those traditional
deferred compensation plans, there would not be a
significant effect on most start-ups. The definition of
“non-qualified deferred compensation” under Section 409A
is very broad, though. Essentially, a non-qualified
deferred compensation plan is any plan that allows an
employee to defer compensation, other than a qualified
retirement-type plan, or a plan that provides for
vacation, sick leave, compensatory time, disability or
death benefit payments. Section 409A applies equally to
employees and consultants.
If a non-qualified deferred compensation plan does not
meet Section 409A’s requirements, the amounts that have
been deferred under the plan are immediately taxable to
the affected employee or consultant. The income is taxable
in the year the employee or consultant’s right to the
income becomes vested. While the service provider has an
obligation to pay tax, the company also has a reporting
and, for employees, a withholding requirement.
Anthony: How are severance
payments made by start-ups affected by 409A?
Anne: From time to time,
start-ups terminate employees and offer them severance
payments. Upon being hired in a senior management
position, employees sometimes negotiate severance
arrangements to be paid if they are terminated without
cause (sometimes only when coupled with a change of
control). Because Section 409A’s definition of deferred
compensation is so broad, severance payments fall within
its reach. Until the Proposed Regulations were issued,
there was not much guidance from the IRS on how severance
arrangements would be treated. Without further guidance,
Section 409A could be read to cause severance payments to
be taxed no later than the date of termination of
employment, regardless of whether the severance is paid as
a lump sum, or paid in installments over a period of time.
The Proposed Regulations have provided some guidance on
how severance payments can be structured to avoid
immediate tax. As the IRS has drafted the Proposed
Regulations, a company can pay a former employee or
consultant severance if the employee or consultant is
terminated involuntarily. The amount of the severance
cannot exceed the lesser of twice (a) the service
provider’s annual compensation for the previous calendar
year or (b) the annual compensation limit for retirement
plan purposes (for 2006, this limit is $210,000). All
payments must be made no later than December 31 of the
second calendar year after the termination. If a severance
agreement provides for payments in excess of the dollar
limit, or for a period beyond December 31 of the second
calendar year after the termination, the severance will be
taxed at the time of the termination.
The Proposed Regulations deal solely with involuntary
terminations, that is, the situation where the company
terminates an employee or independent contractor. They
specifically do not provide an exception to Section 409A’s
immediate taxation for payments that are made following an
employee or independent contractor’s resignation, even if
that resignation is for “good reason.” Many employment
agreements require severance payments if an employee
resigns for “good reason” where those reasons include
things such as a forced relocation, decrease in salary or
benefits, or reduction in job title or responsibilities.
Anthony: To what extent
are stock options affected by 409A?
Anne: For startups, the most
common situation where Section 409A may apply is likely to
be the grant of stock options. The tax law has imposed a
number of conditions on the grant of incentive stock
options (“ISO”s) for many years. To meet the tax law
requirements, the strike price of an ISO must be fair
market value of the underlying shares on the date of
grant. Once an ISO is granted, it generally cannot be
modified; if it is modified, it is treated as a new option
grant. If certain holding requirements are met, there is
no taxable income at the time an ISO is granted or
exercised. Income is recognized when the underlying shares
are ultimately sold. (Though the exercise of an ISO does
not result in ordinary taxable income if certain holding
requirements are met, the difference between the fair
market value of the shares on the date of exercise and the
option strike price is a preference item for alternative
minimum tax purposes, and this can result in tax to the
employee.)
The ISO rules are not unfamiliar. Until Section 409A
became law, companies had a larger degree of flexibility
in granting non-statutory or non-qualified stock options
(“NSO”s). So long as identical options were not publicly
traded, an employee could receive an option with a strike
price below fair market value. When the option was
exercised, the difference between the fair market value on
the date of exercise and the strike price was treated as
ordinary income for the service provider. If the person
exercising the option was an employee, the company was
required to withhold tax on the option spread and report
the income on the employee’s Form W-2.
Section 409A changes the tax treatment for NSOs. If an
NSO is granted with a strike price below the fair market
value of the underlying stock on the date of grant, the
difference between the fair market value and the strike
price is an item of deferred compensation, taxed under
Section 409A. If the NSO is fully vested when granted, the
income is recognized at the time of grant. If the NSO is
not fully vested, the income is recognized and tax is due
as the option vests and becomes exercisable.
