The Dangers of Giving Away Equity of Your Company to Key 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. It is more than just a meaningless saying that your key employees are the most valuable asset any company has. Your key employees can really make or break the company, which is why it is so important to keep them happy. This is especially important for high performing or otherwise essential individuals.

When thinking about ways to keep key employees with the company, and keeping them motivated, 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 the think like owners and be concerned about the “bottom line.” Additionally, it can serve as a “carrot” to keep them with the company.

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

Here are some pitfalls to be thinking about.
 

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 your future.
 

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 might not be a good thing. 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 will mess this up and cause unexpected tax consequences to the employee.

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 tricks 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 Keep Employees Loyal
While these are significant dangers to be aware of, that doesn’t mean that offering equity to employees is never a good idea. We work with businesses in many different situations and can offer you advice and insights on how to best keep employees happy and loyal today, and long into the future. Please contact us to schedule a consultation today.

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