Issuing equity in your company is one of the most effective ways to retain key employees. The hope is that by giving the employee equity in the company, they are more motivated and invested in the company as they will directly benefit from the company's success. With that being said, issuing equity to an employee does come with its risks and should not be done without consulting your attorney first.
The most common risk and most overlooked fact when issuing equity to an employee is now you have a business partner who has all the same rights as a shareholder/member of the company, regardless of the amount of equity you issue to the employee. For example, if any corporate action requires a unanimous vote of the shareholders/members, you would need the employee's vote in order to approve that action. While this risk may seem minor for most activities the shareholders would want to approve, this voting ability can be very problematic if you as the business owner ever want to sell the company to a third-party. As a shareholder/member, the employee would be under no obligation to sell their equity in the company; this ability can make potential buyers somewhat uneasy.
One additional circumstance that is not often considered before giving equity to an employee is that this equity is now the employee's property, and there is no real obligation for them to ever sell it back to the company or to you as the business owner. There are documents business owners can put in place to account for some of these situations – if the company is a corporation, the shareholders can approve a shareholder agreement, for a limited liability company, the members can adopt a operating agreement, and if the company is a partnership, the partners can adopt a partnership agreement – but these agreements tend to be complex, need to be negotiated and adopted by all owners, and might not address every scenario in which a company wants to repurchase equity granted to an employee.
If the purpose of giving the employee equity in the company is for them to share in the profits of the company, there are a handful of ways to facilitate this goal without giving them actual equity in the company. Rather, you can give the employee some form of "synthetic equity." Synthetic equity is a form of deferred compensation that provides the employee some of the economic benefits of equity ownership without giving them actual equity in the company – essentially, the employee is entitled to economic benefits but does not have any voting or management rights. Some of the most common forms of synthetic equity are phantom stock, stock appreciation rights, stock options, restricted stock, profits interests in a partnership or LLC taxed as a partnership, or the company can issue non-voting stock. By giving an employee some form of synthetic equity, you as the business owner maintain control of the company, but a key employee can potentially benefit from the company's future success. If a business owner is looking to explore issuing some form of synthetic equity, please consult your attorney before doing so because these are most often complex and nuanced agreements and the issuance of synthetic equity implicates various tax considerations.
Published: Union Leader
June 2, 2024
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