In addition to the requirement that NSOs be granted at
fair market value to escape taxation under Section 409A,
the Proposed Regulations limit the modifications that can
be made to NSOs after they are granted, similar to the
limitations under the ISO rules. Certain option
substitutions and assumptions are permitted in connection
with an acquisition. Generally speaking, accelerated
vesting is not considered a modification. If a company
wants to permit an employee additional time to exercise an
option following termination of employment, that extended
time will be considered a modification of the option (and
a new grant) unless the extended time period does not
exceed the later of 2 ½ months after the termination or
the end of the calendar year following the termination.
So, any change to an option now requires consideration of
whether or not it will cause problems under Section 409A.
Anthony: I believe this
leads us to the important issue of company valuation.
Anne: Yes, the bigger issue
for startups on option grants is the new requirement that
NSOs be granted at fair market value. As mentioned above,
this has always been a requirement under the ISO rules,
but the ISO regulations have been a bit looser in how a
privately held company determines what the fair market
value of its stock is. The Proposed Regulations expand on
how a company is to determine the fair market value of its
stock. Private companies are required to use a “reasonable
application of a reasonable valuation method.” Each
valuation has to be based on the company’s facts and
circumstances as of the valuation date. The Proposed
Regulations suggest the following factors be considered:
- Value of tangible and intangible assets
- Present value of future cash flows
- Market values for interests in similar corporations
- Control premiums
- Lack of marketability discounts
- Any and all other facts and circumstances relevant
to the company
The company should not use one valuation method for
option grants and something else for other purposes.
Whatever method is used must be used consistently, and any
changes in valuation method should only be applied
prospectively.
The Proposed Regulations provide three safe harbor
methods that companies may use. First, a company can rely
on an independent appraisal, so long as it is no more than
12 months old and there have been no significant events
that would cause the appraisal to be unreliable.
Alternatively, the company can rely on a formula, which
may be based on book value, a multiple of earnings, or a
combination of factors. If the company has a buy-sell
agreement among its shareholders providing for a specific
valuation formula, the company may be able to use that
formula for purposes of option grants.
The third safe harbor valuation method applies only to
privately held companies with less than 10 years of
operating history. The stock being valued cannot be
subject to any put or call rights, other than a right of
first refusal. This restriction is significant, because
many privately held companies do impose a right of first
refusal on any transfer of shares. If a company meets
these criteria, it can use a written report, applying the
factors listed above, that is less than a full appraisal.
Even so, the report must be prepared by someone who has
significant knowledge and experience in performing
valuations.
Anthony: How can start-up
companies minimize the financial burden of complying with
409A?
Anne: The biggest financial
burden in 409A comes with complying with a safe harbor
valuation method for stock option grants. Since the
Proposed Regulations were adopted, there have been a
number of valuation and accounting firms that have
expanded their valuation practices. Some firms are
offering to assist privately held companies to devise
valuation methodologies and formulae. At a minimum, any
privately held company’s board of directors needs to
carefully document how it is arriving at a valuation. The
more documentation available to board members and recorded
in meeting minutes, the more that will be available to
support a valuation. More than ever, companies need to
look at consistent factors when arriving at a valuation.
Anthony: On another front,
what do the new harassment training regulations entail,
and which companies are affected by them?
Anne: Starting January 1,
2005, all companies operating in California with more than
50 employees on a regular basis were required to provide
two hours of mandatory sexual harassment training to all
managers. Since the law went into effect, there have been
a number of questions about how you determine whether or
not a company has 50 or more employees. The proposed
regulations answer a lot of those questions. For example,
you need to consider the number of employees a company
has, regardless of whether or not those people are in
California. If you have a company that has one employee in
California, but 200 in other states, the company is
required to complete the harassment training for any
person who supervises the California employee. A company
needs to have 50 or more employees on each working day for
20 consecutive weeks in the current or previous calendar
year before training is required. This includes full time,
part time and temporary employees. Remember, a supervisor
does not need to be in California, but if someone
supervises an employee in California, the training is
required.
