Plan before attracting a new employee with stock

A few weeks ago, the president of a large family-owned company mentioned the owners were considering offering ownership to a high-level executive they wanted to hire. The role and the candidate were important to their long-term transition plan for the business. Their compensation structure, however, wasn’t competitive enough for their favorite candidate. An equity position could sweeten the pot.

Indeed, it could sweeten the pot. It could also poison the brew if not carefully crafted. For example:

  • New hire risks — There is always a honeymoon period. It takes about a year for relationships and productivity to settle in. Sometimes things work out; sometimes they don’t. Objectivity over continued employment is swayed if the employee is also a shareholder. Depending on the language in the agreement, the employee may or may not still be an “at-will” employee. Unwinding ownership can be very complicated. It’s important that legal documents are well structured.
  • Internal equity — This company employs several high-level executives. Is the company offering a similar compensation structure for similar positions? If not, why? Justification should be well considered and balanced to avoid unintended consequences that could be misconstrued as discriminatory.
  • Buy-sell agreement — This is a family-owned company. How do the other owners feel about a non-family member owner? Does the company have a shareholder or buy-sell agreement (BSA)? Does it address the issuance of new shares? Does it state how shares are valued? What happens if the employee-owner terminates his or her employment? What happens to the shares if the employee-owner is married and later divorces? Can he or she sell their shares to a third party? What voting rights do they have? Can the business have two classes of stock? (S-corps cannot.)

These are only some of the issues appropriate for shareholder agreements. Suffice it to say that getting rid of a shareholder can be a lot harder than adding one, especially if there is no BSA or it hasn’t been kept current.

These are a few of the reasons that using ownership to attract this candidate gave me pause. It’s not a decision to be made lightly or quickly just because a hiring opportunity may be lost. Further, there are other compensation strategies that provide meaningful “skin in the game” for growing value and providing additional compensation to key employees. Two potential tools include “phantom stock” and “stock appreciation rights.” Both tools instill a similar emotional investment in the company without giving actual technical ownership.

Phantom stock is granted as a promise to pay the employee cash at some future point based on a defined value of a designated number of shares. The defined value is calculated in one of two ways. One approach is based upon the actual full value of the stock as of the future date. The other approach is based on the appreciation of the stock’s value between the time that the phantom stock is granted and the future date. Often, the future date is associated with the sale of the company. This provides the employer with the cash to fund the payment and acknowledges the employee’s contribution to the sale value. If not tied to the sale of the company, the phantom stock payments may be established on a fixed, pre-determined date or other milestone.

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Stock appreciation rights (SAR) are very similar to phantom stock. SAR focuses exclusively on the growth in the share value over time. Stock appreciation rights may give the employee the opportunity to receive his or her payment for the growth in value in the form of cash or as actual shares of ownership as of the exercise date. Phantom stock doesn’t allow for conversion to actual shares.

Accounting for this compensation depends on which approach is employed. In general, the change in the employee’s interest in the benefit, subject to a potential vesting formula, is booked as compensation expense each year. Taxes are due when the employee receives a payment, which is taxed as ordinary income and deductible by the employer. If the stock appreciation rights benefit is paid in the form of actual shares, different rules apply for both accounting and tax purposes.

Phantom stock and stock appreciation rights offer employers a great deal of design flexibility and are an attractive executive compensation alternative to actual stock. With flexibility comes the risk of complexity, so consult experienced accountants and attorneys for the design and management of the compensation program. However, this complexity may be much more manageable than untangling stock ownership with a new, untested employee.

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