There are several ways to reward your top employees: promotions, raises, better benefits.
But for your truly top employees there’s another option to consider – equity in the company.
It’s a lot to consider – you’ll be sharing ownership of your company. But there also are a lot of upsides – you’ll be rewarding your best employees. They’ll be personally sharing in your company’s success. And it’s also a great way to start a possible succession plan.
An Employee Stock Ownership Plan – or ESOP – can be complicated and costly to administer but may be viable under the right set of circumstances.
There are tax and other considerations with granting equity to employees. Unless they are an original partner, giving an employee stock outright has two problems:
- The employees and the company could both have immediate tax implications, as the stock grant could be treated like immediate compensation; and
- If an employee were to quit, you don't want them to walk away with the equity.
- Has the right to purchase equity at today's fair market value; and
- The options include a vesting schedule with the employee’s purchase rights being earned over time (e.g., over five years, with 20% earned in each year). That gives your key employees incentive to stay with your company and only rewards them for actual time invested with the business.
Ensure any stock option plan provides your company a way to easily repurchase any exercised shares from your employees at any time, so you can easily recapture ownership down the road should they leave or if there is change of control that requires recapturing 100% of the outstanding shares, say in a sale.
Restricted stock is another option – these are generally offered partnered with vesting restrictions and/or ability to sell. When using restricted stock, stock typically becomes transferrable or vested upon certain conditions, such as working for the company for a set period of time. Some business owners require employees to meet specific goals before their stock becomes vested. The stock value is taxed to the executive when the risk of forfeiture no longer exists.
If you’re a LLC without actual stock to share or if you want something simpler, there are other equity sharing options. If you don't want to spread actual equity or options, you can achieve the same goals with a “phantom equity” plan that basically mimics equity ownership through a profit share plan or something similar.
For example, you could grant an employee 5% of all annual net income instead of 5% equity. Or, an employee could own 5% of the company's valuation at a mutually acceptable revenue, EBITDA or net income multiple. These plans typically are paid in cash, or accrue as interest bearing debt until paid out, so make sure you anticipate having the cash on hand to fulfill these claims before agreeing to such a plan.
Other options include bonuses or deferred compensation based on employee performance. With a performance bonus, key employees are assigned goals at the beginning of the year; and, if achieved, are rewarded with a bonus. This option is especially effective when an employee has significant control and involvement in the outcomes that determine the level of the bonus.
Performance-based deferred compensation is a great option to not only reward but retain key employees. Like a bonus, the compensation is based on meeting required goals but rather than paying the bonus immediately, it’s credited to a deferred compensation account that will vest and be paid out in the future.
Each option has some advantages and disadvantages that could affect your company’s goals, bottom line and tax consequences. Reach out to us for personal advice on how to best compensate your top employees – both for them and for you.