Incentivizing Employees With Equity

5/1/2022 – updated 3/9/2024

Business owners seeking ways to reward or retain excellent service providers (employees or independent contractors) often believe that giving ownership in the company is the only – and best – way to do it.  We strongly disagree.  

Ask anyone who’s had a business partnership go south – once someone is granted equity in your company, you often can’t just take it back without either having to pay fair market value for that interest or inviting a lawsuit if you don’t.  One client (without consulting with us, of course) granted an employee 1% of the company and then terminated the employee FOR cause.  The employee responded with “okay, I’ll take my 1% of your $11 million company, please.”  The client called us in a panic, confirmed that no written documentation had accompanied the grant of 1% ownership, and we could only tell him that he needs to pay the employee for the equity and that there might even be a fight over how the equity is valued.  In short, next time, call us FIRST.

There are ways to incentivize employees that don’t have the pitfalls described above.  On a sliding scale of least to most committed (from the employer’s perspective), we have:

Let’s start on the left or least committed side of the spectrum.  You close out your books for the year and discover you had a great year.  You have enough net profits to keep some in reserve to service your debt and to save for a capital investment.  You want to reward your employees for working so hard to make that great year happen.  So, in a scenario very much NOT like the scene in Christmas Vacation (where Clark Griswold receives, as his bonus, a membership to the jelly of the month club), you issue checks to your employees as a thank you.  Keep in mind another concept captured beautifully by that scene – Clark had already spent money designing a pool, expecting a bonus equal to or more than the one he received the prior year.  Though you should be aware that this generous act may create that expectation, you aren’t committed to meet or beat that amount in any subsequent year. (It’s also my goal to memorize his rant: “cheap, lying, no-good…” That’s as far as I’ve gotten.)

Next we have profit sharing that’s not in writing.  If you have a 401k plan, it may behoove the business owner to engage in profit sharing with employees to reduce the business owner’s tax liability.  You’ll want to consult with your CPA and financial advisor as to the best approach and amount to pay.  This one would also come as a surprise to the employees but again may create an expectation.

In the yellow [if we use the graph], we have a written commitment to profit sharing.  This would be outlined in a service agreement and probably should be tied to metrics. For example, if the company’s net profits exceed $X this year, a pool of Y% of the profits will be available for sharing with employees.  What percentage of that pool each employee receives can be based on their length of service or tied to metrics traceable to their efforts (as with a salesperson).  As you might suspect, as soon as you start putting things in writing, it can create a risk to the company.  However, setting aside a pool of available profits based on net profit rather than gross revenue ensures the company won’t jeopardize its ability to pay its bills just to pay out profits to employees.  That said, if you decide you want to save some money to invest in a fleet of vehicles, as a real life example, and you want to forego the profit sharing one year to do so, you might be in breach of your written agreement.

The next more committed path in orange is incentive equity.  If clients insist on granting ownership to service providers, this is the path we prefer because it allows the company to take back any unvested interest from the employee upon separation, keeping you from having a disgruntled employee as a business partner.  We almost never prefer the choice on the far right of the spectrum (which is why it’s threat level RED). Incentive equity has a few written components: an owners’ agreement (Operating Agreement for an LLC, for example), an equity incentive plan, and an agreement with the employee. Let’s discuss:

  1. The owners’ agreement is, as the name describes, among the owners of the company.  The document must have language that allows the company to grant incentive equity to service providers, without having to follow the first right of refusal protocol often required prior to issuing ownership interest.  
  2. The equity incentive plan is one adopted by the company which provides for more specific guidelines as to how and when the company can grant incentive equity to service providers, details that don’t quite fit into the owners’ agreement or aren’t appropriate to outline until and unless the company wants this option.  The plan includes triggering events that allow the company to redeem or take back the granted equity, such as fraud or embezzlement, material dishonesty or breach of fiduciary duty against the company, or any action that is injurious to the company.  This is especially important if the company holds a privileged license such as a gaming license or liquor license.  If someone who’s been granted equity engages in conduct that jeopardizes the company’s license, the company needs to be able to redeem that interest to preserve its license and continue operating.
  3. The third “leg of the stool” so to speak is the set of agreements between the company and the specific service provider.  This can be an employment agreement or consulting agreement or simply an offer letter, coupled with a grant agreement which specifies how much equity the service provider is eligible for, if/how/when it vests over time, and under what circumstances the interest can be taken back by the company without the service provider’s consent, along with a Joinder Agreement that the service provider signs to agree to be bound to the terms of the owners’ agreement.

Ultimately the key is to ensure the company can buy back the interest from the service provider upon separation, which is not necessarily the case if the company grants straight equity to the service provider without conditions.

Then, the question becomes: how much does the company have to pay for that interest?  Many grant agreements allow the company to set the fair market value of the interest “in its sole but reasonable discretion.”  This is fine and dandy so long as the company and service provider somewhat agree on the value.  In the event of a disagreement, the company might be forced to get an appraisal, which is not only expensive but also may not resolve the issue.  In fact, owners’ agreements almost always include language that addresses what happens when owners disagree on the fair market value of the company.  “If there is a dispute as to the fair market value determined by a Qualified Appraiser, the disputing party may hire its own Qualified Appraiser and then the resulting value is the average of the two numbers.”  Or, if there’s a dispute, the disputing party chooses a Qualified Appraiser and that appraiser chooses a third.  It can get messy and expensive fast.

Hang in there with us for one more option – a liquidity event sharing agreement. “A what what sharing agreement?”  Put simply, this type of agreement allows the service provider (again, employee or independent contractor) to share in the proceeds if and when the company sells.  It’s a cleaner way of rewarding a service provider for their contributions in growing the company without the “stickiness” of any type of incentive or straight equity.  When taking this approach, it’s important to clearly define “proceeds” as the amount of money the seller receives after ALL debt and expenses are paid. This is a great option for service providers who previously thought they wanted to be “owners” in the company but learned that the associated tax obligations are too onerous. 

When clients DO call us for assistance with these questions, they’ve often already had conversations with the service provider that we can’t easily walk back.  Therefore, we strongly suggest you consult with your legal and tax advisors before even discussing these types of reward options with the potential recipient.