Issuing stock to employees would seem to be a relatively uncomplicated strategy to encourage morale, economically reward and retain key employees, and possibly create a long-term ownership transition plan. While it can accomplish those goals, there are some important considerations to keep in mind.
Closely-held businesses are limited in how they can facilitate issuing stock to employees when compared to publicly-traded companies, where stock options or stock purchase plans are favored ways to grant employees ownership. To obtain ownership in a publicly-traded company, employees can freely purchase shares from an open exchange. If shares are purchased via options or a stock purchase plan, they may realize taxable income, to the extent of any bargain element to the acquisition, under the tax code.
Closely-held companies operate under the same accounting and tax rules as public companies. But because these companies lack scale, they generally limit the number of equity owners and can encounter difficulties in pricing their shares. This means that options and stock purchase plans generally don’t fit well. Therefore, a direct transfer to a limited group of key employees is more feasible, where the goal of existing owners is to retain majority ownership, (as opposed to an indirect ownership vehicle such as an Employee Stock Ownership Plan).
Here are 10 considerations for a closely-held company that is considering issuing ownership to employees:
- For smaller to mid-sized closely-held companies, there is good reason to require an employee to put “skin into the game” and pay something for their stock. Psychologically, no one fully appreciates that which is given to them for free.
- The price, for any purpose, should approximate fair value, with applicable discounts for lack of control. The majority owners should engage a valuation specialist to measure the company’s fair value and assess appropriate discounts, if any.
- Issuing stock at a measureable discount causes the company to record a financial statement expense with a concurrent credit to equity. This could cause an undesired net income result to the company.
- Employees recognize taxable compensation if there is a bargain element to a stock purchase; the company recognizes a corresponding tax deduction. The taxable compensation may be an unwanted surprise to the employee if not clearly spelled out in advance.
- The company will want to restrict transferability or, at a minimum, have a right of first refusal to repurchase stock the employee owns, dependent on future events.
- A well-thought-out shareholder or repurchase agreement provides a plan to ensure the company or other existing shareholders have a virtual lock on repurchase at certain triggering events. The agreement should set out the terms triggering a buy-back. It is a necessity to avoid any possible ownership by an unwanted player such as the spouse or children of an employee, a competitor, or any unknown person.
- Triggering events, terms, and measurement of any repurchase price are integral elements of a repurchase arrangement. They must be clear and can be formula-based if broadly applied. They also must be set out in an agreement that is negotiated and binding on the employee and the company at the time the employee first acquires the stock. There should be flexibility to allow the company or other shareholders to repurchase any shares.
- Bank debt agreements need to be reviewed for possible restrictions or covenant matters that could be violated as a result of issuance or for any downstream repurchase obligation. If necessary, renegotiate to fit the company’s needs.
- Mind the voting and legal rights associated with shares owned by an employee. Unless it is restricted at issuance, voting creates an exercisable right on corporate governance matters, a right to dividends, and a right to legal process as a shareholder.
- Consider alternatives such as phantom stock or stock tracking rights to meet a similar objective of incentivizing key employees to share in a company’s growth.