Why I Chose to Implement ESOP at Integral: Beyond the Balance Sheet

Ashok Sivanand, CEO @ Integral
January 2, 2024

We are pleased to present a unique feature on our blog today. The following post comes courtesy of a guest contributor, Collective 54 member Ashok Sivanand, CEO @ Integral. We are honored to share his knowledge and viewpoints with our readers. Enjoy this unique piece that broadens the horizons of our usual content.

During my time at Shoplogix and Pivotal Labs, I experienced the transformative power of Employee Stock Ownership Plans (ESOP). While the outcomes for me were moderate at-best, (think downpayment on a house), I was fortunate to have experienced this first-hand on my journey to founding Integral.

Witnessing how ESOP reshaped the workplace was enlightening – it felt more than business strategy. It was a catalyst for a more engaged and vibrant company culture. Compared to my time at larger enterprises, I clearly felt and experienced increased employee commitment, a surge in tenacity, and a strong sense of belonging among employees. This wasn’t just about numbers; it was about nurturing a workplace where everyone feels invested and accountable to our collective success.

My close interactions with the founders offered me a unique perspective on the intrinsic value of ESOPs and how they help bridge the typical divide between shareholder and employee. ESOPs create a shared sense of purpose and success, transforming every team member into a stakeholder in our collective journey.

The Viability of ESOP in Professional Services

Implementing ESOP in a professional services setup isn’t always a straightforward path. Similar to how Collective 54 has a pro-serve specific model to EOS (Entrepreneurial Operating System), ESOP demands tailoring the popular models catered to product companies to fit our industry dimensions

Considerations at the Forefront

Here are some of the top considerations we had to confirm in order to confidently implement our program.

- Intent of Business: Decide early whether you’re running a lifestyle business or growing a scaled business. It’s my opinion that an ESOP makes a lot more sense for the latter.
- Structural Choices: While it’s more straightforward to implement the program for a C-Corp, there are various approaches like phantom stock that can help achieve the same goals for an LLC.
- Vesting Strategies: Consider whether vesting happens based on time (eg. 4 years), performance, or some combination. Time-based vests are a lot simpler to implement and will likely work for most cases.
- Ownership Percentages: Decide early what percentage of the business you want to allocate to the stock option pool. Since you can always allocate more shares in the future, i’d recommend starting small. We started with 15% with the intent of adding another 15% as we grow.
- Compensation Balance: Generally, stock options allocations follow similar proportions as salary allocations. The % of upside an employee might receive from the equity versus their salary increases as the employee is more senior.
- Stage of the Firm: In the earlier days, when cash was tight and we couldn’t afford to pay market salaries, we allocated higher values of stock options. As we grew, we adjusted to market compensation and reduced the stock option allocation per employee.
- Managing Exits: Plan for scenarios like key employees leaving and be transparent about it. I have witnessed peers end up in wasteful legal battles with senior executives leaving and trying to take them off the cap table.
- Dividends for Alumni: If you choose to pay out dividends, you’ll have to decide early whether alumni shareholders get paid those dividends. Like the point above, this can seem difficult, especially if the alumni left on bad terms. My advice is to remind you that you set out to build something great. Channel that emotional energy toward solving meaningful problems and serving more people and chalk these payments up to “dumb taxes” as the Collective 54 members call it.

Implementing ESOP: Legal and Practical Learnings

- Choosing the Right Law Firm: It’s crucial to work with a firm that has experience with this. My initial struggle with a non-specialized firm led to high costs and no results, whereas a specialized firm in Palo Alto was more efficient and cost-effective.The initial cost was $3,500 with the right firm.
- Options Galore: There’s a variety to choose from, like ISO/NSO. At the bottom of this post, I have attached a table prepared by my legal firm in 2017. I would advice legal and tax consult to confirm this information is still relevant before taking action. Deciding between options is more about aligning with your company’s values and principles than just logic or math.

