Spreadsheet for Y Combinator’s Post-Money Safe (with Valuation Cap and Optional Pro Rata Rights)

May 5, 2021 By in SAFEs Leave a comment

Y Combinator’s post-money Simple Agreement for Future Equity (Safe) is essentially a series of mathematical equations in the form of a legal document.

My spreadsheet for Post-Money Safe with Valuation Cap (and Optional Pro Rata Rights) allows companies to test hypothetical future dilution scenarios (i.e., Series A financing and liquidity event) to measure projected Safe-caused dilution to founders and others. This spreadsheet is available for purchase in downloadable Excel format here.

This spreadsheet allows testing of potential dilution as specifically applicable to your company by creating inputs for:

  • pre-Safe pre-Series A company capitalization, including common stock, options, promised options, and unissued option pool;
  • up to two different Safes with different purchase amounts, valuation caps, and optional pro rata rights;
  • a Series A round with variable new raise, pre-money valuation, target post-money pool, and lead investor purchase amounts; and
  • liquidity event proceeds;

The inputs build separate cap tables for post-Safe conversion, post-Safe conversion and post-equity financing, and post-liquidity event.

This spreadsheet is for use only with Y Combinator’s post-money Safe with valuation cap (and optional pro rata rights), and not for use with any other Y Combinator Safes.

As suggested on page 13 of the quick start guide, the post-money Safe can be highly dilutive to founders, including diluting up to 100% of founder equity (e.g., a $5 million raise at a $5 million post-money valuation cap). To prevent unwelcome surprises, please determine dilution resulting from your planned Safe financing before raising that first penny of capital.

How I Quit My Big Law Firm Job, Moved to an Island, and Built a Thriving Boutique Practice Closer to Nature

June 21, 2019 By in Uncategorized Leave a comment

 

 

It was the spring of 2015: I was a corporate law partner in the Austin office of a 200-lawyer firm with a successful practice. The firm was collegial and my partners were smart and amiable. Our two kids, then ages 6 and 7, enjoyed Texas life, friends, and attended an excellent Waldorf school. My wife, Shannon, had a lifelong group of friends and family and a thriving yoga teaching practice. We had an eclectic group of friends and lived in a cool mid-century ranch house within biking distance to Barton Springs Pool and the Barton Creek Green Belt.  While Austin was hip and we were in the groove, we felt something was missing.

Indeed, during our eleven years as a family in Austin, the city’s population had increased by over 30%, transforming what once felt like a relatively small college town into a major metropolis with valet parking.  The inveterate traffic and furnace heat during most of the year increasingly made it a challenge to move about and enjoy being outside.

Having attended a small outdoors-oriented high school in Idaho and the University of Colorado at Boulder for my undergraduate degree, I developed a strong affinity for nature.  I thought escaping the urban life from time to time might be our remedy to Austin’s congestion.

My initial solution was to surprise the family with a vintage Sportsmobile that I purchased, sight unseen, on eBay.  We camped locally a couple times, sweltering while listening to our campsite neighbors crank up their generators and A/C units.  We made the seven-hour drive to Big Bend National Park, a desert treasure with purple mountain sunsets and ocotillo that proved too hot and too far to become part of our weekend routine. One summer, we spent a month living in a VRBO on Toddy Pond in Maine. Another, we rented a rustic cabin and small fishing boat at a lodge in Hayward, Wisconsin.  One more, we spent a week at a family camp in the Adirondacks.  

These nature sojourns confirmed that bigger lifestyle changes were required.  As woo-woo as it sounds, I felt a preternatural force pulling me closer to nature. Synchronicity at work, Shannon also experienced a need for change and a strong call to the wild.  Of course, the children were eager for more of life’s natural wonders.

That was about the time when I discovered Dylan Tomine’s wonderful book, Closer to the Ground, describing his family’s life on an island in the Pacific Northwest: fishing, foraging, picking berries, and gathering firewood. Although I am no expert fisherman, the lifestyle sounded right to me. Shannon read the book and agreed to make a solo reconnaissance trip to the island.  Huddled around the laptop, the kids and I watched via FaceTime as she rambled down a trail flanked by massive Douglas fir and Western red cedar trees, passing llama and sheep down to a local Italian restaurant. “We could live here,” she said with thoughtful optimism. And that was sufficient impetus for all four of us to board a plane and a ferry a few weeks later to conduct a family assessment.