Under the California law, the training must be
interactive. Audio, video and computer training are
permitted, so long as there is an opportunity for
feedback, asking questions and receiving answers. Testing
for comprehension is required. E-training programs and
webinars need to incorporate feedback, with a
participation component at least every 15 minutes. The two
hours of training does not need to be completed
consecutively. Classroom or webinar training can be
completed in half hour increments, and 15 minutes is the
minimum segment for an e-training program.
All companies with 50 or more employees were required
to complete the training for their supervisors before
January 1, 2006. If you haven’t completed the required
training yet, it should be done as soon as possible. For
new employees and those promoted to supervisory positions,
training is required within six months of starting the new
position.
Anthony: What's new about
the computer professional exemption?
Anne: California labor law
incorporates a limited exemption for computer
professionals. Computer professionals must be paid at a
rate not less than $45.84 per hour. It is important for
employers to understand that an annual salary of $95,347
is not enough to meet this exemption if the employee works
more than 40 hours per week. Computer professionals should
be paid at least $45.84 for each hour they work.
Depending on their job duties, individuals who qualify
for the computer professional exemption may qualify for
another exemption, which would not require payment for
hours worked in excess of 40 in a week.
Anthony: How should
employers handle payment of wages on separation of
employment?
Anne: California law has
specific timing requirements for the payment of wages when
an employee terminates employment. Generally, payment is
due at the time of termination or resignation. The only
exception is if an employee resigns with less than 72
hours notice. In this case final payment is due within 72
hours. Effective January 1, 2006, the final payment can be
made by direct deposit if that’s how the employee is
normally paid.
Anthony: Are there new
laws regarding the information reported on paychecks?
Anne: Yes. Currently,
employers are required to provide employees with accurate
itemized paychecks that list the employee’s name and no
more than the last four digits of the employee’s social
security number or employee identification number. The new
law makes it clear that the employee identification number
cannot be the same as the employee’s social security
number. Effective January 1, 2008, employers must list an
employee identification number that is not the same as the
employee’s social security number on a paycheck, or no
more than the last four digits of the employee’s social
security number if there is no separate employee
identification number.
Anthony: Thank you for
sharing your expertise with the readers of Propel Your
Venture.
Bio
Anne Senti-Willis
As Special Counsel in the Business Group of
Thoits,
Love, Hershberger & McLean, Anne
focuses on business and corporate matters, with an
emphasis on tax and employee benefits. She joined the firm
in 2000 after starting her legal career at
PricewaterhouseCoopers LLP in San Jose, where she worked
on corporate and international tax structuring and
planning issues. Anne graduated magna cum laude from
Hastings College of the Law, where she was a student
editor for The Back Forty and concentrated in the area of
taxation. She earned her undergraduate degree in actuarial
science from the University of Illinois at
Urbana-Champaign. Prior to attending law school, she
worked as a pension consultant |
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New Hire Checklist
By Josiane Kristensen and Anthony Nassar
Imagine yourself smoothly navigating a financing or
acquisition transaction. That is until you discover that
you are missing a number of documents on the due diligence
list, including fully executed employment agreements. To
make matters worse, some of these missing employment
agreements belong to employees who have left the company a
while back, and may not be willing to cooperate on this
matter.
When hiring a new member of your team, it is best to
have a process in place to help insure that you have a
complete, fully executed set of documents satisfying the
law and best practices of the start-up industry. This is a
3-step process consisting of using:
- a new hire checklist
- a system to identify missing documents/signatures
and follow up through completion
- an exit process which includes a final check that
all relevant documents are complete and executed before
the employee leaves the company.
In this article, which is geared towards companies
based in the US, we’ll discuss the basic components of a
new hire checklist and briefly cover how a tracking system
and the exit process can be used to help maintain complete
records.
Before we address the checklist, we’d like to stress
the importance of providing your staff with an employee
handbook. This document sets forth a number of policies
and procedures including at-will employment, equal
opportunity, business ethics, immigration law compliance,
conflicts of interest, exempt vs. non exempt, employee
benefit programs, leaves of absence, timekeeping, safety,
travel expenses, internet and e-mail usage, and many
others. If you do offer an employee handbook, you should
always obtain a signed acknowledgment from your employees
confirming receipt of the document.
