It can be tempting to offer shares of your company to finance its growth. However, with a pinch of creativity, using equity as a form of currency dilutes your position and may not be necessary. Rather than thinking of your shares as a currency to distribute lavishly, consider your stock the essential ingredient to growing your business value.
Business owners benefit from issuing equity in lieu of paying higher salaries. Additionally, making employees owners aligns their incentives with the company, and can also be used to retain key employees.
Trudie, the owner of a clothing retailer in southern Berkshire County, gave a key employee, Topher, a 10 percent equity position of her company and did it wrong. Trudie’s main goal was to make sure Topher would not leave the business. Instead, Trudie made it so that Topher now had a retirement plan and could retire by selling his ownership to whomever he wanted, including one of Trudie’s competitors.
Giving away a piece of your equity could cost you when it comes time to sell your business, especially if a minority holder balks at the idea of the sale, blocking the acquirer from controlling 100 percent of the company. Conversely, since the employees’ shares are nearly worthless in price until you sell the company, they may pressure you to sell when you’re not prepared to.
When you give an employee shares, you are creating a minority owner who may have unintended rights and responsibilities. You are incentivizing good outcomes, but you are also giving your employees leverage. For example, Trudie was obliged to show Topher her financials, which emboldened Topher to ask for a raise or he’d sell his shares.
When you take a distribution from your company, you’ll have to make a pro rata distribution to your employee-owners. Your employee may come to expect, even rely upon, these distributions.
When you are the sole owner, profits matter in the long run, but some years you may forgo short-term profitability to make a big investment, hire new employees, or expand your services. This will drive down profits, and with it, your distribution amounts.
You’ll have to convince your people that, by not collecting this year, it could be more beneficial in the long run. And that won’t fly for employees who want the money now, or if the “long run” benefit is to a family member who will still be at the company long after the employee is gone.
Also, was that golf trip in Scottsdale really a business expense? You’ll be held accountable to your new minority partner, whose distribution gets smaller when you’re out gallivanting on the corporate dime.
And what if, after gifting equity, you don’t get the desired result from your employee?
Do it some other way.
If it’s a matter of aligning goals, consider offering a cash bonus tied to your employee’s success. Or, consider using synthetic equity.
Synthetic equity grants an employee the right to receive the value of the equity without receiving actual ownership, and all of its encumbrances. Synthetic equity programs are designed to be more flexible than traditional equity compensation and allow for fewer technical, accounting, tax and securities law concerns while simultaneously rewarding the employees and aligning their goals with those of the company. The most common types of synthetic equity are phantom stock and stock appreciation rights (SARs).
Phantom stock can be redeemed for cash. For example, two years ago, Graham, who owns a cable assembly operation near Worcester, wanted the pros of giving his employee, Meredith, equity, but he didn’t want to be entangled in the cons.
Graham and Meredith agreed on goals and tracked the metrics to determine how much progress was attributable to Meredith. Based on Meredith’s contribution to the firm’s success, she earned a 5 percent stake in the business, based on the valuation of the firm on the date of payment.
Based on their agreement, including some continued goal-oriented conditions, Meredith may redeem those phantom shares in 2025. When redeemed, Meredith will receive a cash payment equal to the value of the company stock at that time. For Meredith, that payment is taxed as ordinary income and is deductible to Graham’s company.
In contrast, when using SAsRs, the value of the award is dependent on the increase in the price of the company stock. For example, if Meredith were awarded a SAR instead of phantom stock, she would not be able to redeem the shares at full value — she’d only be entitled to the appreciation of the stock value. Either version allows the business owner greater control over cash flow than traditional equity does.
Whatever method you choose, there should be clearly defined goals and responsibilities so that your employee’s actions are motivated toward the outcome you intend.
This article originally appeared in The Berkshire Eagle on July 31, 2020.