Our visit confirmed not only that it would be possible to live on an island in the PNW, it would be phenomenal. We decided to make it happen, but how?  Due to a stroke of luck and my wife’s Texas-born tenacity, on the last evening of our trip, we arranged for a showing of a fairytale home for sale by owner: a historic, 1900 farmhouse on over two acres with a magnificent garden and orchard. Three days later we signed the purchase contract and sold our home in Austin within the same week.

As these events transpired, I resigned from the big Texas law firm and launched my boutique solo practice, adding a Washington law license to my quiver (Washington allows admission by motion to Texas attorneys practicing for three of the past five years).  I am thankful to my clients, who were understanding of our life changes and elected to continue as clients of John Dorsey PLLC.

We are now approaching our fifth year on the island and we have truly become closer to nature: we plant our gardens in the spring; we drop crab pots for Dungeness in the summer; we harvest our apples, plums, and pears in the fall; we collect and split wood for the stove in the winter; we sail and swim year round; and we try to live outdoors. We have developed new friendships and continue to explore our new Pacific Northwest surroundings.

My law firm’s clients are mainly from Washington, Texas, and Mexico.  I visit clients in Austin about once per quarter, and travel to Seattle, Mexico City, and elsewhere as needed. Shannon has a thriving home, garden, arts, writing, and yoga teaching practice. Our children are well-settled and enjoy a Waldorf education (yes, they are vaccinated) and life with hens, cats, dogs, coyotes, and owls in communion with nature.  

A couple of years ago, at the local 4th of July parade, we encountered Mr. Tomine and shared that our story to move to the island was influenced by his writings.  He replied with a reticent smile, “Really? That is a big responsibility. Don’t call me in February.” We are still here. And we hope to be here for awhile, closer to it all.

 

 

Top 10 Negotiation Points for Sellers in M&A Investment Banking Engagement Letters

June 18, 2019 By in M&A, Private Equity Leave a comment

Engaging a reputable investment bank to assist in the sale of a business is generally money well spent. A good investment bank will work diligently to maximize the seller’s enterprise value and coordinate a disciplined, organized, and successful transaction.

This article discusses the top ten negotiation issues in investment banking engagement agreements. Although the recommendations below are designed mainly to benefit the business seller, they are also intended to be reasonable to the investment bank. For the purposes of this article, I assume that the seller has an enterprise value ranging from $5,000,000-$30,000,000, which is the typical M&A transaction size among my clients.

1. Transaction Scope. The first draft of the investment bank’s form engagement agreement will often define the engagement to include every transaction imaginable, including a sale, minority investment, equity financing, debt financing, joint venture, etc. To avoid having to retain and compensate the investment bank for services the seller does not require, the agreement should specify that the banker’s services are limited to only those services the seller needs at the time of engagement (e.g., financial advisory services for a sale of all or substantially all of the company’s stock or assets). The engagement agreement should itemize the services to be provided by the investment bank in the engagement, which may include: (i) advising the seller on a target price range; (ii) preparing a confidential information memorandum (CIM) and executive summary (or “teaser”) for delivery to potential purchasers; (iii) locating, contacting, meeting with, and following-up with potential purchasers; (iv) arranging conference calls, visits, and management presentations; (v) reviewing, organizing, and managing due diligence materials in a virtual data room; (vi) obtaining (in coordination with counsel) confidentiality agreements from all potential buyers; (vii) soliciting, analyzing, and comparing competing offers; (viii) advising on transaction structure, negotiation strategies, and deal points; (ix) negotiating the acquisition term sheet and definitive purchase agreement; and (x) coordinating communication between buyer, seller, legal counsel, and other professional advisors.

2. Fees. The investment banker’s fees may be affected by the reputation and capabilities of the bank, as well as deal size, complexity and likelihood of closing. The main fees are the retainer and the success fee.

