The ability to retain and attract employees has become a well-known essential component of any business’s current success, future growth, and ability to sell. Offering good vacation and medical plans simply isn’t enough to hold valuable employees in place today. So, what’s the solution?
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Is Equity Interest A Good Idea To Attract And Retain Employees?
Many business owners attract and incentivize high-value employees by issuing them equity directly in the business. It looks like an appealing option on the surface, but it can complicate a business beyond measure once it’s implemented.
While a direct equity interest is advantageous because it doesn’t require a business to have large cash reserves, which can be a particular obstacle for startups, small businesses, and others with limited budgets, it’s also risky. How?
With stock incentive strategies, the employee becomes a shareholder. As both a shareholder and employee, the person now has certain privileges and rights that could drastically alter the normal employer-employee dynamic. Many such relationship changes go undetected and unanticipated until an issue arises that interferes with the company’s objectives and strategies.
Before considering a direct equity interest in the business to attract employees, look at more low-risk options, such as Stock Appreciation Rights (SARs).
Stock Appreciation Right May Be The Better Route For Employee Retention And Attraction
The good news is that business owners have a different route to retain key employees without placing their business operations at risk by granting them equity ownership. It’s called Stock Appreciation Right (SAR,) or Phantom Stock. In LLCs, it’s often called Profits Interest.
With SARs, the employee isn’t granted voting rights and other such powers unlike when issuing a direct equity interest. Instead, the employee is guaranteed an economic benefit in the company’s profits that’s akin to a stock percentage. Basically, the reward value is equal to that of a company’s stock appreciation over a period of time specified within the contract.
With SARs, business owners have ultimate flexibility in what conditions, such as vesting schedules and eligibility rules, they want to apply before an employee realizes their reward. It’s an ideal route to incentivize employees to both stay and take an interest in the growth of the company for their own financial gain without diluting ownership rights or causing changes to the employee-employer dynamic.
A look at the advantage and disadvantage highlights may help business owners decide if SARs are the best option to help bolster the retention of high-value employees.
Stock Appreciation Right Advantages
There are innumerable pros to SAR plans, including:
- Avoids employee-employer conflicts of interest related to minority shareholders.
- Provides flexibility in that plans have few, if any, regulatory restrictions.
- Offers employers a performance-based tool for retention through the creation of vesting schedules.
- Allows employers to set in contract what the employee receives should they be terminated or quit.
- Employees can share in the stock’s profits without having to pay for it.
- Employees are incentivized to help their company succeed and grow since their SAR award increases in value.
- Yields a tax deduction for the company upon paying an employee any SAR-related benefit.
- For LLCs and Subchapter S corporations, allocation of taxable income and record keeping for minority shareholders isn’t necessary.
Stock Appreciation Rights Cons
Business owners will find that there aren’t that many disadvantages to SAR plans. The main three considerations are:
- Medicare and FICA taxes may apply to accrued employee benefits.
- Unlike shareholders who pay capital gains taxes on direct equity held upon a liquidity event, employees holding SARs will be taxed at an ordinary income tax rate, which is higher than the capital gains tax rate.
- The payout to employees can take two to five years.
How Is A Stock Appreciation Rights Plan Designed And Implemented?
SAR plans are straightforward and relatively simple to design. They typically follow this three-step process:
1) The business owner(s) sits down with an advisor to create a SAR plan outline. Do ensure that the advisor is familiar with SAR plan designs, the business itself, and the business’s employees. Decisions are made on which employees will receive bonuses, what the value of those bonuses will be, vesting rules, and so forth.
2) After a final draft is designed, the business owner hands the plan over to their corporate attorney for review. The attorney will ensure the plan doesn’t violate any laws and is in the best interest to his/her client. The attorney then creates a legal document based on the SAR plan.
3) The legal contract can now be offered to employees as a benefit.
In conclusion, business owners are recognizing more and more the challenges in attract and retaining good employees. SARs and phantom stock programs are proving to be a flexible attraction and retention tool with many benefits and few risks.
If you would like to learn more about how to hire your first C Suite executive, then you won’t want to miss this Boulder Startup Week event: Building Your Leadership Team: How Do I Design a Compensation Plan to Bring on the Best C Suite Possible?
Register now and learn from this expert panel the lessons on designing out the right package that won’t break the bank or cost you too much equity.
The Panel
Moderator
Kendra Prospero
CEO/Founder, Turning The Corner, LLC
Speaker
David Kendall
Founder, CEO & Attorney, Bold Legal
Speaker
Heidi Huntington
CFO, AVL Growth Partners
Speaker
Joann Nelson
Principal, Rooted Resolve
Speaker
Shina Culberson
President, Quist Valuation
UPCOMING EVENT
To get your specific questions answered about applying this in innovative approach in your company, join us at Boulder Startup week for this panel discussion.
