Equity Compensation for Key Employees

Employers frequently seek to find ways to reward their key employees for valuable and loyal service, while simultaneously aligning the key employee’s interests with those of company ownership.  One of the most popular ways to accomplish these goals is by making the key employees co-owners of the business itself.  The employers hope that by tying a substantial amount of the employee’s current or future compensation to the overall performance of the business, the employee will be encouraged to work hard and maximize value for all business owners.

This concept goes by many different names and can be accomplished in many different forms, including “sweat equity”, stock options, “carried interest”, “profits interests”, phantom stock plans, employee stock ownership plans (ESOP), and non-voting stock grants, among others.  Different types of businesses and different industries may select one form of equity compensation over others for a myriad of reasons.  There is no “one size fits all” approach.

In making the decision to compensate key employees with equity in the business, employers have to think carefully about their goals for the compensation plan, the economic and non-economic costs of the arrangement, the tax implications of the compensation plan on both the employer and the employee, and even the personality of the targeted key employees.  A plan that is poorly fitted to the business objectives and culture of the employer, or that is structured improperly, may actually end up damaging employee morale, driving away key employees, and hurting the business of the employer ¾ exactly the opposite of the results the employer was trying to achieve.

Over the coming weeks, I will be adding articles discussing many of the important aspects of key employee equity compensation schemes.  This is a complex topic, and there are many options and factors to consider.  At Carruthers & Roth, P.A., we have designed and implemented many different types of key employee equity compensation plans, and have been involved in fixing plans that were poorly designed or had unintended results.

First, know your goals. 

Employee equity compensation plans can run into trouble quickly if the structure and benefits are out of line with the goals of the business owners.  In order to design an effective equity compensation plan, owners must first determine exactly what they are trying to accomplish with the plan, and the behaviors they want to encourage in key employees.

Often, the goals of business owners are described in very broad and general terms.  For example, a business owner will tell us “I want to align my key employees’ interest with mine”, or “I want my key employees to think like owners, and not just employees.”  The problem with these broad statements is that they don’t sufficiently target the types of behaviors that employers really want to encourage and reward.

The first question that an employer must ask is whether the behaviors and results it wants to encourage are short-term or long-term in nature.  Generally speaking, in a closely-held business (i.e., one whose stock is not publicly traded), it is difficult to encourage short-term behaviors using equity compensation.  For example, if an employer wants the vice president of sales to boost the sales results over the next quarter or year, granting stock to the employee will generally not be as effective as offering a cash bonus, unless the employee is able to immediately sell the stock for cash ¾ very difficult, if not impossible, in most closely-held companies.   One of the advantages of being a publicly-held company is that the stock of the employer is a liquid asset, and thus can be used to provide short-term rewards to employees.

Once exception to this general rule is the situation in which a closely-held business is nearing a sale.  If the owner knows that the business is about to be sold to a competitor or strategic buyer, then the owner may need to make sure the key employees stay on board to assist with the sale, make sure the business continues to thrive until the closing, and successfully transition the business to the new owners.  In this situation the owner can offer the key employees a share of the sale proceeds as a reward for staying on through the transition.  This can be accomplished in the form of actual equity grants of stock in the company, profits interests in an LLC, or perhaps a contractual phantom stock plan type arrangement.

A few fortunate closely-held businesses may produce significant distributable profits on a regular basis.  These businesses may be able to offer key employee’s equity in order to encourage short-term goals, since the employee’s efforts (for example, to increase sales or hold down costs) will yield fairly immediate rewards in the form of increased profit distributions.

Aside from these fairly rare situations, closely-held businesses will generally be better served by using equity compensation to encourage and reward long-term results, such as loyalty to the company, careful stewardship of the company’s resources, and successful accomplishment of major company goals that will predictably produce cash distributions or other liquidity events.

One of the most effective uses of equity compensation is to encourage employee’s loyalty to the company.  If an employer operates in an industry in which there is strong competition for talented executives or specialized workers, employers will often attempt to tie an important employee to the company by granting him or her ownership in the company or a contractual interest in the profits, but tying the grant to a vesting schedule so that the employee doesn’t receive the full benefit of the grant for several years.  The grant may also be tied to a non-competition covenant preventing the employee from working for the company’s competitors while he/she is still a shareholder or member of the company, and for a period thereafter.

Some industries are particularly suited to equity compensation because, by their very nature, they operate on a long-term reward horizon.  Employees in these sectors appreciate that value takes a long time to build, and appreciate being allowed the opportunity to participate in the significant wealth creation that accrues over time.  Real estate development is a particularly good example.  Equity compensation in the real estate industry is very common, for several reasons:

1. Traditionally, owners of real estate projects have been able to extract  significant cash from the projects by refinancing debt, often on a predictable time line (although the recent constriction of the lending market has upset this traditional model);

2. Successful real estate projects lead to fairly regular cash distributions to ownership, thus providing immediate rewards to key employees for successful management; and

3. Because real estate is generally held by LLCs or limited partnerships, equity compensation can be subject to significant tax advantages in the form of “carried interests” or “profits interests”.  I’ll explore this type of equity compensation in more detail in a later post.

Of course, once an employer decides exactly what it wants to reward, it has to determine exactly what kind of equity compensation will provide sufficient incentives for the desired behavior.  More on this later.

 




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