  • Retainer.  A non-refundable retainer or “work fee” is generally paid to the investment banker from the commencement of the engagement. The retainer demonstrates that the seller is serious about selling the company and compensates the investment bank for its initial work. Retainers generally range from $25,000-$75,000 and are payable monthly or in other increments and capped. It is reasonable for the seller to require that the retainer be paid on a monthly basis and credited dollar-for-dollar to the success fee (described below).
  • Success Fee. The largest component of the investment banker’s compensation is the success fee. It is usually either (i) a simple percentage of the transaction value or (ii) an upward scaled percentage (e.g., 3% of the transaction value up to $X and 4% of the transaction value over $X or from $X to $Y, etc.). If a scaled percentage is used, the bank might set $X at the “walk-away price”, meaning the lowest favorable price at which the seller is willing to close a deal, with value tranches and percentages increasing from $X. As long as $X is satisfactory to the seller, this structure will align the parties’ interests by incentivizing the investment bank to pursue a sale at or above the $Y price to earn the enhanced fee. In transaction values from $5,000,000 to $30,000,00, success fees typically range from 3%-8% of transaction value, with the higher percentages levied on lower valued transactions. There will often be a minimum success fee of $200,000 to $600,000, with most minimums at the lower end of the spectrum. Success fees are payable on closing or possibly over time if the transaction requires contingent payments (as described below).
  • Avoid Progress Fees. Some investment bankers will request a progress fee (e.g., $100,000+) payable upon the signing of a letter of intent or definitive purchase agreement. Progress fees are not standard and the seller should resist them because a transaction will not necessarily close after signing the definitive agreement, and is even less certain of to close after signing a non-binding letter of intent. If a progress fee must be included, it should be payable only on the signing of the definitive purchase agreement, not the letter of intent. Like the work fee, the progress fee should be credited against the success fee.

3. Transaction Value. The success fee is calculated on the basis of “transaction value”, which should be defined to mean the enterprise value paid to seller and its shareholders in the transaction. Transaction value will customarily include: (i) all payments to the shareholders (including cash, securities, and other property); (ii) debt that buyer assumes or pays at closing; (iii) the value of any equity that seller retains in the target post-closing; and (iv) above-market value payments on employment, non-compete, licensing and supply agreements. The transaction value should always exclude cash on hand and pre-closing cash distributions to seller’s shareholders to avoid paying the banker a fee on seller’s existing cash. Similarly, payments to specific employees that do not result in value to the shareholders (e.g., post-closing employment agreements with the buyer) should be excluded from the definition of transaction fee, as should the value of real estate owned by seller or affiliates and any post-closing real estate leases to purchaser at fair market value. It is customary for the banker to seek to have its success fee paid on the full transaction value at closing, including on the value of contingent payments such as escrow holdbacks, earn-outs, or promissory notes. However, in order to better align the banker’s interests with those of the seller, the seller should attempt to require that the banker receive its success fee on contingent amounts only if and when such amounts are actually received by the seller. This position is somewhat aggressive and may be resisted by the investment bank.

4. Expense Reimbursement. The engagement agreement will invariably require seller to reimburse the investment banker’s expenses relating to the engagement, including travel, data room charges, and printing and materials costs. It is usually not controversial for the seller to mandate that reimbursable expenses: (i) include only out-of-pocket payments to third parties (as opposed to the investment banker’s ordinary overhead expenses); (ii) be capped at a certain dollar amount; (iii) be pre-approved by the seller if in excess of a certain individual dollar amount; and (iv) and be subject to reasonableness standard. Expense reimbursements of $25,000 to $50,000 should be expected.

5. Term, Termination and Tail. The customary term of the investment bank’s engagement is between six months and one year, whatever is sufficient to market and sell the business. The seller should generally have the right to terminate the engagement without cause by giving 30 days’ written notice. In addition, the seller should be able to terminate the engagement immediately for cause upon the investment banker’s material breach of the agreement or willful misconduct, gross negligence, or bad faith. Unless the investment bank is terminated for cause, it will have the right to receive its success fee if the seller consummates a transaction during a “tail period” of between 6 and 24 months after termination with any purchaser that the investment bank introduced to the seller during the term. To avoid a dispute regarding whether a success fee is payable during the tail, the agreement should require the investment bank to provide seller with a list of introduced purchasers within 10 days after termination. If the investment bank fails to provide the list, the seller should be excused from the obligation to pay a success fee during the tail period. It is reasonable for the seller to require that the tail period not exceed 12 months after termination. Upon termination, the work fee will typically be non-refundable and seller will be obligated to reimburse the banker for expenses incurred through the termination date. The seller should confirm that the investment bank’s confidentiality obligations (described below) remain in effect for at least 1-2 years after termination of the engagement.

