Dear Littler: We need to hire some key personnel for our new tech company. We intend to offer them equity in the enterprise as compensation. The equity should be very valuable in the long run, and the deal we have in mind is reasonable for our industry. But we figured we should double-check with a lawyer first: this plan is legal, right?

                                                                                    —Palo Alto Pioneer

Dear Palo Alto Pioneer,

Your question highlights a common dilemma, particularly in California’s tech industry: how to recruit and compensate critical talent as the business emerges? While you would rather focus your effort and passion on product innovation than on comparatively mundane personnel issues, failure to comply with state and federal wage and hour laws can halt the growth of a new business before it gets off the ground.

Many starts-ups—particularly those that are initially cash-poor—consider offering new hires equity in the business, either in lieu of or in addition to wages. While this approach would seem to solve the recruiting problem, it can lead to legal trouble. In fact, payment of employees¹ through stock or stock options can violate both federal and California wage and hour laws.² Although you may have hoped for a quick thumbs-up, the issue is fairly complex.

The Basics on Minimum Wage and Overtime Requirements

Under the federal Fair Labor Standards Act (FLSA), nonexempt employers must earn a minimum wage of at least $7.25 per hour. Many states have enacted a rate that exceeds this floor, including California. As of January 1, 2018, the minimum wage in California is $10.50 per hour for employers with 25 or fewer employees and $11.00 per hour for employers with 26 or more employees.³ Moreover, numerous municipalities within California have raised the minimum wage even higher for employees working within their boundaries. The hourly wage in Palo Alto, for example, is now $13.50 per hour.⁴

Nonexempt employees are also entitled to overtime under federal and California law. The FLSA requires employers to pay time-and-a-half for hours worked in excess of 40 per workweek.⁵ California law is more stringent and obligates employers to pay overtime both for hours worked beyond 40 per week and for hours worked over 8 in a single day. California employees working more than 12 hours in a single day are paid double their regular rate.⁶ As discussed in more detail below, exempt employees in California also must receive a minimum annual salary.⁷

But What Counts as “Wages” for Wage Payment Purposes?

With those principles in mind, can equity comp serve as “wages?” The FLSA, for its part, does not contemplate equity as “wages” for minimum wage purposes. According to the statute and its regulations, minimum wage and overtime pay must be disbursed: (1) in cash; (2) with a negotiable instrument (i.e., a check); or (3) in room, board or similar “facilities” provided by the employer. The term “facilities” excludes, however, “[s]hares of capital stock in an employer company, representing only a contingent proprietary right to participate in profits and losses.”⁸ Thus, under federal law, wages must be paid free and clear to the employee, without considering the value of any equity compensation.⁹

The law in California seems more unsettled about whether various forms of equity are considered “wages.” The labor code defines “wages” very broadly, and California courts have held that incentive compensation—including bonuses, profit-sharing plans, and already-earned restricted stock—qualify as “wages” for some purposes.¹⁰ That being said, federal courts in California have held that stock options are not wages because “[t]hey are not money at all . . . [but] are contractual rights to buy shares.”¹¹

But even if a particular form of equity compensation qualifies as “wages,” there are additional possible problems. Most states, including California, require payment of salary and/or minimum and overtime wages at regular intervals: weekly, semi-monthly, or monthly.¹² Incentive compensation would not conform to these wage payment laws. And, of course, employees receiving equity as part of their compensation may not earn amounts that meet the pertinent minimum salary, minimum wage and/or overtime requirements, depending on the value of the equity (assuming it counts as “wages”), the amount of cash wages received on payday, and the actual number of hours worked.

In short, relying on equity compensation to satisfy salary and/or minimum wage and overtime laws is a delicate proposition. As a result, employees (including founders) who receive significant incentive compensation may or may not earn hourly wages or salaries that meet minimum wage and overtime requirements.

Possible Exemptions under the FLSA and California Law

Given these complications, and the typically professional nature of their staff, tech employers frequently anticipate that their employees are exempt from minimum wage and/or overtime restrictions. Federal and state laws provide several exemptions for white-collar and computer employees.¹³ Unfortunately, Palo Alto Pioneer, these exemptions are not the easy fix they may seem to be.

The white-collar exemptions apply to executive, administrative, and professional employees who meet two criteria. First, their responsibilities must involve various types of exempt duties, such as managing a department or performing work that requires specialized knowledge. Second, employees must earn a specified minimum salary, a requirement known as the “salary-basis test.”¹⁴ Even if your employees perform exempt work, they may not qualify as exempt if they cannot pass the applicable salary-basis test.

For entrepreneurs, the question becomes whether equity compensation, in whole or in part, can satisfy the salary-basis exemption test. California follows the FLSA’s interpretation of “salary basis.”¹⁵ And under the FLSA, employees are paid on a “salary basis” if they “regularly receive[] each pay period on a weekly, or less frequent basis, a predetermined amount” of compensation that is “not subject to reduction because of variations in the quality or quantity of work performed.”¹⁶ Compensation issued as shares or options presumably would not satisfy the salary-basis test because it fails to meet this standard. Regardless of value, equity incentives are not structured in a way that can constitute “salary” by this definition.¹⁷ Accordingly, employers should use traditional compensation to determine if their employees may be exempt from minimum wage and overtime laws, and should not depend on equity compensation in order to meet salary-basis exemption requirements. 

There are a few additional exemptions worth noting, which might offer you more limited assistance. Under the FLSA, a special executive exemption applies to employees who own at least a 20% equity interest in the enterprise.¹⁸ This exemption includes business owners who are actively engaged in the management¹⁹ of the employing entity. Although there is no salary basis for this exemption, it may not be of much help to founders given the significant ownership transfer that would be required to render employees exempt.²⁰ Notably, this exemption is not available in California.

Beyond the white-collar exemptions, a narrowly tailored exemption exists for computer professionals under both federal and California law.²¹ The two tests are detailed and fact-specific. But, generally speaking, the exemptions apply to systems analysts, programmers, software engineers, and other skilled computer professionals who perform certain sorts of tasks. While these exemptions include a compensation requirement, it can be met through payment on a fee or hourly basis. Qualifying computer professionals who may not pass the salary-basis test thus may be exempt based on their hourly earnings. The federal threshold is $27.63 per hour, while the California requirement is $43.58 per hour as of January 1, 2018. Equity compensation would not count towards these hourly wages, but certain employers might be able to satisfy the computer professional exemptions for eligible employees, even where the white-collar exemptions fail.²²

Takeaways

While equity incentives will likely always play a role in tech recruiting, employers in your shoes that offer equity incentives to recruit talent should be careful about how they design their compensation packages. Namely, employers should consider:

• exercising caution in classifying new hires as exempt, particularly if equity is a substantial component of their compensation;
• how to comply with minimum wage and overtime requirements—which require traditional compensation—if onboarding employees are not exempt; and
• consulting with employment counsel well-versed in designing employee compensation packages in order to avoid potentially costly wage and hour mistakes.

Employers operating outside of California should also be aware that wage and hour laws vary widely by jurisdiction. Employers should not lose sight of state laws and local ordinances that might affect their operations.