By David M. Wang, Esq.
Collective Insights on business ownership has David Wang posing the question to business owners, “Should I Give Employees Equity in the Business?” with added food for thought from our in-house attorney consultant.
Many business owners need to find ways to recruit and retain employees. The cost of training employees is high, and finding a great employee can be difficult and time-consuming. The reoccurring idea to solve this problem is handing out equity. In other words, giving them a participation in the upside as a way of recruiting and incentivizing employees to stay. However, giving employees a piece of the upside is the most complex way to give employees equity. There are many things to consider when making a determination to go this route.
Giving equity is a taxable transaction. You are giving an employee an asset of value.
It may not be cash, but the tax code treats it as income. Outright giving the equity to an employee means that the company will need to do a valuation to determine the value of that equity. That valuation has a cost. The employee will report that equity as income and have tax liability for the value of that equity. The employee will not see getting the equity as a positive experience unless you pay for that tax liability.
Many business owners ask about granting options.
Their friends that work for Texas Instruments and Frito Lay get stock options. Stock options work for a publicly traded company because the employee can sell the stock to convert their stock compensation to cash. This cash can go toward the purchase of a car and pay the taxes associated with getting the stock. The equity of privately held companies does not have a market, and you do not want employees selling your equity to just anyone that will buy it. This means that equity in a privately held company cannot be converted into cash. In fact, the equity in most privately held companies does not produce any cash until there is a sale of the company, which in many cases is a long time or never.
The most complex part of giving equity is how you get it back when the employee takes another job, is fired or laid off.
Most businesses do not want employees to be able to keep the equity after they stop working for the company. The concept is that the employee needs to be employed when the equity becomes cash. This means that you will need to have buy-sell terms that deal with the employee quitting, getting fired for cause, getting laid off, getting divorced, dying and becoming disabled. These terms will need to include what triggers the buy-sell terms (i.e. what is “cause” and what is “disabled”), how to determine the purchase price, payment terms of the purchase price, and other important terms. Then, the governing documents (i.e. company agreement for a limited liability company) need to take into account voting rights of the employee, manage participation, tax treatment and other complex issues.
As you can see, giving an employee equity is complex and must be documented with solid agreements. You cannot go with an “understanding.” Employees will remember the “understanding” the way they need to remember it. Getting all of this squared away could mean a few thousand dollars in legal fees and other professional fees, including valuations.
One way to look at equity is that the only people that should be equity holders should be people that are your true business partners.
True business partners, in this sense, means that they are people that can and will borrow from their 401K to make payroll. They are people who will not “go get a job” when the going gets tough. The investment that is required to take on and deal with a partner is significant and that person should be worth that investment.
So when asking, “Should I give employees equity in the business?” the decision should include a conversation with your attorney and CPA for why, how and which ones. You can also consider giving employees participation in the upside through bonuses and profit sharing plans. These alternatives are usually easier to structure, give you more control, and can require less in professional fees. These alternatives can be explored in future articles.
David M. Wang is a partner of Grable Martin Fulton, PLLC. He is a business attorney with over 21 years of experience. He can be reached at (214) 334-4755, or firstname.lastname@example.org.