6. Indemnification. It is customary that the seller agree to indemnify the investment bank for all claims and expenses arising from the sale process (whether or not a sale occurs) other than claims and expenses arising from the investment bank’s fraud, gross negligence, or willful misconduct as determined by a final non-appealable court decision. If the investment bank’s acts or omissions give rise to the claim, its liability is generally limited to the amount of fees it received under the engagement agreement. Reputable investment banks will not engage in any substantive negotiation of the indemnification provisions. However, the seller should confirm that the investment bank is obligated to promptly notify the seller of any claims subject to indemnification and that the seller has the right to control the defense of such claims. Since any claims that arise are likely to be attributable to the seller’s disclosures, acts, or omissions (on which the investment bank relies to market the seller’s business), the investment bank generally has a reasonable basis for defending its indemnification rights.

7. Key Persons. The seller should specify in the engagement agreement whether any members of the investment banker’s team must lead the project. If there is key person that is essential to the transaction, the seller should obtain the right to terminate the engagement if he or she disassociates from the investment bank. The investment bank may resist this effort since it has little or no control over the employment decisions of its personnel. In that case, the seller could require that if a key person leaves investment bank, his or her replacement must be acceptable to the seller; and if not, the seller should then have the right to terminate the engagement, perhaps coupled with a reduction in the duration of the tail period.

8. Confidentiality. The seller and the investment bank should enter into a stand-alone confidentiality agreement or include a comprehensive confidentiality provision in the engagement agreement. If the seller discloses confidential information to the investment bank before the engagement, a stand-alone confidentiality agreement should be signed before the disclosure. The seller’s confidential information should not be used by the investment bank for any purpose other than to serve the seller’s interests in the engagement. The seller should confirm that the duration of the confidentiality obligation continues for at least 1-2 years after termination of the engagement, with trade secrets being subject to confidentiality obligations as long as they are trade secrets under applicable law. Finally, the seller should prohibit the investment bank’s disclosure of confidential information to departments of the investment bank that are not involved in the project. If a stand-alone confidentiality agreement is used, the engagement agreement should incorporate its provisions by reference.

9. Conflicts of Interest. To avoid conflicts of interest, the investment bank should generally be prohibited from representing a potential buyer in the same transaction and from engaging any other advisors or sub-agents to participate in the transaction. However, the seller may consent to the investment bank’s request to be allowed to assist a potential buyer with financing the transaction.

10. Exclusivity. It is reasonable for the investment bank to request that it be designated as the seller’s exclusive advisor for the transaction, which avoids having competing advisors working at odds. But if the seller has previously engaged or wishes to engage additional financial advisors for different purposes, the seller should confirm that the other advisory agreements do not conflict with the investment bank’s engagement.

If you have any questions regarding this article, please feel free to contact me at john@jmdorsey.com.

Originally published at Exhibit10.com.

#MeToo: Use a “Morals Clause” in Contracts to Deter and Quash Perpetrators of Misconduct

February 28, 2018 By in Contracts Tags: , , , , Leave a comment

Conde Nast TagID: null/Photo via Conde Nast

Morals clauses (or morality clauses) have long been part of celebrity, musician, athlete and other talent contracts.  With widespread revelations of sexual harassment and other misconduct in the wake of the #MeToo movement, the use of morals causes is expanding beyond traditional talent contracts to executive employment, consulting, distribution, and other contractual arrangements.

A morals clause gives one party the right to terminate the contract if the other party does not meet a certain behavioral standard. The standard is typically illegal, offensive or immoral conduct, resulting in a negative impact on the other party.

Morals clauses originated in Hollywood in 1921 in an effort by movie studios to curb the private misconduct of actors.  One year later, a morals clause appeared in Babe Ruth’s contract with the Yankees:

[Ruth] shall at all times. . .refrain and abstain entirely from the use of intoxicating liquors and. . .shall not during the training and playing season in each year stay up later than 1 o’clock A.M. on any day without the permission and consent of the Club’s manager. . .[I]f at any time. . .the player shall indulge in intoxicating liquors or be guilty of any action or misbehavior which may render him unfit to perform the services to be performed by him hereunder, the Club may cancel and terminate this contract.