New Hire Checklist
The list provided in this article is for illustrative
purposes and may not address the specific situation of
your company. Please seek the advice of a qualified human
resources and/or legal professional when developing a new
hire checklist for your company.
Offer Letter/Employment Agreement
This document sets forth the terms of the employment
offer, including job title, duties, at-will employment,
salary, bonus, commission, stock option and vesting,
time off, health and welfare benefits, employee start
date, and other additional terms specific to the offer
such as sign-on bonus, vesting acceleration upon
termination, etc. It is executed by a company
executive (often the President/CEO in the case of an
early stage start-up) and the employee. In some
cases, companies use a different version of the
employment agreement for key employees. This document is
requested in the course of due diligence.
I-9
The purpose of this form is to verify the identity and
eligibility of an employee to work in the US. This form,
including document verification, must be completed by a
company representative and the employee
within three business days of the date employment
begins. The form and instructions are available for download
on the US Citizenship and Immigration Services
website.
I-9 forms should be filed separately from the
employees’ personnel files. Once the document
verification is completed, there is no need to keep a
copy of the verified documents on file with the I-9.
W-4
Form W-4
or withholding exemption certificate is used by the
employee to indicate marital status and the number of
withholding exemptions claimed, which should not exceed
the number to which the employee is entitled. The W-4
must be completed, signed and dated by the employee on
or before the date of employment.
Proprietary Information and Inventions Agreement
The PIIA addresses the handling of company proprietary
information by the employee, the assignment of
inventions to the company, exclusions of prior
inventions, and other related matters. This document
must be completed and signed by the employee as well as
the company. Note that this document is absolutely
essential for start-ups, and one that will be requested
in the course of due diligence.
Non-Disclosure Agreement
The NDA governs matters related to confidential
information disclosed by the company to the employee. In
some cases, the NDA is embodied in the PIIA described
above. When it isn’t, a separate NDA agreement is
executed by both the company and the employee.
Similar to PPIA, the NDA is requested in the course of
due diligence.
Resume
A clean resume should be included in the employee’s
file. By clean, we mean a copy that has no scribble,
comments, drawings, and other markings. The resume
provides an inventory of skills and experience which may
be requested by prospective investors, or used when
planning resources for future development, marketing or
administrative projects. When applicable, the
application for employment should also be included in
the employee’s file.
Employee Information Form
This form summarizes basic employee data such as name,
address, telephone number, birth date, hire date,
dependent status, dependent information, and emergency
contacts. There are packaged solutions on the market
such as People
Manager from KnowledgePoint
that track employee data and more. Also, some payroll
service providers offer an HRIS (Human Resources
Information Systems) option for a fee, which include
online tracking tools of personnel data.
Employee Benefits
Depending on the benefits offered, the employee will be
required to complete a number of enrollment forms
including medical, dental, vision, life insurance,
disability insurance and a retirement plan such as a
401(k). The law requires that all health related forms
be filed in a location that is different than the
employee’s main personnel file.
Payroll Service Enrollment/Direct Deposit
Information
If you’re using a payroll service, the employee will
need to complete an enrollment form providing basic
information and direct deposit details, when applicable.
PTO-Vacation Policy and Form
Even if the company does not have an employee handbook,
it must have a policy describing how the employee
accrues and uses time off. The policy will also drive
how the finance department will accrue these hours on
the books of the company. Time off can be in the form of
an all-purpose personal time off (PTO), or vacation and
sick leave. It is best to provide employees with a form
where they can request a certain number of hours or days
of PTO/vacation in advance from their supervisor. Such a
form enables managers to better plan resources,
especially with start-ups where resources are scarce. It
also allows finance to record the actual hours taken
against the vacation accrual. Please note that by law,
exempt employees cannot take PTO/vacation by the hour.
The minimum unit for them is one day.
Expense Report and Policies
The expense report form is used by employees to document
and file business expenses for reimbursement. The
company needs to supply all new hires with an expense
report template along with an expense reimbursement
policy.
