The Perils of Equity-Based Compensation

Monday, 01 July 2013 14:47 Written by  Susan Maslow

Employers frequently want to attract new, super-talented management to an existing Company, or potentially worse, have already promised to give one or more trusted and loyal current employees equity as part of their compensation package as soon as the time is right.  Unfortunately, this is easier said than safely done. 

Clearly, equity can be a powerful, seemingly low-cost form of compensation and motivation.  Having your most valued employees vested in something beyond their pay check certainly seems like a fine idea.  If the Company does well, the employee shares in that growth in the form of annual distributions or a buy-out upon death, disability, retirement or other termination of employment.  So, what do I have against such an idea?

 

• Statutory and Case Law Shareholder Rights.  Those pesky new shareholders may surprise you by having an opinion about everything and a lawyer willing to force the issue.  Even though you and your family members or trusted advisors might retain Board control and a majority share or even a super-majority at the shareholder level, the need to document good faith Board action or inaction and informed shareholder participation in every fundamental corporate event is essential to continued corporate bliss under state law.  It is a big transition to go from wholly-owned or closely-owned to a place where you have to manage your relationship with individuals you historically view as subordinate, valuable yes, but not necessarily persuasive.    Under state law, however, you have to keep in mind statutory rights every shareholder has to corporate books and records not to mention dissenter’s rights available to shareholders. Minority shareholders have the ability to bring an action against the Company or you as the controlling shareholder or Board Member under a variety of claims that range in their degree of creativity. 

• Possible Inadvertent Shift in the Balance of Power:  If there are currently two or three equity owners with equal ownership, watch out. You might be surprised to learn that the shareholder with the swing vote actually controls the Company since the required majority or supermajority vote may depend on their assent.  All the while, the minority holder may not have to guaranty corporate debt like the original owner or owners which may lead to his or her greater comfort with risk.

• Unforeseen but Foreseeable Tax Consequences:  Unless your entity is a C corporation and adopts a Qualified Stock Option Plan, upon full vesting and the loss of any risk of forfeiture, the grant of equity to an employee without requiring Fair Market Value payment for the shares is a taxable event for the employee. Since the IRS views this as compensation for services, the tax obligation will be based on the current value of the Company at the time of the fully vested grant times that employee’s income tax rate under Federal, state and local law.  Employees may surprise you and expect a bonus equal to the tax due sometime in March of the year after the stock grant unless this issue is clearly vetted out as part of the original discussion. 

• The Danger of Dilution in Dribs and Drabs: How will you determine which employees “deserve” stock and which do not? What is the message to those employees that are told there is no equity in their future?  And, on the flip side, if you keep giving away equity in the Company to many, what effect does that meant in terms of the resultant dilution of the original shareholder group who made real capital contributions (of left capital on the table for so many years) in addition to providing employment services to the Company?

All of these issues should be considered before the Company starts issuing grants of stock or options to employees.  Failure to do so can lead to loss of founders’ up-side ownership potential and control.   

But, do not be discouraged.  If you have already made a promise to grant equity and your key employee understands the personal tax consequences unless he or she actually pays for the stock, your By Laws can be amended and a founder/employer-favorable Shareholders’ Agreement or Operating Agreement can be written that will attempt to put to bed as many of the issues above as state law may allow.  The important thing is to get these materials adopted before your employee becomes your co-shareholder or co-member and present them for signature by the employee as a pre-condition to receipt of the equity. 

And, if there is still time and you have not made a promise regarding equity you are uncomfortable withdrawing, there are a variety of programs that can be created to simulate the transference of equity to key employees without doing so under Stock Appreciation Rights (SARs) or Phantom Stock Plans.  The outcome of such plans is that participants enjoy the fruits of good company performance without actually taking an ownership position which trigger voting rights and dilution of the company’s ownership. 

Last modified on Monday, 01 July 2013 14:55
Susan Maslow

Susan Maslow

Sue concentrates her practice primarily in general corporate transactional work and finance documentation in the areas of Business Transactions, Business Law, Private Finance, Real Estate, Contracts, and Non-Profit Law. She represents entrepreneurial individuals and privately-held companies in a great variety of business transactions, including stock and asset acquisitions, banking negotiations, mergers, secured and unsecured financing, real estate and business acquisitions and leases, capital arrangements for hospitals and other health care providers, distributorships, license arrangements and business separations and dissolutions.

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