More recently, morals clauses have been used to suspend or terminate deals with Tiger Woods (extramarital affairs), Michael Vick (dog fighting), Kobe Bryant (sexual assault), and Kate Moss (cocaine).

The allegations and acts of sexual and other misconduct that gave rise to the #MeToo movement have caused Hollywood studios and distributors to review and revise their contracts to include morals clauses, like this one:

Company may, at its option, terminate or suspend this Agreement immediately upon written notice to [Party B], if during the Term: (a) [Party B] commits any criminal act or other act involving moral turpitude, drugs, or felonious activities; (b) [Party B] commits any act or becomes involved in any situation or occurrence which brings [him/her] into public disrepute, contempt, scandal, or ridicule, or which shocks or offends the community or any group or class thereof, or which reflects unfavorably upon Company or reduces the commercial value of Company’s association with [Party B]; (c) information becomes public about how [Party B] has so conducted [himself/herself] as in (a) or (b) in the past; (d) [Party B] becomes involved or associated with an event or circumstance caused by [Party B]’s immediate family members or others closely associated with [Party B] (other than Company) which reflects unfavorably upon Company or reduces the commercial value of Company’s association with [Party B]; or (e) [Party B] takes any action or makes or authorizes statements deemed by Company to be in derogation of Company or its products.

Note that in the above example, the hiring company has the option to “terminate or suspend” instead of simply terminate.  This allows the company to take a wait-and-see approach if allegations of misconduct prove to be false or other favorable facts come to light.  (In the employment context, the employer’s right to “terminate or suspend” under the morals clause is in addition to the employer’s right to terminate for violation of the company’s code of conduct or anti-harassment policy.)

Some companies are going a step further, and implementing morals clauses not only in traditional talent agreements, but also in executive employment, consulting, and other agreements.

Given the substantial negative implications of misconduct on its victims, as well as on company morale, culture, and reputation, it makes good sense to think creatively about expanding the use of morals clauses to a range of business contracts.  Moreover, the immense power of the media to magnify the impact of a single event of misconduct requires companies to take (and to obtain the contractual right to take) swift remedial action upon any occurrence of misconduct in accordance with their policies.

A well-drafted morals clause can serve as a deterrent to potential misconduct and provide a heavy penalty for actual misconduct (e.g., contract termination).  It should also send a clear message to potential perpetrators of misconduct that such behavior will not be tolerated under any circumstances.

(Note: for talent, executives and others, there are often good arguments for seeking “reverse morals clauses“, but that is a post for another day.)

 

Two Client Case Studies: How to Raise Capital Using the New SAFE for LLCs

January 6, 2018 By in Financing, LLCs, SAFEs, Startups Leave a comment

case studies labelI created the Simple Agreement for Future Equity (SAFE) for LLCs for my LLC clients that needed a simple financing instrument to raise capital swiftly without much legal expense, while retaining pass-through tax treatment for their businesses. The SAFE for LLCs is an alternative to the Y Combinator SAFE, which is designed specifically for C-Corporations.

With the passage of the Tax Cuts and Jobs Act of 2017, the LLC remains an excellent structure for many business entities, the individual owners of which are now eligible to deduct 20% of their LLC-derived “qualified business income” on their US federal tax returns (subject to certain exceptions and limitations).

Since the LLC is largely a creature of agreement, its flexibility allows the SAFE for LLCs to be tailored to a wide variety of financing transactions. Here are two case studies showing the way my clients have used the SAFE for LLCs:

(A) Search Fund Financing:

