Q. I have decided that I want to reward some of my key employees with equity. However, I built this business to the point where it is today largely without their help. I am reticent to give them a share of the value that was created before they arrived. I am also concerned about giving up true ownership, is there a way that I can reward them without giving up actual equity?
A. If you give equity to your employees, they will receive not only value that is created in the future, but also value that was created in the past. You will also create a tax event for your employees because the IRS considers the value of the stock they are awarded to be compensation. For these reasons many publically traded companies use options to incent their employees to create shareholder value going forward.
An option gives someone the opportunity to buy a share of stock at some time in the future at a predetermined price, called the strike price. By awarding options with a strike price of today’s market price, employees are not compensated for the value that was created prior to them receiving the options. The value they receive will be determined by the difference between the market price at the time the options are exercised and the strike price. Therefore, if an employee receives an option with a strike price of $50 (today’s market value) and exercises the option when the market price is $60, he/she will receive $10 of value. The current value of the share of stock ($60) minus the price that the employee will have to pay for the stock ($50).
You can do essentially the same in a privately held company using phantom options. Equity holders receive value in two ways, dividends and the capital gains they receive when the shares they hold are sold. You can use a profit sharing program to compensate an employee in the same way that dividends would. For example, if you are trying to simulate equity that is worth 10% of the value of the company, you might decide to pay the employee 5% of the profits the business makes. The assumption is that half of the money the business makes is reinvested in the business and your employee receives 10% of the half that is distributed. Obviously, depending on your circumstances, you may choose to adjust these numbers.
To compensate the employee for the value she/he would receive for selling shares, you could agree that you would pay him/her a percentage of the value you receive if the company is sold less the estimated value of the business when the phantom options were issued. For example, let’s say you wanted to compensate the employee as though he had options equal to 10% of the company. If the company was worth $1 million when the grant was made and sells for $10 million. The employee would receive $900 thousand = ($10 million - $1 million) X 10%.
You may also wish to compensate your employee upon retirement at a particular age by repurchasing the phantom options. This can be done over a period of years. We recommend that you also spell out what happens under various circumstances, e.g., the employee is terminated for gross misconduct, the employee leaves of her/his own volition, the employee is terminated for other than gross misconduct, etc.
Providing equity to employees can be a powerful motivator. However, you can accomplish essentially the same goals without issuing actual equity. Further, by issuing phantom options, you can avoid giving away value that was created before the employee arrived.