As we grapple with rebuilding a new and better economy that is potentially fairer and more equitable, the question of employee ownership has started to come up more often. There are many ways to get to employee owned. Before attempting this feat, however, a business owner (or owners) should consider the why and the how.
Employee Ownership through Equity Incentives Compensation
It has been a long time since many have heard the tale of how a scrappy startup company (suspend your imagination if you were not born before 1970) gave its workers stock options in lieu of compensation, who then hit it rich when Microsoft went public.
Equity Incentive Compensation is a compensation method used by business enterprises – primarily those with a growth mindset that will either be acquired or have an exit event (think IPO) – that want to:
- strongly align the interests of, and incentivize high-level performance from, key employees or service providers;
- build employee loyalty and develop a more authentic sense of purpose; and
- save and redeploy early-stage cash that would otherwise have to be spent on salaries or contract labor.
Most basically, employees and workers are paid a portion of their wages with some form of equity incentive; by default this creates employee ownership.
Types of Employee Equity Incentives
Equity Incentive Compensation can take many forms for private companies, with each presenting a unique set of advantages and disadvantages. While the optimal types and structures for any given company will depend on its particular business circumstances, below is a summary highlighting some of the most popular kinds of equity incentives used by many private companies today.
- Stock Options. Stock options are a well-known form of equity incentive compensation that can be utilized by business enterprises. The holder of a stock option has the right to buy stock of the business at a set price, called the “exercise price”, for a certain period of time (typically ten years), beginning when the stock option vests. The exercise price is usually equal to the fair market value of the stock at the time the option is granted. Stock options typically vest over time (3-4 years) to motivate the recipient to continue to be employed with the enterprise for a longer term. The holder only becomes a shareholder of the business when the option is exercised and the stock underlying the option is purchased for the exercise price. Stock options can be attractive to employees if the enterprise expects substantial growth and/or a liquidity event (sale) down the road at an increased value. However, if there is no appreciation in the enterprises stock over time, then the option provides the employee with no financial benefit. Options generally come in two forms – Incentive Stock Options (ISOs) or non-qualified stock options. The form is dictated by employment status and a few other items.
- Restricted Stock. Restricted stock is an actual grant of shares of stock, but for a period of time (restricted period) the shares (1) can typically be repurchased by the enterprise for a set price, (2) are subject to forfeiture by the employee without payment upon the occurrence of certain events, such as when the employee’s services to the enterprise terminates prior to vesting in full, and (3) are subject to restrictions on transfer or resale. Because the employee will become a shareholder on the grant date, they will normally have the right to vote and receive dividends.
- Profits Interests. Profits interests are awarded to key employees and service providers in exchange for their contribution of services to the enterprise (in lieu of being required to make a cash or other tangible capital investment). A profits interest is technically an ownership interest that gives the employee the right to a share of future profits and appreciation of the enterprise.
- Other. Other equity-based forms of incentive compensation include stock appreciation rights, phantom stock, and long-term cash incentive plans.
Its important to remember that equity incentive compensation has tax implications for both the enterprise that issues compensation in this manner and the employee or service provider who receives it. Entire treatises have been written on this topic (Tax Implications on Incentive Pay), so it’s important to connect with professionals who understand these issues and can assist.