  • Background: A former business executive at a multinational corporation and his business partners joined to form a search fund to acquire and roll-up various retail business assets under an LLC holding company. The assets were to be consolidated, re-vamped and re-branded under a single name, thereby adding substantial value.
  • Challenge: The client needed to quickly raise $500,000 to finance the asset search, due diligence and initial asset purchases. From their contacts in the industry, the client team had access to capital from private accredited investors, but needed a contractual mechanism to receive and deploy the funds.
  • Solution: I created a variant of the SAFE for LLCs called a “Seed Financing Investment Agreement (SFIA)” that allowed the client to raise the capital and spend it over 6-month search period (extendable for another 6 months) to identify and place assets for acquisition under contract. Upon the closing of a “next equity financing” (i.e., financing of at least $3,000,000) or a “liquidity event” (i.e., sale of equity or assets of the LLC), each SFIA automatically converts to the SFIA investor’s pro rata portion (based on his/her investment amount) of 25% of the the equity units owned by or issued to the LLC founders in the LLC as of the closing. This structure, in which the founders actually shared a portion of their equity with the investors, coupled with the founders’ experience and acumen, clearly aligned the investors’ and founders’ interests, and the target $500,000 was raised in short order. After the issuance of all SFIAs, the LLC succesfully closed the “next equity financing” for the acquisition and roll-up of the target assets and the SFIAs converted to founder-equivalent equity.

(B) The Film Financing:

  • Background: A film production company needed to raise capital for a new documentary film involving a time sensitive and controversial matter. The funds would be used to identify a screenwriter, develop a script, and engage in related film development activities.
  • Challenge: The client, a special purpose LLC wholly-owned by the film production company, wished to raise approximately $300,000 to finance the initial development of the project.
  • Solution: I created a variant of the SAFE for LLCs called a “Film Development Investment Agreement (FDIA)” that allowed the client to raise sufficient capital to finance the project within 30-60 days. The FDIA automatically converts to a special class of equity units upon the closing by the LLC of a “next equity financing” for the consummation of the project. The equity units to be issued to FDIA investors are the same as the equity units to be issued to investors in the “next equity financing”, except that they offer a 3% enhancement in preferred return relative to the preferred return payable on the standard equity units issued in the next financing. If a “liquidity event” occurs before the “next equity financing”, each FDIA investor had the priority right (over the LLC owners) to receive his/her original investment amount plus 30% of such amount, reduced on a pro rata basis among investors based on the LLCs available cash. The LLC is presently using the FDIA funds to develop the film.

These two case studies are merely examples of the many ways in which LLCs can swiftly and efficiently raise capital using the SAFE for LLCs. If your business is an LLC or a limited partnership and needs to raise seed capital, the SAFE for LLCs may be a viable option for you. Please contact me for details.

Introducing the Simple Agreement for Future Equity (SAFE) for LLCs

October 4, 2017 By in Financing, SAFEs 10 Comments

Updated March 31, 2021:

There are now two versions of the model form Safe for LLCs:

  1. The new post-money Safe with valuation cap (short form), which may be viewed here and purchased here; and
  2. The original pre-money long-form Safe with optional discount and valuation cap, which may be viewed here and purchased here.

—–

My Simple Agreement for Future Equity (SAFE) for LLCs is the first SAFE specifically designed for limited liability companies classified under U.S. federal tax law as partnerships or disregarded entities.

THE SAFE FOR LLCS IS FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY AND IS NOT LEGAL OR OTHER PROFESSIONAL ADVICE. NOTHING CONTAINED IN OR REFERENCED BY THE SAFE FOR LLCS CONSTITUTES RENDERING OF LEGAL OR PROFESSIONAL ADVICE FOR ANY SPECIFIC CASE OR SITUATION. NOTHING IN THE SAFE FOR LLCS IS A SUBSTITUTE FOR THE ADVICE OF AN ATTORNEY.  YOUR USE OF THIS SAFE IS AT YOUR OWN RISK. AND YOU MUST CONSULT WITH AN RELY UPON THE ADVICE OF YOUR OWN PROFESSIONAL LEGAL AND TAX ADVISORS WITH RESPECT TO THE ISSUANCE OF, AND INVESTMENT IN, THE SAFE FOR LLCS.  

Beware of “Hotel California” Contracts

September 15, 2017 By in Contracts Leave a comment

hotel-californiaBeware of what I call “Hotel California” contracts.  These are contracts that may be easy to enter into but difficult to leave (i.e., terminate).

Before you sign a new contract, train yourself to think like a spy entering a hotel lobby, “Where are my exits if things go awry?”

For more on this, please read my article: “Your Right to Terminate: Quite Possibly the Most Important Right in Your Business Contract.”  Relationships change, and some day you may need a clean exit.