Operationalizing the ESOP Program

- Educating Employees: We observed a trend where many colleagues either undervalued or overvalued their stock options. Addressing this through regular education sessions and transparent communication about valuations has been key.
- Encouraging Voluntary Participation: We’ve been cautious not to sway employees towards participating or create a divide between those who exercise their options and those who don’t. It’s tempting to use future valuations as a significant part of compensation, but this should be approached carefully based on the factors mentioned above.
- Attracting Talent: Interestingly, some colleagues were drawn to our firm because of the stock option program, resonating with their own values and aspirations to be part of the firm’s growth trajectory. They chose us over competing offers and marginally higher compensation for the value alignment.
- Maintaining Transparency and Fairness: We emphasize transparency in our operations but also respect privacy by keeping shareholder identities confidential and ensuring equitable treatment.
- Tools for Efficient Management: I highly recommend software tools like Capshare or Carta for managing ESOP programs and your annual valuations (409A). These tools offer efficiency and clarity in administration.

Implementing an Employee Stock Ownership Plan in a professional services firm is more than just a strategic decision; it’s a transformative journey towards collective growth and success. ESOPs offer a unique opportunity to align the interests of your employees with those of the company, creating a powerful sense of ownership and shared destiny. This alignment not only enhances engagement and commitment but also drives innovation and performance, as every team member becomes an integral part of the firm’s success story. As you grow and evolve your firm, consider the profound impact that an ESOP can have. It’s not just about sharing financial success; it’s about fostering a culture of unity, motivation, and collective achievement. Embrace this opportunity to not only grow your business but to also enrich the lives of those who contribute to its growth. Let the journey of ESOP be your firm’s stepping stone to new heights of success and fulfillment.

