This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs). Below is a longer, more comprehensive version. Please shoot me any questions you may have in the comments section – or feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco). Many thanks, Scott
We launched a consumer internet site about a year ago, and we’re starting to get some really good traction. We’ve spoken to a bunch of angel investors and they all told us that we need to get an engineer on our team (my partner and I are both business guys and we outsourced the development). The problem is we’re in Silicon Valley, and we obviously don’t have the money to compete with the big tech companies for talent. Can you please give us some advice on hiring a superstar engineer and the key legal issues that we should be addressing. Thanks!
On the business side, I think the only way you’re going to be able to attract a superstar engineer is to treat him (or her) as a co-founder from an equity perspective – which means offering him 10-20% of the equity. You also must get him really excited about your startup. As Seth Sternberg, the co-founder and CEO of Meebo, recently discussed (see video below):
“Engineers want to build awesome product. They want to change the world. . . . If an engineer is really passionate about the problem that they are going to solve, then they can get excited about your startup….”
On the legal side, there are a number of significant issues that you need to button-down.
1) Equity Issuance. At this stage of your company, it will likely be problematic to issue shares of common stock (as opposed to stock options) to the engineer because of the potential tax liability. Indeed, unless the engineer purchases the shares for their fair market value, the issuance will be deemed compensation to the engineer; and he will have to pay ordinary income tax at the federal and state level, and the company will have tax withholding obligations. There are also tricky securities law issues.
Accordingly, you’re going to have to set-up a stock option plan and issue stock options to the engineer, which are not taxable upon issuance and can be easily tailored to comply with applicable securities laws. As I have previously discussed, however, stock option plans are complicated and will require compliance with Section 409A of the Internal Revenue Code – which means you will need to value your company (typically by retaining an outside appraiser) to ensure that the exercise price of the stock options is equal to the fair market value of the underlying shares of common stock as of the grant date.
2) Vesting. The other important issue you must think about in the context of the options issuance is a vesting schedule in order to incentivize the engineer to remain with your company and to help grow its business. The most common schedule vests an equal percentage of options every year for four years, with a one-year “cliff” (i.e., 25 percent of the options vest after 12 months) and then monthly, quarterly or annually vesting thereafter – though monthly is the most common.
For key employees, like the engineer you intend to hire, there is also generally a partial acceleration of vesting upon a triggering event (such as the sale/change of control of the company or a termination without cause); or more commonly, two triggering events, such as a sale/change of control followed by a termination without cause within 12 months thereafter.
3) Offer Letter. To protect your company, it is important that the engineer execute some form of offer letter or employment agreement, which will set forth all of his rights and obligations, including position, compensation (including stock options and vesting), benefits and, most importantly, that the relationship is “at will.”
If things don’t work out, the company must have the flexibility to terminate the engineer’s employment with or without cause – and that’s what “at will” means. And, again, everything must be in writing because you certainly don’t want a situation down the road where you need to replace him, and you get into a dispute with regard to what his deal was and whether, for example, he is entitled to severance if he’s terminated without cause.
4) IP Agreement. The engineer must also execute a Confidential Information and Invention Assignment Agreement, which is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any intellectual property developed by the engineer is legally owned by the company.
Note, however, that under California Labor Code Section 2870, an employer may not require an employee to assign rights in an invention that the employee developed entirely on his/her own time without using the employer’s equipment, supplies, facilities or trade secret information except for those inventions that either: (i) relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or (ii) result from any work performed by the employee for the employer.
5) Minimum Wage. Finally, make sure you pay the engineer at least the minimum wage. A lot of startups make the mistake of hiring a key employee and merely give him or her “sweat equity” in lieu of any ongoing cash payment/salary. Unfortunately, this is illegal in California and could lead to criminal liability. So be careful — this issue can really come back and haunt you, particularly from a disgruntled employee.
I hope the foregoing is helpful. Below is the video referenced above in which Seth Sternberg discusses his hiring philosophy with startup guru Chris Dixon in a must-see episode of Founder Stories. (It is best viewed in chrome or firefox.)