Sharing equity with your team can be a powerful motivator, and there are two basic ways most firms do it.
In a prior article, I talked about the reasons why it might be time for you to share equity with your team.
But that brings us to today’s topic, which is how you can give equity to your team.
In this piece, I’ll focus on two typical models: direct ownership and phantom stock or synthetic ownership. There is another model of sharing equity called Employee Stock Ownership Plans or ESOPs, which is a different mechanism best discussed in an article of its own.
- Direct Ownership
One approach to sharing equity with your people is to either grant them stock or equity in the business or give them the chance to purchase stock from you – something that is called direct ownership. This is most often done over a period of time, say like 20% of the grant per year over five years. In this model, you are making your employees your business partners: they now have the right to vote on decisions and to collect a share of the profits of the business.
The upside is that you now have alignment in that your employees should now think and act more like owners of the business. They also have the incentive to stick around to see their shares grow in value. The potential downside from an owner’s perspective is that you have now complicated your governance structure. You now have other people to answer to, even though they are minority holders, which might change how you lead the company moving forward.
It’s worth noting that most owners also retain the right to buy back the stock from employees if they should decide to leave the company, usually using the same formula they used to establish the original strike price.
The direct ownership approach can be very appealing from an employee’s perspective, because they are getting the chance to own a piece of the company that immediately has value. Unless the company vaporizes, the shares in the business will be worth something to the employee. Of course, that also gives employees more incentive to help grow the business, which will increase the value of their stock.
The downside, however, is that if an employee receives a stock grant, the IRS considers this income. That means they have to pay tax on it. If you were to give an employee $10,000 worth of stock, for example, they might need to put up $4,000, depending on their tax bracket, in cash to pay for it. If the shares are purchased, there is no tax obligation. That can obviously become a major sticking point for some people.
There are some ways to try and work around the tax burden. One strategy is that you can grant shares at a valuation for tax purposes, which include a number of discount factors, including the minority position. As long as you and your advisors can justify to the IRS the value you come up with, you can reduce the tax on those grants. The other workaround is to have your employees buy the stock from you. While it’s not as generous as taking the grant approach, it does eliminate the tax burden on the employee and it means any gains are taxed at a long-term rate depending on the holding period. It also causes them to have more “skin in the game,” if you will, where they could become even more aligned in helping grow the business because their money is now at risk as well as yours.
- Synthetic Equity
An alternative to giving employees direct ownership in the company is to distribute what is called a stock appreciation right or SAR, which is also known as “phantom stock.” The idea is that you are not actually giving the employee any stock – you still own it. But what you are giving them is the right to the stock appreciation from the time you grant them the SAR. For example, let’s say a share of your stock was worth $10 when you issued the SAR. Then, after a year, the stock price grows to $15 based on improved earnings. Your employees would now have an asset worth $5 per share.
This strategy appeals to both owners and employees. For owner, they don’t actually lose any equity in their business while still creating alignment and loyalty with their team. Employees like it because there are no tax consequences of receiving phantom stock and they still have an incentive to help the company grow its value.
One wrinkle is that an employee would need to receive more phantom stock relative to direct ownership to get the same amount of equity compensation because they are not receiving the underlying value of the stock. Additionally, any gains will be taxed as short-term income.
Both of these approaches to sharing equity with your team have pluses and minuses. You should also speak to your tax adviser and accountant to walk through the advantages and disadvantages of each approach as well.
But when you add it all up, sharing equity in either form can be a great way to get your team working together to put your company’s growth on the fast track.