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5. FINANCIAL MATTERS

c. Compensation

Cash is King

The personnel of a fund management company will normally expect compensation for their services. Compensation may take the form of cash or other benefits. If the personnel are treated as employees, their cash payments are called "wages" if paid hourly, or "salaries" if paid on annual basis. If the personnel are treated as independent contractors, their cash payments are called "fees". Independent contractors are typically paid on an hourly or project basis.

In general, the target compensation is "fair market value" (FMV). Companies may negotiate below-market rates (subject to the minimum wage laws, which apply to employees but not independent contractors). In addition, non-exempt employees may be entitled to extra pay and benefits for working overtime. Exempt employees and independent contractors are usually not entitled to such benefits. Employment benefits depend on the laws of the state where services are rendered.

Companies may pay amounts higher than market standards, but at the risk of being sued by the owners for wasting company assets, breaching fiduciary duties, and other grounds.

Other Types

Most start-up companies lack the cash to pay fair market value. The solution is to pay a package of cash and other compensation types, such as the following:

• Equity. A company may provide compensation in the form of equity. In the case of a corporation, “equity” refers to stock or a variation thereof such as options, warrants, stock appreciation rights, and phantom stock. In the case of an LLC or LP, "equity" refers to membership or partnership interests (respectively) or a variation thereof. In either case, equity is a “capital interest”, meaning an ownership stake in the capital assets.

• Profits Interest. LLC's and LP's (but not corporations) may also elect to award “profits interests” instead of “capital interests”. A “profits interest” is not an ownership stake, but merely the right to receive allocations and distributions related to operations. Because the profits interest is not an ownership stake, the interest holder is not entitled to distributions in connection with the sale of capital assets.

• Revenue Sharing. The company and the service provider may have a "revenue sharing" arrangement, where they share the gross revenue attributable to the services for the company. This arrangement is common where a company refers its clients to an independent contractor on the premises. The company may also provide additional services to the independent contractor, such as administrative support and the use of office equipment. The independent contractor provides services to the referred clients, and the parties split the revenue 50/50 or otherwise.

• Credit. Another form of compensation is credit – reputational, not financial. This is common in the entertainment industry, where production companies provide “above-the-line” cast and crew members with prominent credits in products and marketing materials. The private equity industry may also use this form of compensation. For example, a fund management company could highlight personnel and other service providers in press releases and other marketing materials.

• Co-Investment Opportunities. A fund management company could provide co-investment opportunities to its service providers. This means allowing them to invest their own capital in the private equity funds or portfolio companies. In addition, the service providers could receive a contractual "right of first refusal" to invest in future opportunities.

• Other. Other types of compensation may be available. If cash is tight, entrepreneurs must be creative in establishing compensation packages. When in doubt about legality, consult with an attorney.

Timing

The timing of compensation is generally subject only to the agreement of the parties.

In the case of cash, companies may pay their employees or independent contractors promptly upon the performance of services. Alternatively, companies may defer all or a portion of the cash until a future date. With regard to consultants, the common arrangement is payment of 50% up-front and 50% upon completion of services. In that case, the up-front amounts are usually treated as refundable advances on the earned fees. The back-end amounts may be staggered to correspond to specified milestones. For example, a fund sponsor could agree to make a payment to the fund manager once the fund achieves a specific IRR.

Similarly, awards of equity and its derivatives may vest in installments over a period of time. In the technology sector, the common vesting schedule is 25% per year for each of the initial four years of employment. An employee leaving the company early may lose the unvested portions and be required to sell the vested portions back to the employer. This structure may be available to a fund management company.

As a general rule, new companies should try to defer all cash payments for as long as possible. It is not uncommon for service providers to agree to defer all or some of their fees until their client turns a profit.

Paying the Founders

The founders of your company may also want compensation for their efforts. Their compensation may come in different forms – management salaries, distributions of net profits, equity options, developer fees, and other forms. When structuring compensation, be sure to consider the taxation of the different types. If necessary, consult with a CPA or tax attorney.

Many entrepreneurs make the fatal mistake of bleeding capital from their companies prior to viability. Avoid this mistake by setting aside a sufficient amount of income in reserves. Try to resist the urge to make distributions too early in the lifespan of your company.

For tax purposes, set the management salaries at a reasonable level in order to avoid raising a “red flag” with the IRS and other tax authorities. If salaries are too low in relation to distributions, the tax agencies might argue that the company or its personnel are avoiding employment taxes. If salaries are too high, the tax agencies might argue that the company is avoiding income taxes (in the case of a corporation). To be safe, the salaries and distributions to the founders should be equal to each other (50/50).