Granting employees equity can be a great way to reward and motivate employees. Most employees will work harder once they have some skin in the game. However, granting equity can be complicated and it’s easy to make mistakes. Before granting equity to your employees, ask yourself these important questions:
- Is equity really the right choice?
Make sure you have a clear understanding of what you want to achieve. Are you aiming for retention, compensation, empowerment or other goals? There are multiple ways to grant traditional equity, and there are alternatives to traditional equity, such as cash bonuses, profits interests and stock appreciation rights. An alternative to traditional equity may achieve your business objectives while avoiding the inherent complications of making an employee your business partner. If you’re only thinking about one kind of “equity,” you may be limiting yourself and may not achieve your goals. - Are you making it too complicated?
Once an equity program is created, someone must be tasked with administering it. And you have to pay for that administration. If you’re considering a complicated structure or would regularly make exceptions to the rules of your program, step back and think about what you’re really trying to achieve. There may be a simpler way to get there. - What if things don’t work out?
Having a disgruntled former employee as a shareholder can be a nightmare. You need the ability to repurchase your equity from departing employees, but check with an attorney to make sure the repurchase mechanism works as expected, and that it is enforceable. Buy-outs under these circumstances can be contentious and you want to make sure you’ve followed appropriate procedures. - Have you considered all of the tax consequences?
f you grant equity that has value, or grant a stock option with a strike price below fair market value, you’ve just saddled your employee with a current tax obligation-even though the employee does not get paid any cash. The tax code is full of complexities dealing with equity compensation that can lead to adverse tax consequences for the company too (e.g., forfeiting S-corp status, withholding obligations, running afoul of ERISA rules, losing the ability to properly claim certain tax deductions, etc.). Make sure your program provides the expected benefit and not an unexpected tax bill. - Have you complied with securities laws?
Many people are unaware that granting equity to an employee is a securities transaction governed by federal and state laws. If the total annual value of compensatory equity granted to employees exceeds $5,000,000, you will need to provide specific disclosures to recipients. Additionally, many states have filing requirements for equity grants of any value or size, and some states have specific disclosure requirements or require the payment of a fee. Check with a securities attorney to identify compliance requirements. - Are you unintentionally giving employees rights you don’t want them to have?
Ownership of traditional equity makes employees shareholders. Equity owners in Minnesota companies generally have the right to review the company’s sensitive information, including board and shareholder minutes, financial statements, and shareholder lists. They may also get voting rights on matters important to the company, like amending articles, merging or liquidating the company. Be sure you have a clear understanding of these rights before the grant occurs. - Does granting equity provide lifetime employment?
If your company is closely held (generally 35 or fewer owners), an employee who owns equity may assert that she is no longer an at-will employee because the ownership of equity gave her a reasonable expectation of continued employment. While you can contract around this problem, you have to do so proactively and thoughtfully. - Have you protected yourself from having unwanted co-owners?
While you may be willing to allow an employee to be a co-owner of your company, you need to avoid unwittingly allowing an employee’s spouse, children, your competitor or an unknown third party to become a co-owner. You should have strong restrictions on the transfer of equity in the form of a restricted stock agreement, buy-sell agreement, member control agreement or shareholder agreement. If you don’t, your employee may be able to transfer the equity to a person you don’t want to have as a co-owner. - Have you contacted an accountant?
Granting equity will impact your company’s financial statements. You need to work with an accountant experienced in equity grants to fully understand that financial impact. - Have you contacted an experienced business attorney?
Equity is complicated. Do it right at the beginning and avoid problems later. An experienced attorney can assist you in designing an equity program that achieves your business goals, avoids tax surprises, complies with securities laws and reduces the risk of future disputes with your employees.
When done right, granting equity can be a great way to motivate and retain employees. When done wrong, it can be a massive headache for your company and create legal, accounting and tax problems.