‘Relax’ said the night man, ‘We are programmed to receive. You can check out any time you like, But you can never leave!’   – Eagles

Free, Publicly-Available Startup Company Forms and Document Generators

August 28, 2017 By in Corporations, Financing, LLCs, SAFEs, Startups Leave a comment

The angel investor network Blue Water Angels has compiled a nice summary of free, publicly-available, startup forms and document generators, including direct links to those forms and generators, all available here.

Remember: even if you start with a good form, always engage your favorite corporate lawyer to review your documents before signing off.

The devil is in the details.

How to Create a Simple Cash Bonus Plan to Incentivize and Attract Employees

June 20, 2017 By in Contracts, Incentive Plans Leave a comment

showmethemoney-Jerry-Maguire-1Your employees, like wide receiver Rod Tidwell (Cuba Gooding Jr.) in the classic movie Jerry McGuire, are valuable commodities.  They will stay with you if offered proper incentives, especially if you “show them the money.”

One of the best ways to do this is to create a simple cash bonus plan.  A cash bonus plan offers employees a financial reward for achievement of corporate, business unit and/or individual goals. The goals can be short-term (e.g., annual or quarterly) or long-term (e.g., three to five years), or both.

The best cash bonus plans are easy for employees to understand and easy for companies to operate. The plan is memorialized in a short written document that is specifically tailored to the company. The company retains the right to amend the plan at any time.

A cash bonus plan can be particularly useful for LLCs and S-corporations that wish to share the economic benefits of ownership with employees without the burdens of issuing Schedule K-1s (with negative tax consequences to employees) or having additional owners with voting and other rights. Cash bonus payments are taxed as ordinary income to employees and subject to standard payroll withholdings and deductions.

A well-crafted plan is a wonderful tool to incentivize and attract high-performing employees.

Here is a summary of the main issues you should cover to create a simple cash bonus plan:

  1. Purpose. The purpose of the plan should be stated clearly so that employees understand its goals, such as “to attract and retain superior employees by providing a competitive bonus program that rewards outstanding performance.”
  2. Eligibility. To be eligible, an employee must typically work at least a minimum number of hours (e.g., 40) as a full-time employee. Employees who have been terminated or who have resigned prior to the bonus payment date are usually ineligible, as are temporary workers. Companies may implement special eligibility requirements as they deem appropriate.
  3. Funding Metrics. The bonus pool can be a percentage of company net income, adjusted net income, earnings before interest, taxes, depreciation and amortization (EBITDA), or any other pool of money that the company identifies. The pool is generally capped as a percentage of the chosen metric.
  4. Performance Goals. Performance goals should clearly describe the metrics that the employee is required to achieve to earn a bonus, and how award determinations are made. Goals should align corporate, business unit and individual performance targets with company interests and encourage teamwork, while retaining incentives for individual performance. Many plans define the maximum target bonus available to each plan participant at the beginning of the performance period if all goals are achieved. Goals may be separated into organizational and individual categories, such as corporate goals to increase earnings and individual goals for productivity, customer satisfaction and client procurement/retention. Goal categories may be weighed (e.g., 50% EBITDA, 50% individual) to encourage one factor over another or equal weight in each category, depending on company objectives. However, the simplest, most easily understsood plans tend to be the most successful.
  5. Bonus Payments. Bonus payments are customarily made within 30-60 days after the end of the performance period (e.g., quarter or year). Bonus payments may be prorated for employees who take approved leave, including maternity or parental leave, and according to date of hire.
  6. Calculation Method. The bonus payable to each employee may be calculated as a percentage or multiple of annual base salary or as a percentage of the bonus pool. Bonuses are often capped at a certain amount.
  7. Non-Assignment. Bonuses should be non-assignable to prevent incentives from being mis-directed. IRS private letter rulings require S-corporations to prohibit assignment of bonus rights to prevent classification of the bonus as a second class of stock.
  8. Withholding. All bonus payments should be subject to applicable deductions and withholdings for federal, state and local taxes, and any other required deductions.

If you are interested in creating a simple cash bonus plan for your company, please contact me at john@jmdorsey.com.

Photo credit: ‘Show me the money!’: Tom Cruise as Jerry Maguire