“Control your destiny or somebody else will.”
You’ve probably heard the stories of how random secretaries from Microsoft or Facebook became gazillionaires because of the shares of the company stock that they held. If you’re a small business owner, you want to align the interests of your employees with yours and allow them to take part in the upside of the company if everyone delivers on what they’re supposed to.
The idea that likely comes to mind is that you want to give them some ownership in the company. It’s often a way to provide incentives and compensation that doesn’t require cash and salary up front, keeping your initial costs to a minimum and freeing up capital to deploy in growing the company. You want them to have skin in the game. You want them to work for a lower salary than you’d otherwise have to pay. Who doesn’t?
Research from Rutgers University supports this notion. Employees who are owners of their companies, participating in employee stock ownership programs (ESOPs), find a higher commitment to their employers. Furthermore, it’s not the size of the ownership stake which increases the commitment, but, rather, it’s the mere fact of ownership. Productivity generally increases between 4-5% in the year that employee stock ownership is established and that increase is maintained going forward.
But, is giving out a stake in your company the best way to go?
Let’s look instead at something called phantom equity.
Phantom equity is when you give your employees (or anyone else, for that matter) a contractual right to the proceeds of the company – profits, distributions, and proceeds from a sale – rather than actually giving them ownership in the company. This is exactly what we did at the company I co-founded and subsequently sold, and it helped us to align incentives properly AND avoid some of the complications that occur when you give ownership of your company to employees.
There are a lot of reasons that you would want to give phantom equity to your stakeholders (employees, contractors, etc.) rather than giving them actual equity.
- If you have to raise capital, you’re already diluted from giving out shares if you’ve distributed them to employees. Early and mid-stage investors do not like to see their ownership stakes diluted in downstream capital raises, and giving equity to your employees only serves to further that dilution.
- There are tax implications for the employees. Yes, there are also tax implications if you give them phantom equity, since the money that you distribute will be in the form of ordinary income rather than capital gains. However, one of the biggest issues we ran into when we issued equity and before we converted everyone over to phantom equity was that our company was a LLC which received partnership tax treatment. At the end of the year, once we’d filed our taxes, we had to send everyone a K-1 with a check for the taxes that they incurred as a result of owning the company – regardless of whether or not we’d issued a distribution. There were also issues with wages, as LLC owners cannot receive W-2 wages. It also affected SEP contributions and the tax implications of having the company pay for health insurance. Having multiple owners made filing our corporate taxes more time-consuming and expensive, and it complicated the personal tax filing for everyone involved. We were better off providing phantom equity distributions as bonuses. Even though the recipients received less money, they were happier because the tax situation wasn’t as complicated and it didn’t cause them to question whether or not we knew what the heck we were doing.
- A sale causes difficulty with the shareholders. If you’re looking to get your company acquired, the acquirer is going to want to deal with as few shareholders as possible – ideally one or two. While it’s the seller’s responsibility to handle the distributions, and, if necessary (see below), wrangle the shareholders into agreement, having to deal with fewer parties in the process reduces complications and takes one bargaining chip against the seller off the table.
- The controlling owner risks losing control. If you want to run the company the way you see fit, then you need to maintain majority control of the shares in the company. If you’re not careful with how you distribute the shares, particularly if you’re including incentive bonuses in equity, you could wind up with a minority share in the company. While this probably won’t lead to your downfall, once you own less than 50% of the shares in your own company, the other shareholders could all get together and remove you. Another way around this issue is to create special voting shares or require supermajorities in your corporate bylaws.
- You need more cash on hand to prevent orphan shareholders. In many equity agreements, the company purchases back the employee’s shares if the employee leaves. While you could create a Ulysses contract which states that the employee agrees to give the shares back for nothing if he leaves, I think it’s more just if you give them a fair value for the value that they create and the increase in share value that they’ve contributed to. Therefore, if you have an agreement where the company buys back the shares for fair value upon an employee’s voluntary termination, then you will need to have extra cash in reserves to fund the buybacks. When you’re in growth mode, that’s money which you could be using to grow the company and to gain market share rather than needing to keep in held back just in case someone leaves. If you don’t include such a buyback clause in the equity agreement, you could find yourself in a situation with a lot of small shareholders who are no longer part of the company. The administrative burden on keeping track of those shareholders is not trivial, as you have an obligation to send them distributions and tax returns. With phantom equity, you don’t need to have this arrangement, since it’s a contractual agreement tied to the continuing performance of the employee.
It’s great, as a business owner, to want to include your employees in on the growth and the benefits of a successful entrepreneurial venture. However, giving away equity may create unintended consequences for the business owner. Instead, give employees phantom equity. Make sure that you work with a skilled attorney who understands how to structure the phantom equity contract to achieve the outcomes you desire and who also can guide you through the contingencies you’ll need to plan for when issuing phantom equity.
We switched from equity ownership to phantom equity and never looked back.