	Corporation	Corporation	LLC	LLC	Corporation/LLC
Incentive Award	Incentive Stock Option (ISO) (early exercisable) (employees only)	Non-qualified Stock Option (NSO) (early exercisable)	Option to purchase common LLC Unit (early exercisable)	Profits Interest	Cash Incentive Program
Mechanism	Employee is granted an option to purchase shares of the Company’s common stock in the future, exercisable immediately but subject to vesting based on continued service to the Company.	Person is granted an option to purchase shares of the Company’s common stock in the future, exercisable immediately but subject to vesting based on continued service to the Company	Person is granted an option to purchase units of the Company’s common equity in the future, exercisable immediately but subject to vesting based on continued service to the Company.	Employee is granted an interest in the Company’s future profits and losses, which may or may not be distributed to employee depending upon operating income and tax distributions. May be subject to vesting.	Program allows for grant of specified number of units, and each participant is granted a number of units, which may or may not be subject to vesting. Payment on units made on change in control only.
Documentation	Stock Option Plan, Notice of Grant, Option Agreement and Exercise Agreement.	Stock Option Plan, Notice of Grant, Option Agreement and Exercise Agreement.	Equity Option Plan, Notice of Grant, Option Agreement, Exercise Agreement, Operating Agreement	Equity Incentive Plan, Profits Interest Agreement, Operating Agreement	Cash Incentive Program and Award Agreement
Exercise Price	> FMV at grant	> FMV at grant	> FMV at grant	N/A	N/A
Individual’s Tax Treatment	Taxed only on sale of shares acquired upon exercise of option. If holding period is met, difference between sale price and exercise price is taxed at long-term capital gain rates. Holding period = 1 year from exercise & 2 years from date of grant *Spread at exercise may be included in taxable income for purposes of determining AMT.	Taxed at exercise at ordinary income rates on difference between exercise price and FMV on exercise date assuming 83(b) election is made. Additional tax upon sale at capital gain rates on difference between FMV on exercise date and sale price.	Taxed at ordinary income rates when units are issued upon exercise on difference between exercise price and FMV on exercise date. Taxed on date of sale at capital gain rates on difference between FMV on exercise date and sale price.	Taxed annually when profits/income is allocated to profits interest holders. Allocation of profits to profits interest holders may occur only if certain thresholds are met.	Taxed only upon payment in connection with a Change in Control. Taxed at ordinary income tax rates when cash is received.
Treatment upon Change in Control	Unexercised awards (or exercised but unvested awards) will accelerate immediately prior to CIC unless otherwise assumed or substituted by acquirer. Holders of vested shares will receive same consideration if, when and as other stockholders are paid.	Unexercised awards (or exercised but unvested awards) will accelerate immediately prior to CIC unless otherwise assumed or substituted by acquirer. Holders of vested shares will receive same consideration if, when and as other stockholders are paid	Unexercised awards (or exercised but unvested awards) will accelerate immediately prior to CIC unless otherwise assumed or substituted by acquirer. Holders of vested units will receive same consideration if, when and as other stockholders are paid	Paid out in accordance with terms of Operating Agreement (generally will convert into right to receive a cash payment at closing, subject to the threshold and any senior equity rights.	Each unit represents the right to receive a cash amount equal to X% of the consideration paid to the Company’s owners in connection with a Change in Control, if, when and as paid to the stockholders. Program is treated as a liability that is paid out before the stockholders receive consideration for their equity.
Treatment upon IPO	Full stockholder rights upon exercise of option. (Vested shares are freely tradeable.)	Full stockholder rights upon exercise of option. (Vested shares are freely tradeable.)	N/A (unlikely that entity would go public as LLC)	N/A (unlikely that entity would go public as LLC)	No payment is made without a change in control.
Treatment as Stockholder/ Member	Full stockholder rights upon exercise of option; provided that unvested equity can’t be transferred.	Full stockholder rights upon exercise of option; provided that unvested equity can’t be transferred.	Full member rights upon exercise of option; provided that unvested equity can’t be transferred. Eligible for tax distributions.	Full member upon grant of profits interest, regardless of vesting (provided that unvested equity can’t be transferred). Eligible for tax distributions.	No
Treatment as Employee	Yes	Yes	Prior to exercise, yes. Following exercise, treated as partner, and the employee-partner will be responsible for paying the employer portion of his/her own employment taxes (FICA, Medicaid, etc.). Any benefits paid for by the company (e.g., medical benefits) cannot be provided on a tax-free basis.	Immediately after grant, treated as partner and the employee-partner will be responsible for paying the employer portion of his/her own employment taxes (FICA, Medicaid, etc.). Any benefits paid for by the company (e.g., medical benefits) cannot be provided on a tax-free basis.	Yes
Tax Reporting	Form 3921 regarding exercise of option must be distributed by company to employee in the year following year of exercise. If option is exercised for unvested shares, Section 83(b) election must be filed by employee with IRS within 30 days of exercise.	If option is exercised for unvested shares, Section 83(b) election must be filed by employee with IRS within 30 days of exercise. Income at exercise reported by company on W-2/1099.	After exercise of option, Form K-1 must be distributed annually to partner detailing partner’s shares of profits and losses for each fiscal year. If option is exercised for unvested Units, protective Section 83(b) election should be filed by employee with IRS within 30 days of exercise.	Form K-1 must be distributed annually to partner detailing partner’s shares of profits and losses for each fiscal year	Form W-2 will report income earned in transaction as compensation.
Effect on Entity Tax Treatment	No effect on entity tax treatment.	No effect on entity tax treatment.	Prior to exercise of first option or sale of equity to another third party, entity is treated as sole proprietorship. Once first option is exercised or equity is sold to a third party, entity is treated as partnership. A new tax ID may be required. Partnership tax returns are then required.	Prior to first grant, entity is treated as sole proprietorship. Following first grant of a profits interest, entity is treated as partnership. A new tax ID may be required. Partnership tax returns are then required.	No effect on entity tax treatment.

November 7, 2023November 7, 2023

IRS Section 174: Amortization of R&D Expenses and Why It Matters to You

Robin Way, Founder and CEO of Corios
November 7, 2023

We are pleased to present a unique feature on our blog today. The following post comes courtesy of a guest contributor, Collective 54 member Robin Way, CEO of Corios, who brings a fresh perspective and expert insight on a recent change to the tax code affecting boutique professional service firms. We are honored to share his knowledge and viewpoints with our readers. Enjoy this unique piece that broadens the horizons of our usual content.

What is this IRS Section 174 thing?

Sure, the title of this article probably made you flip to the next page. Few stories are less sexy than tax regulations and Congressional legislation. But, if you are a professional services firm who invests in research and development of any kind, you should be paying attention.

