One of the first major steps in growing a new business is taking on employees. Often, a business founder will wear all the hats in a company while waiting for a certain financial threshold (or personal exhaustion) to justify adding employees and the expenses that come with them. If that step goes well, somewhere down the road the founder may seek to reward and incentivize those employees – or entice others – by offering an ownership stake in the company. What should founders consider before doing this?
There are a number of ways to offer ownership stake to employees. An employee may be granted ownership interests outright. Those interests may enjoy all the perks of ownership right away, or they may vest over time based on achievement of certain milestones. Alternatively, the employee may have to pay the company or the founder for ownership interests. The details of that arrangement may have major tax implications for the company, the founder and the employee, so founders should consult with a tax professional before offering this.
Another issue that is often overlooked or under-considered involves what happens if the employee later leaves the company. Typically, the offer of ownership to an employee is based on:
Sadly, all good things must come to an end. Unforeseen life events may cause an employee-owner to leave unexpectedly. Or, the employee-owner may eventually retire. In either case, unless the company conditions ownership on ongoing employment before the employee gains stock or membership interests, it may be stuck with a minority owner entitled to distributions of profit, voting rights, and access to company records long after she stops coming to work.
The terms under which employees may gain an ownership stake should also address how and why they must later divest that stake. Unfortunately, the employee’s exit may be prompted by a violation of company policies or even criminal actions. In this case, the company may not want to pay fair market value to an employee who damaged the company’s bottom line or reputation. Even under the friendliest exit scenario, the company may need cash flow flexibility in paying an exiting employee for her ownership interests. Proper planning can provide certainty for both employer and employee before the relationship evolves to co-ownership. A company wary of such a semi-permanent relationship and the eventual cost of re-acquiring stock or membership interests may even consider a “phantom ownership” arrangement. Under this structure, the employee is rewarded with bonuses based on the dividends or distributions issued to owners as if she held a stake in the company but without the rights, obligations, and buy-back considerations that come with actual ownership. Of course, these decisions are unique to each business and each employee circumstance. They must be carefully considered to protect against unintended consequences that can later limit the businesses’ flexibility.
Phelps business and labor and employment lawyers can help structure complex employer-employee agreements that provide mutually beneficial financial incentives while limiting future risks, expenses and uncertainty. Please contact Derek Larsen-Chaney, Jason Pill or any other member of Phelps’ Business or Labor and Employment teams if you have questions or need advice and guidance.