What to Consider Before Giving Away Company Equity to Employees

Whether you’re just starting a new business or you have been successful for years, you need to constantly be thinking about your key employees. The saying that key employees are the most valuable asset in a company has proven true time and time again. Your key employees can really make or break the company, which is why it is so important to find ways to keep them content and motivated. This is especially important for those high performing, essential individuals.

When thinking about ways to keep key employees with the company, many business owners consider offering them equity in the business. The idea is that employees who also own a portion of the business are more likely to think like owners, take more ownership, and be concerned about the “bottom line.”  It may serve as a “carrot” to keep them with the company. 

However, business owners should carefully consider their options before “giving” equity away to their key employees.  The process needs to be carefully planned out and properly structured so that the business owner gets what he/she expects.  

Here are some things to consider:

Shareholders or Members Are Entitled To Certain Rights

Shareholders in a corporation or members of a limited liability company are afforded certain rights by law.  For example, most state laws provide that either type of owner (i.e., shareholder or member) are entitled to information about the company, which could include financial statements, documents evidencing actions taken by the board or managers, lists of other owners (and their ownership percentages), copies of agreements (e.g., shareholder agreements, bylaws, operating agreements, etc.).   If you decide to give equity to employees, make sure you fully understand what disclosure obligations you will have, what inspection rights that they have, and how that will impact the future of the business.

Employees Don’t Always Make Good Owners

Great employees often have a specific skill set and temperament that help them to perform well in their positions. That does not mean, however, that they will make good partial owners of the business. Depending on how much equity an employee has, they may want to start having some input on business decisions, which may complicate things.  Worse yet, if the investment isn’t properly structured or thought through, they may be legally entitled to vote on certain decisions.

Setting Expectations

When just starting out with just a few employees, it may seem like offering equity in the business is an easy way to keep people happy. If you do it, however, you are setting a precedent that future employees may come to expect. While you certainly aren’t obligated to continue to offer future employees equity, you will need to have a plan on exactly how and when you will end this program. Even with this plan, it is likely that it will upset some employees, which has the opposite effect you wanted in the long run.

Tax Consequences

Often times, there are tax consequences to these transactions. Some transactions can be accomplished in a tax free manner.  But, unless a business owner consults with his or her professional advisers, they’re at risk of harming the company structure down the road, and could potentially cause unexpected tax consequences for  the employee.

Challenges with Compensation

In addition, in the context of an entity taxed as a “partnership” (e.g., an LLC with more than one member), the addition of an employee to the LLC as a member will change the way in which that employee is required to be paid.  A member of an LLC (no matter how small of a percentage they own) can’t take compensation in the form of W-2 wages – they need to receive “guaranteed payments”. Guaranteed payments are not subject to the typical wage withholdings (e.g., FICA, Medicare, etc.).  Thus, that employee is likely going to be required to make quarterly tax payments. Such an arrangement can be a very difficult adjustment for folks that are used to being paid as employees.

Methods to Avoid These Issues

Of course, there are many methods and structures to solve some of these problems.  They include the following (and in many cases, a combination of several tools): options or option plans, “profits interests” (for LLCs), vesting and forfeiture, buy-sell agreements, non-voting interests, etc.  However, there is no “one-size fits all” solution here. Tailoring a plan that meets your objectives is a highly fact intensive process.

We Can Help

While these are significant challenges to be aware of, it doesn’t mean that offering equity to employees should be avoided. We work with businesses in many different situations and can offer you advice and insights on how to best keep employees loyal today, and long into the future. Please contact us to schedule a consultation today.

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