By Joe Wallin
Many times I have seen the following happen: a company is running out of money. In order to keep going, the team is going to have to take pay cuts. The Founder & CEO tells the team–”We’ll have to ‘defer’ your salary. As soon as we raise our next round (or as soon as we sell), we’ll pay you what you have deferred.”
This is a mistake, and sometimes a costly one. The word “defer” is a dirty word in the law. Sort of like the word “back dating” (ok, maybe not that bad, but it is still not a good word). Why is “defer” a dirty word? Because when you “defer” you give rise to a number of potential adverse legal complications that you should, and can, avoid.
What are these bad consequences?
- Potential employment law violations–including a potential personal obligation to pay damages and attorneys’ fees if the “deferred” wages are not ultimately paid. (The size of the penalty can vary from state to state.)
- Potential Section 409A tax problems, which include a 20% penalty tax on the affected employees.
How can you avoid these problems? Don’t “defer,” instead:
- Reduce folks’ salaries to whatever you need to. This can be tricky because you do not want to breach any written or verbal employment contracts, so document a consensual written agreement.
- Offer incentive bonus payments, which only vest upon the triggering event (i.e., completion of the next round of financing, sale of the company, etc.). It is best to make it clear this money is at risk—if the company does not hit the target, then there is no obligation to pay.
- Usually, a salary reduction/bonus agreement will achieve the business goals.
What are the benefits of this type of agreement rather than deferring salary amounts?
- If you don’t raise your next round, or sell, you don’t have potential personal liability, including double damages and attorneys’ fees, for the deferred amounts.
In conclusion, be careful.
Joe Wallin is a Partner ar Davis Wright Tremaine LLP and the Founder and Editor of this Blog.
For More Information About Deferrals See: