The saying goes that “Cash is King.” However, entrepreneurs often quickly learn (sometimes in painful ways) that it is Cash Flow that is really King. Run a quick Google search for “accounts receivable” financing or factoring to get a sense of how important that market is for businesses. Working for a telecommunications manufacturer, I can remember struggling with how to finance purchases and employee wages to deliver that next big order. The lesson you learn is that it doesn’t matter how much money is coming in the future if you don’t have enough money now to get there. From a wage and hour perspective, this issue often comes up when businesses need to hire employees but do not (yet) have the cash flow to pay them. So, sometimes we are asked: to conserve cash, can we pay employees in equity? In other words, allow the employees to work their way into a minority ownership stake—rather than paying them the full minimum wage and overtime pay? In most situations, the answer will be “no.”
FLSA Requirements for “Business Owners”
The Fair Labor Standards Act outlines an exemption from the law’s minimum wage and overtime requirements for executives who are also “[b]usiness owner[s].” 29 C.F.R. § 541.100 outlines what an “employee employed in a bona fide executive capacity” must do (the “duties” test) to meet the executive exemption. According to Section 541.101, an executive employee who is a “business owner” must own at least a bona fide 20% equity interest in the business. That’s the first requirement. Want to pay your employees in equity? It does not matter how much cash value a share of the business has or could have, federal regulations require that the equity stake be at least 20%.
Second, the regulation requires the employee to be “actively engaged” in the business’s “management” (though the regulation does not require this to be his or her “primary duty” as with non-equity holding executives). The term “management” is defined in § 541.102. As you will notice, the duties all involve general management functions, such as interviewing, selecting, and training employees; setting and adjusting their rates of pay and hours of work; directing their work; preparing budgets; handling purchasing; addressing employee complaints and grievances; and disciplining employees. Unlike some state laws, federal law does not include any minimum percentage of time that the employee must perform these duties, just the requirement that the employee must “actively” perform at least some of them. So remember, an employee with a 20% stake in your business is not automatically exempted from the FLSA’s minimum wage and overtime requirements. They have to perform “management” duties, too.
State Laws Make It Harder
The “business owner” definition in the FLSA is new. The Bush administration introduced it as part of its 2004 amendments to the FLSA’s regulations. As we have mentioned in the past, not all states elected to adopt the FLSA’s 2004 amendments. Illinois, for instance, adopted regulations that specifically define “Executive Employee” to mean “an employee as defined by 29 CFR 541 (March 30, 2003),” i.e., the definition that pre-dates the 2004 amendments. New York has excluded minority owners from its definition of “executive” as well, as has California.
Paying your employees in equity rather than in wages seems like a creative way to solve a common problem. However, it is a decision fraught with potential wage and hour liability if not done carefully and correctly.