If the company does not have an employee handbook, it
needs to develop a reimbursement policy covering travel,
meals, entertainment, telephone/mobile and other
miscellaneous purchases. Such a policy is essential to
avoid disagreements between the employee on one hand,
and management or finance on the other, about whether or
not an expense is reimbursable. This may seem trivial,
but what would you do if you don’t have a policy
covering the reimbursement of mobile phone expenses, and
your employee submits an expense report for $600 in
mobile charges incurred in one month for work-related
calls made in good faith? It’s best to be proactive and
develop such policies before problems surface.
Tracking System
No matter how complete your checklist is,
some documents will invariably fall through the cracks, as
everyone gets busy with their daily tasks. That is unless
you have a tracking system, or a sort of dashboard listing
every employee on one side, and every document on the
checklist that has not been completed. Using this
dashboard, a designated employee in HR or accounting can
follow-up with management and employees to get every
pending item executed and filed appropriately.
Exit Check
Even if the above system is implemented properly, there
is a chance that some documents may still be pending for
an employee who is terminating his/her employment with the
company. As part of the termination procedure, the HR
records should be checked one last time, and missing
documents completed, before the exit process is deemed
complete.
Early stage entrepreneurs sometimes express their
dismay regarding such an onerous process, especially at a
time when they are stretching every single resource to
reach the next milestone. Interestingly enough, some of
those entrepreneurs who have succeeded beyond the seed
stage have expressed their appreciation for this
systematic approach that helps maintain the records up to
date, and contributes towards their company’s readiness
for the next significant event’s due diligence.
Josiane A. Kristensen is a Human Resources
Consultant offering companies a wide range of Human
Resources related services through her firm,
Kristensen Consulting. Josiane’s background
includes 23 years of domestic and international experience
in the Human Resources field. Since founding Kristensen
Consulting in 2000, Josiane has been working with many
major corporations including hotels, distribution, food
service, property management and retail. Her generalist
background enables her to provide a menu of services to
assist in a variety of corporate environments.
Since founding
Venture Momentum
in 1994, Anthony Nassar has advised start-ups and
small businesses as a financial management consultant and
contract CFO on various matters including angel and
venture financings, acquisitions, due diligence, financial
reporting, and internal controls. Throughout his various
assignments, he advised companies on transactions valued
at well over $100 million, including private equity
financings, acquisitions, and portfolio management.
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Karavans
is a new site launched by a technology entrepreneur with a
passion for self-sufficiency.The site takes an eclectic
approach to the subject by incorporating insights from
economics, business, history, and anthroplogy. It will be
of special interest to anyone interested in reducing their
dependency on the "grid" for both power and food, in an
age of escalating energy costs. One of the site's main
focuses will be on the creation of small-scale,
community-owned, renewable energy utilities.
www.karavans.com
A
Sound Match For music lovers
looking for love.
A Sound Match (ASM) is an online dating service that
uses music to predict compatibility between people. After
taking the 3-minute Music Personality test, members
instantly receive compatible matches and can exchange and
listen to each other’s music directly from profile pages
and inside emails (using Rhapsody’s music service).
If you love music, discover your Music Personality and
meet your Sound Match. For now, ASM is free!
www.asoundmatch.com |
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At
Venture Momentum, Inc., we work with start-up
entrepreneurs who wrestle with finance and accounting. We
help you put together the pieces of your financial puzzle
by providing a solid foundation from which to successfully
raise capital, manage growth and achieve liquidity. To
learn more, give me a call at 1.415.897.0195 or visit
http://www.venturemomentum.com. |
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Disclaimer: The information in the e-zine (the
"Information") is current as of the date of the issue shown at the top
of the e-zine. The Information is intended solely to illustrate
general concepts and guidelines on various business subjects. It may
not apply to specific situations. The Information does not constitute
accounting, financial, tax, legal or other professional advice. You
are urged to consult with a qualified professional who can understand
your specific situation and advise you accordingly. No Information
creates a warranty. All Information and links to other websites are
provided on an ‘as-is’ basis without any warranties, express or
implied, including warranties of merchantability or fitness for a
particular purpose. In no event shall Venture Momentum, Inc., its
authors, publishers, contributors and editors be liable for any
indirect, incidental, special, consequential, or punitive damages of
any kind whatsoever arising out of your use of this e-zine, the
Information, and/or links to other websites regardless of the cause of
action.
Copyright ©2006 Venture Momentum, Inc. All
rights reserved.
All marks are the property of their respective owners.
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