Ask HN: Convertible notes for new hires in pre-funded stage?

[yrashk]

Hi,

Just wondering if anybody else thought about it already. We all know how hard it is to build a team until you're financed enough to be able to pay wages; even if you get a person on board, it is hard to estimate their actual commitment vs. what they promised and what their stake should be. Then, if that person quits for any reason before their stock is fully vested, it is another legal burden to manage.

What if instead of offering a stock compensation off the bat the company would issue convertible notes in a lieu of wages, with the cash value equal to the what that person would have been paid if there was cash in the company? Then, if that person quits before funding, the company still owes that person so if the company is getting liquidated or financed (or sold) the person would either get paid (w/ interest on top of it) or he would get a good discount for the dollar amount of services that he provided to date?

What do you think about this? Does it make any sense? Any caveats? Any legal reasons to avoid this scenario?

[cperciva]

I've long thought that the vesting-equity model is wrong, and if I were free to design a compensation system I would set it up more or less as you describe: No equity grants, but wages would be paid as a combination of cash and convertible debt. If someone leaves the company, they keep whatever they've been paid so far; they would be treated just the same as any other convertible debt holder. The debt would have a significant rate attached (say, 1% per month) due to its high risk.

Unfortunately, I don't think this would ever work, due to income tax issues. As I understand it, the convoluted games startups play with equity grants are to avoid having the equity taxed at its real value; but I imagine that the IRS would demand that income taxes be paid immediately on the total wages, including the value of the debt -- which would very quickly create a cash flow crunch for all but the wealthiest employees.

If this were possible, though, it would make things much simpler -- just imagine, having founders, employees, and angel investors all hold the same form of equity!

EDIT: Just to be clear, I would say that the cash+debt model should continue indefinitely, rather than being limited to 4 years. The idea that someone's effective salary should drop dramatically 4 years after they were hired (i.e., when they are no longer vesting stock each month) seems absolutely loony to me.

[yrashk → cperciva]

The tax issue is very important, indeed. I would try to get some consultations about that. I wonder want might be the difference between CRA and IRS in this respect (I'm from Canada)

P.S. You're giving a talk at Vancouver's hackathon this October, right?

[cperciva → yrashk]

I wonder want might be the difference between CRA and IRS in this respect

I vaguely remember seeing something in the T1 guide about handling wages owed but not received... it's just possible that this would cover things, but I don't remember looking into the details.

P.S. You're giving a talk at Vancouver's hackathon this October, right?

Yep. Evening of October 9th.

[Kliment]

Curious. I wonder if that is a problem in funding rounds, since the person has no financial incentive not to quit like there is with vesting, and yet has stakes in funding events. I expect investors would be scared off by this just due to the pure unfamiliarity of it. Can anyone more intimate with the legal side comment? grellas?

[yrashk → Kliment]

Good point about incentive not to quit. I think this can be somehow managed in convertible note term sheet. For example, convertibility kicks in after a certain threshold.

[yrashk → Kliment]

Good point about unfamiliarity, too. Have no workaround for that so far.

[btmorex]

What's the benefit for the prospective employee? If the company does well, they would be much better off with equity. If the company does poorly, they aren't going to get paid anyway.

[yrashk → btmorex]

The point is that if the company will do well, he'll get the equity (convert).

I can see a situation when a company gets profitable without funding and I guess this can be covered in the term sheet as well.

[btmorex → yrashk]

You wrote "with the cash value equal to the what that person would have been paid if there was cash in the company". There's no upside there. Why wouldn't he/she just get a job at a normal company and actually get paid over maybe getting paid the same amount in the future?

[JoachimSchipper → btmorex]

Well, the investors (hopefully smart people) in that particular round hope to get more money for their shares than they paid for them - so one could make the case that one dollar of shares is somewhat more valuable than one actual dollar.

On the other hand, what employee wants to put his wages into a highly-risk investment like a startup? (High-risk investments can pay off, sure, but you don't want to take those risks with money you need for food and housing.)

[yrashk → JoachimSchipper]

That kind of employee that could work for equity. There's not much of those, but that's how it seems to work ;)

It's not even necessarily full time at the very beginning

[yrashk → btmorex]

Getting job at a normal company is also "safer" than joining a startup for just equity.

This cash value will once be eligible for conversion to equity at a decent discount. I personally see this as stock compensation on steroids. With pure stock compensation there is no chance to recover any cash whatsoever if company fails, also prior stake estimation may be unfair (i.e. overestimated or underestimated).

[jaggs]

I can see this maybe working with a couple of caveats:

a) There's a premium paid on conversion over what he/she would have earned in wages.

b) There would be a minimum payment for them even so, which would be almost living expenses.

But that's just off the top of my head, there may be legal issues.

I think the unfamiliarity issue only comes to the fore if your idea is not compelling enough. If it is, someone will find a workaround.

[yrashk → jaggs]

a) That's what discount is for, isn't it? b) Well, that's up to a specific situation, just like in equity compensation scheme.

[bobf]

From the company's perspective, the main problem seems to be that it becomes harder to get investment as you accrue debt. The only incentive I see for an employee to accept such a scheme might be if a convertible note would have tax advantages to the employee compared to wages.