Mastly White Paper

The Case for Performance-Based Equity

BACKGROUND: Global New Company Formation Tops 100 Million Firms Per Year

Consider this staggering statistic on entrepreneurship: every year, approximately one out of every 70 people in the entire world starts a company. Yet, employee stock ownership lags terribly. For example, according to Loren Rodgers, executive director of the National Center for Employee Ownership, only about nine million US employees (not owners, but employees) own or have option rights to own stock.

As we will see later, there are numerous reasons, including cost, why employers haven’t democratized stock ownership. Mastly, a cloud-based platform which enables performance-based equity to be easily and immediately granted to employees, could change all that. To see how large the market opportunity is, consider the following:

The best estimate of the number of new companies formed each year comes from the Global Entrepreneurship Monitor’s 2011 annual report. The countries they surveyed included about 63% of the world’s then 6.3 billion-person population. In these countries, 300 million people were trying to start 150 million new firms. An additional 57 million people were owner-managers of 37 million established firms. Extrapolating, this means that about 100 million new firms are started worldwide each year. Interestingly, almost as many fail each year. Therefore, the global annual “churn” in companies is itself close to 100 million.

SECTION 1: The Problems with Conventional Equity: NQOs, ISOs and Restricted Stock Grants

Even if all employers wanted to grant their employees stock, there are seven key reasons why the majority could not.

1. Most Employees Don’t Understand Conventional Equity Plans
Incentive stock options, non-qualified (or non-statutory) options, restricted stock grants, phantom stock stock appreciation rights, and even ESOPs (Employee Stock Ownership Plans) all require a good amount of financial and tax expertise to understand correctly. The best proof is that, during the 2000-2001 dot-com crash, many otherwise brilliant Silicon Valley employees found themselves owing hundreds of thousands or even millions of dollars in taxes on exercised options that had become worthless. If even Silicon Valley wunderkinds can make this kind of mistake, or if they need to hire lawyers and accountants not to make it, then how can one possibly expect ordinary business owners and their employees to understand the complexities of conventional equity?

To address this, complexity must be turned into simplicity.

2. “File & Forget” Doesn’t Incentivize or Motivate Teams
Even if conventional equity grants were simple, they fail to motivate. That’s because the grants are codified in documents signed by the employee, who then promptly forgets about the document. This is why so many employees don’t even know how much equity they have, vested or unvested, whether in options or in actual stock. The static nature of these documents means that the incentives fail, often becoming “out of sight, out of mind.”

To address this, static, obscured equity must be made dynamic and transparent.

3. Potential for Large Tax Liabilities
Options are complicated, because ordinary income tax (in the US) is due on the difference between the acquisition price and the exercise price, while capital gains tax is due on the difference between the exercise price of the option (unless there was an 83(b) election) and the disposition price of the stock itself (unless held for less than one year, in which case the preferential capital gains rate does not apply). If, as noted before, the stock tanks after exercise, the employee ends up with a massive tax bill for no profit, enough potentially to bankrupt him or her.

To address this, equity grants must have only upside, not a financially bankrupting downside. Further, the tax calculations themselves need to be made much simpler.

4. High Legal and Plan Administration Fees
Corporate attorneys can charge tens of thousands of dollars simply to set up an equity plan. Then, each year, the costs of administering that plan, including accounting and other fees, can be quite large. At the same time, employees often cannot understand the ramifications of their own equity plan, forcing them to spend large sums on personal attorneys and accountants.

To address this, one-size-fits-all preapproved legal documents, updatable as regulations and laws change, can be made part of a platform that enables dynamic, performance-based equity grants. The initial cost becomes close to zero for the company and zero for the employee, while yearly administrative costs are also vanishingly small, if not nonexistent.

5. Difficulties Incentivizing Contractors, Outsourced Providers and Advisors
In an ideal world, contractors, consultants and the like could easily be offered the same stock incentives as employees. Practically, however, this is both more costly and more difficult to do. A contractor who has a short two-week job isn’t worth the effort of having numerous documents prepared and executed, for example. Further, while employees may receive ISOs, contractors are ineligible for them and can receive only NQOs or restricted stock.

To address this, a performance-based equity distribution platform is needed that would automate and systematize the documentation needed, so anyone—employee or contractor—could be onboarded and incentivized immediately.

6. Most Small Businesses Don’t Use Equity Grants At All
Today’s stock plans are mostly the province of large companies or well-funded technology startups. There is no democratization. The great majority of small businesses have no practical way to incentivize their employees through equity, so the owners end up being the sole shareholders. This often creates an “us vs. them” mentality that harms business cohesion, creating different incentives for ownership and employees.

To address this, one needs an online platform which makes giving employees stock easy, low-cost and fast not just for technology startups, but also for any small business: a boutique retail store; a construction company; book, music, art or festival producers; restaurants; crowdfunded projects; and more.

7. Businesses don’t realize they can preserve and/or reallocate working capital.
With performance-based equity, not only salaries but also fees to outsourced providers can be reduced in return for the recipient’s ability to profit from the company’s success. This can extend their runway considerably.

As we will see, Mastly is the only platform that solves all seven of these problems.

SECTION 2: How Performance-Based Equity Works

First, let’s look at how Performance-Based Equity (PBE) is earned and distributed.

1. PBE can be task-based (complete a given task, receive a certain number or percentage of Restricted Stock Units or RSUs) or time-based (work for a certain amount of time, receive a certain number of percentage of RSUs). Let’s look at an example.

In a time pool, each participant’s share is calculated by dividing [their number of hours (or days, weeks, months, etc.) x their hourly equity rate] by [the sum of each person’s hours x that person’s hourly equity rate].  For example, if Ben works 500 hours at $20 equity per hour and Anna works 500 hours at $40 per hour then Ben currently owns 500x$20/(500x$20 + 500x$40). This is 10,000/30,000, which is 33% of the equity pool.  If the company has 1,000,000 shares total in all classes of equity, and if the pool contains 100,000 shares, then if a liquidity event occurred today, John would receive 33,333 shares.

