Editor’s note: Linda Markus Daniels is a founder of and principal in the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.

Perhaps we need a new show on the TLC network…following in the footsteps of Stacy and Clinton. Rather than remaking the entrepreneur’s wardrobe, however, we would remake his communications on certain issues. We could look at how others perceive what is being said, and revise it to be more effective…not to mention substantially reducing business problems resulting from using the wrong words or concepts. The first and foremost language makeover would be to never use the words “stock” and “give” or the words “stock” and “percentage,” or heaven forbid the words “stock,” “give” and “percentage,” in the same sentence…and preferably not in the same paragraph.

Never Use the Words “Stock” and “Give” in the Same Sentence.

It happens every day. An executive of a Company is trying to recruit a talented new employee and says to him: “If you join us we will give you stock in the Company.” The person being recruited agrees to become an employee, and shortly after beginning work he asks for the stock certificate for the promised stock. At this point several problems usually become painfully apparent.

First, the person making the promise may or may not actually mean that the stock will be a “gift,” i.e., the stock will be “given” to the employee without any payment on the part of the employee. Normally the employer expects the employee to pay something for the stock, and what was really intended by the offer was that the Company would make shares available for purchase. Nevertheless, the employee may expect to pay nothing based on the commitment made as part of the job offer. To the extent, however, that the employee pays any amount for the stock that is less than fair market value, the difference between fair market value and what is paid is taxable compensation-related (W-2) income. This means not only that the employee will need to pay income taxes on the stock received even though there may be no cash paid to cover the taxes, but also that the Company will be expected to pay over to the government the withholding related to this compensation income even though there was no cash paid from which to withhold. Thus, the employee will have to provide the cash for the withholding to the Company. Further, the Company will be responsible for the employer taxes that must be paid on the value of the “gift,” just as it must pay with any cash compensation income

Second, the employer often does not intend for the stock to be provided to the employee immediately and unconditionally upon commencement of employment. In fact, often the intended offer may really be for stock options, options which would allow the employee to buy stock in the future if things work out. Options may also allow the price of the stock to be locked in at its current valuation.

Alternatively, the employer may have intended the offer to be contingent on the employee remaining with the company a certain number of years or meeting certain goals. While stating this specifically would certainly helps prevent a portion of the problem, it also exacerbates the compensation income issue since the stock will (hopefully) have a much higher value when the time comes to issue it than at the time it is offered…and the taxes discussed above will be measured from the time of issuance of the shares. Thus, the value on which the income and employer-related taxes must be paid will be substantially higher.

Finally, if the employer is going to provide the shares upon initial employment then the employer is also likely to want the right to get the shares back if the employee does not remain with the Company or otherwise meet certain goals. The Company normally will want other “strings” attached to the shares as well, such as might relate to the transfer of the shares, the voting of the shares, or the lock-up of the shares upon a public offerings. The employee, however, may balk at these restrictions…especially on the restrictions that would oblige the employee to sell the shares back to the Company.

Never Use the Words “Stock” and “Percentage” in the Same Sentence.

In that same employment offer, or perhaps in an offer to an early investor, the entrepreneur may suggest that the shares to be transferred will be equal to a certain percentage of the Company, e.g., 10%. In this case the entrepreneur usually intends that the person will have 10% of what has been issued. So, for example, if there are 900 shares issued the entrepreneur assumes that the employee would get 90 shares. Ninety shares, however, is only 9% after issuance, since at that point there would be a total of 990 shares outstanding. In order to have 10% after issuance the employee would need to receive 100 shares (100 shares/900 shares+ 100 more shares issued = 10%). Thus, determination of the date on which the percentage is calculated (known as pre-issuance or post-issuance) becomes important.

In this same regard, there are two other extremely common issues that arise from the offer of a percentage. The first is a confusion between issued or outstanding shares and authorized shares. The terms issued and outstanding mean the same thing, which is the total number of shares owned by all shareholders. The term authorized means the total number of shares the Company is permitted to sell under its Articles of Incorporation. There may be 900 shares issued and 1,000,000 authorized. Any percentage would need to be related to the issued shares, but it is not uncommon for there to be an expectation that the percentage be of the authorized shares. If the person were to receive a percent of the authorized shares, that percentage would clearly result in ownership of massively more than the indicated percentage. For example, 10% of 1,000,000 authorized shares is 100,000 shares. If this were added to the 900 shares outstanding in the above example, the shareholder would own 99.1% of the shares (100,000/100,000 = 900 = 99.1%). The total authorized shares is actually an irrelevant figure when calculating percentages of ownership.

The second issue of confusion is intertwined with the above concept and relates to the promise of a percentage itself. Many unsophisticated employees, consultants and even investors think that when the percentage figure is offered this means that the person receiving the shares will own the stated percentage forever. While extremely complex measures could be taken to create such a scenario, it is very rare that this is what was actually is intended. All shareholders should expect new shareholders to be added, and as additional shares are issued to those new or even to current shareholders the percentage owned by other shareholders will decrease.

Never Use the Words “Stock,” “Give” and “Percentage” in the Same Sentence.

Thinking through the above, then, what happens when the employer offers to give the potential employee 5% of the stock in 3 years? First, the Company will need to determine from what date the 5% is measured, i.e., the date of the commitment (which is probably what was intended) or the date the stock is to be issued, and whether the percentage is pre or post issuance. Then, of course, there is a question of whether the employee is entitled to anything if he works less than 3 years. Next, the tax consequences are superimposed on this, with the increasing tax burden as the fair market value of the stock (presumably) increases over the three year period. Finally, it may be difficult to impose normal restrictions on the shares, which can be problematic when professional investors look at the Company.

What to Say Instead

Assuming that you do intend to provide stock rather than options to the employee, consultant or investor, the offer needs to be made for a fixed number of shares at a fixed price…and if there are any strings attached then a mention of those need to be made as well. For example, the offer might be for “1000 shares at $0.10 per share, subject to rights of first refusal and other terms that will be in a restricted stock agreement.” It is possible that you can advise the person to whom the offer is made that 1000 shares is currently equal to x% of the Company…but only if two things are made very clear: (i) that it the x% is, indeed, the current percentage and this percentage will change as more shares are issued; and (ii) the basis for the calculation of the percentage, i.e., is it based on all the shares then-issued, or is the calculation made on a “fully-diluted basis,” which means all the shares then-issued plus all the shares that would be then-issued if anything such as options or convertible debt were changed into shares at that time. Overall, it is always better to simply state a number of shares and provide any other factual information the potential shareholder asks, allowing the potential shareholder to make his own calculations on whatever basis he wishes. Running spreadsheets of what percentages might look like under different scenarios can be equally confusing and misleading…and will almost never create the scenario that actually happens.

Simply put, do not say the words stock and give, the words stock and percentage, or even worse the words stock, give and percentage, in the same sentence.

Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Linda Markus Daniels concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, technology and international matters. Comments or questions can be sent to ldaniels@d2vlaw.com.