Greg Alexander, Founder of Collective 54, has shared a lot of perspectives about productizing your services, diversifying your sources of revenue, and creating mechanisms to earn fees that are not dependent on billable hours. If you have done anything with this advice, chances are you have probably made an investment in R&D whether you knew it or not.

Does this apply to you?

If your firm delivers technology, engineering, design, architecture, or IT services, chances are good that you will incur R&D oriented expenses, whether you know it or not. (This little condition will come back around later, wait for it…)

Here is some good news that you have potentially already been taking advantage of, under the federal government’s R&D tax credit program: you can deduct some of these costs from your tax liability as a tax credit.

The US federal government has provided R&D tax credits since 1986, under what is called IRS Section 41 “Credit for increasing research activities”. Corios has benefitted from this program for about 5 years, and it has taken some of the sting out of our federal tax liabilities, depending on how much we spent on qualified R&D.

To meet the standards of a “qualified research and development expense” under IRC Code Section 41, these R&D expenses need to meet all the following criteria:

- The costs for in-house or (domestic) contract labor and supplies.
- Associated with experimental development processes.
- Associated with improving the functionality, quality, reliability, or performance of a business component.
- Where there was some technical uncertainty about the outcome of the research.

What is interesting about the “experimental” and “technical uncertainty” clauses is that, if your staff are performing fixed price work for your clients, and this work contributes to building a technical product that your firm owns, then you can also take credit for the labor costs of performing that work. Note that this only applies to fixed price contracts, since under that approach, your firm holds the risk of performance, and this cannot be a work-for-hire where the client owns the deliverables and/or the intellectual property. Your auditor will read all the contracts to ensure these projects meet those criteria.

So, yes, those R&D tax credits sound rather good! Stay tuned for the bad news…

What is different this time?

I mentioned IRS Section 41 above, which defines expenses subject to the tax credit. There is another section of the federal tax code, called Section 174. This (previously) defines how firms can deduct their R&D expenses in the year in which they were incurred. For comparison’s sake, other countries offer manufacturers and other companies investing in R&D a “super deduction” that is vastly preferable to what we have here in the US. In China for instance, firms can deduct 200% of their R&D expenses in the current year.

A major amendment to IRS Section 174 was introduced 5 years ago as part of the Tax Cuts and Jobs Act (TCJA), passed in 2017. It amended the way that Section 174 expenses were deducted, by making business amortize those expenses over a 5-year period. When this was signed into law, there was a 5-year delay in its implementation, so it only affected business taxes starting after Dec 31, 2021.

Section 174 is entirely different than Section 41 tax credit. From my vantage point, you can think of Section 174 treatment of R&D expenses as a penalty. Section 174 makes your firm amortize your expenses over a 5-year period, rather than allowing you to deduct these costs in the year in which they were incurred as a normal expense. (If that sounds boring, it should not. I will clarify this with a simple example a little later…)

Section 174 qualified R&D expenses include everything under the Section 41 definition, and now they add on the following additional categories of expenses:

- Non-qualifying software development and related expenses
- Non-taxable benefits costs
- Foreign research expenses (note that Section 41 only gives you credit for domestic expenses)
- Depreciation
- Overhead
- General and administrative costs
- Utilities
- Rent
- Securing (but not acquiring) a patent

You might be thinking, “OK, so the R&D expense category is larger now, is that a good thing?” Nope. The 5-year amortization requirement is going to really be the part you end up hating. Let us compare your new R&D deductions rate (20% per year) with China’s (200% per year). Big difference.

Why should you care?

Usually, your firm pays taxes based on your EBITDA. The more income you make, the more taxes you pay. Well, Section 174 is completely different. It is not tied to how much profit you make, but to the costs you incur. The more R&D costs you incur, the larger the penalty will be, because your effective current-year R&D OpEx costs now go DOWN, and hence your implied (but not actual) income goes up, and hence so does your tax liability.