In a task pool, each task is associated with a given number of points. Thus, neither hours worked nor rates apply.  This approach is especially useful when there are large numbers of very specific tasks which crowds of people could perform. Imagine 1,000 customers writing a blog post about your company; or 100 users compensated with equity when a friend they refer purchases a recommended service.

Measured by Time

hours equity per hour total pool split
Ben(PR) 500 $20 $10000 33%
Anna(Dev) 500 $40 $20000 67%
$30000 100%

 

Measured by Task

post blog (5pts) complete sale (10 pts) total pool split
Jesse 30 10 250 33%
Sam 0 50 500 67%
750 100%

2. given company can have both task-based and time-based equity compensation. There is no need to limit it to one or the other.
Second, let’s look at how PBE is conveyed.

  1. Mechanism
    Performance-based equity (PBE) is conveyed through RSUs. RSUs are different from restricted stock itself because, unlike restricted stock, RSUs (i) have no voting or dividend rights; and (ii) are promises of stock (which may vest) rather than grants of stock (which may vest). Additionally, RSUs can sometimes be redeemed for cash, much like phantom stock or stock appreciation.
  2. Taxation.
    RSUs are taxed as ordinary income when they vest or reach a “landmark event,” which in the case of Mastly’s clients is almost always a change of control.

SECTION 3: How Mastly Works To Make Performance-Based Equity Possible

Imagine if any new or existing company across the globe could instantly empower its employees, contractors and stakeholders by implementing PBE in days, without legal expenses, without hassles and with complete transparency.

That’s what Mastly has the power to do for tens of millions of businesses each year. That’s what’s new. Fortune 1000 companies have been doing this for years, but by using phantom stock. Mastly democratizes PBE by making it available to practically any business in the world.

Mastly is a cloud-based platform, so once data is loaded into it, it is available to everyone using the platform, subject only to administrative access controls. The basic steps are:

  1. The company’s founders allocate to the PBE pool a certain percentage of company equity. RSUs are the default form, although if a superior form of equity is available in a jurisdiction, Mastly can also support that (as well as standard equity). This PBE pool is for team members only, not for private investors or the public (unless the public means crowdfunding participants).
  2. Using Mastly, team members electronically sign legal documents approved by Mastly. No new legal documents need to be drafted. When these documents need to be updated or upgrades, Mastly does it automatically, including sending any required notifications to PBE recipients.
  3. Team members log time and/or tasks completed by using the Mastly platform. They can view their “dynamic equity” at any time simply by using Mastly’s dashboard. The pool fluctuates in near real time, displaying each team member’s then-current percentage of the equity pool. Simple pie charts and graphs facilitate this understanding.
  4. Mastly freezes this dynamic equity pool when a predetermined landmark event, such as an acquisition, IPO, or any change in control) occurs. Then, Mastly distributes the equity to each team member per the exact allocations in that frozen pool.

But: Is it legal? Yes, unequivocally so. In fact, Mastly’s system is based on the deferred compensation rules set forth in ERISA, the Employee Retirement Income Security Act of 1974, passed by Congress and signed into law by the President. From a technical perspective, Mastly uses a deferred compensation bonus which is dispersed when a change of control or other landmark event (IPO) occurs, provided that cash is available.  ERISA is generally compatible with approximately sixty other countries, and we continue to add more all the time.

The key is this: Since the value of each team member’s equity is continually changing and has a substantial risk of forfeiture over time, it is not taxable until a ERISA-specific landmark event occurs.  Thus, participants will only pay taxes if their pool is paid out. They will never be at risk of paying taxes for money they never see, as happened during the end of the dot-com era.

SECTION 4: Mastly Use Cases from Beta Tests

Mastly is not an idea. It is working and has, for the last three years, been subjected to rigorous beta tests, including these:

  1. Wonder, a small company buffeted by small but ever-growing numbers of expenses that were consuming working capital.
    • Wonder saved cash, enabling them to stay afloat, while their employees rallied around a shared end financial goal.
    • Mastly allows entrepreneurs to get business going quickly and reward team members with a radically new system.– Heather O’Brien, Co-Founder
  2. An established company having difficulty keeping its team motivated.
    • Mastly’s PBE enabled the team to focus on the company’s long-term success, because each of them benefitted.
  3. Friends and Guests, a more flexible alternative to AirBnB and Couchsurfing, needed to use highly skilled contractors, but the company couldn’t afford to pay them.
    • CEO Justin Gordon saw the opportunity but realized it required the services of expensive global experts. He launched his product fully-featured and ahead of schedule by adopting Mastly, through which he has paid out to over 20 contractors about $500,000 for hours worked, while also rewarding them with a large portion of the company for the cash they chose to forgo in lieu of equity.
  4. Couchsurfing was a passion project for linking together independent travelers, but monetization was not the company’s top priority.
    • The Couchsurfing team remained dedicated to the project even though they weren’t able to be paid until the company had gained mainstream traction.
    • Wish we had Mastly years ago to solve the heartache of not being able to fairly reward our hardworking, deserving team members. – Casey Fenton, Founder

Conclusion
The opportunity for Mastly, therefore, is to democratize across the globe the distribution of equity not just to owners and founders, but to team members, contractors, advisors and more.

Because of Mastly’s application of ERISA’s preexisting rules, equity recipients only pay taxes on stock or cash actually received when a landmark event occurs.

By overcoming the seven serious problems associated with conventional equity, Mastly becomes attractive to at least several million new businesses out of the total available market (TAM) of approximately one hundred million business formations per year.