Here’s a (relatively) simple example:

Before Section 174 phased in, assume your firm earns $100 per year in income, less $40 for COGS (mostly, the salaries and benefits of staff who are not in R&D), leaving $60 in gross margin. Now come the operating expenses. As a tech-investing firm, you have $30 in R&D expenses each year and another $20 in all other expenses. This leaves $10 in EBITDA, and if the effective tax rate (note: Corios is based in Portland, Oregon, the home of high taxes) is 40%, then your annual tax liability is $4.

Now let us run the very same simple scenario but add in Section 174. The only difference is that R&D expenses need to be amortized over a 5-year schedule. Hence you can only claim 20% of the year 1 R&D expenses in year 1. Your actual OpEx is unchanged, as is your actual EBITDA. However, your effective R&D expenses in year 1 become only $6 (instead of $30) because you can only deduct a part of the first year, making your “effective” EBITDA $34, and now your tax liability is $13.60–more than triple your “Before Section 174” taxes! (Yeah, “holy crap!” is right.) Note that you do not actually earn any more EBITDA, and there is not more money in your bank account; actually, there is less of it, namely $9.60 less of it, due to the increased tax liability. By the end of year 5, your amortization schedule has caught up and now your effective OpEx and effective taxes are back to normal, but in the meantime, you are getting screwed. Royally.

What to do about it

There is some promising news on the horizon, but it needs your help to push it into reality. You too can act and make a difference.

The Senate has introduced a bipartisan bill called the American Innovation and Jobs Act (AIJA), which will repeal the previously amended Section 174 to go back to the way it was before the TCJA. Democratic Senator Margie Hassan introduced the bill in the Senate in March 2023, with co-sponsorship from Senator Todd Young of Indiana on behalf of the Republicans. Support is broad on both sides of the aisle, but the bill needs to be attached to an omnibus spending bill to get adopted. There is a corresponding bill in the House, called the American Innovation and R&D Competitiveness Act, which enjoys a similar bipartisan support.

Despite this bipartisan desire to get this bill passed, many Democrats want to pair the AIJA with a reinstatement of the Child Tax Credit. This is where progress on the bill has stalled a bit (do not take my word as gospel, I am not an expert on the back-room conversations here, but I am passing along what I have heard from the lobbyists).

Several weeks ago, through Corios’ membership in the Technology Association of Oregon, I was invited by Yelp and their lobbyist, Dentons, to visit Washington DC and tell our story to several US Senators. Specifically, two weeks ago we visited the offices of four US Senators: Senator Todd Young (Indiana), Senator Chris Murphy (Connecticut), Senator Ron Wyden (Oregon), and Senator Mazie Hirono (Hawaii).

My role was to tell the story of the “little guy”, namely, the pull-up-by-your-bootstraps entrepreneur who is struggling to get by and for whom the impacts of this Section 174 provision are a big punch in the jaw (or insert a more colorful metaphor, which works just as well). The goal of the lobbyists is to build momentum for both bills in each house of Congress and to get them attached to the major spending bills. To reach this objective will take a journey, not a one-day meet-and-greet.

So, here is what you can do, and it is simple: write to your Senator and House representatives, telling them your story. Here was my story:

“I’m the founder and CEO of Corios. We are not a large company like Google, Amazon, or Netflix, but we employ Americans and pay them a good wage and strong benefits. I believe in innovation, and I actively invest in our software products so that we can stay as competitive as possible in a very tough industry. So now, given the implications of Section 174, my tax liability has skyrocketed, and the incremental taxes are equal to an entire month’s cash flow. That means I cannot pass along pay raises or bonuses to my team members or hire more members of our team to grow. Meanwhile my offshore competitors are enjoying tax incentives that dramatically outpace our own, and meanwhile I am being penalized for trying to invest in my company and my team. Bear in mind, our R&D investments are really an investment in hiring Americans to build our products and paying their salaries. We are not hiring ChatGPT or something, these are real jobs and good salaries. But now that I have less to pay for everything else, I am faced with the decision of paying offshore developers to do the work that ought to stay onshore in the US. But when offshore developers cost $30 per hour and onshore ones cost $100 per hour, that is a very tough decision to support. I need you to get this amendment to Section 174 repealed. “

You can put this story however you would like, but I encourage you to tell your story, and do it today.

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