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Stock Option Plans, Restricted Stock, Phantom Stock and
Other Incentive Plans
for Closely Held Businesses
Article #2 – Equity Plans, including Stock Options and
Restricted Stock
This series
of articles explains how restricted stock, stock options,
cash plans and phantom stock really work for closely held
companies, and what their real value is for the company and
the employee.
The articles in
the series are:
In this article
#2, I explain how you use equity plans, that is, stock
option plans and restricted stock plans to reward and
encourage your employees. Equity means stock or ownership,
so with an equity plan you give ownership in the company to
the employees. This article applies to both stock option
plans and restricted stock plans.
Here are ten key
concepts for equity plans.
-
There are two types of equity plan
- stock option plans and restricted stock plans. I
discuss the former in detail in
Article 3 – Stock Option Plans, and the latter in
Article 4 – Restricted Stock Plans.
-
Stock isn’t money; it’s paper.
The value of cash is fixed; the value of stock is
unknown. Your upfront benefit in giving stock is that
you’re not spending money today. Your risks are that,
from today’s perspective, the employee might consider
the stock to be worthless paper; but tomorrow the stock
might have risen to a value much higher than a straight
cash payment today.
-
An equity plan has two benefits for the employee, one
economic and the other psychological.
Regarding the economic benefits to your employees,
they have a possible payday if the company is ever
sold. Remember that you are a closely held company.
This means you’re probably not going public. The
employee/shareholder can receive annual dividends or
distributions, but they likely are not high. The
primary economic benefit of a minority stock holding is
a payoff if the company is ever sold or merged. The
employees usually must wait until someone is willing to
buy the entire company before they can receive any money
for their shares. Upon the sale of the company, the
employee gets his share of the proceeds.
Regarding the psychological benefit to your employees,
they become stakeholders. For high level employees this
can be very important. In fact, I’ve found that
long-term managerial employees for small companies want
equity, if for no other reason than face. It’s hard to
be deeply involved in running a small business but have
everyone know that you’re not an owner.
-
What does giving equity mean to
you, the owner? First, you’re compensating
employees without paying them cash. This is the main
reason why the Silicon Valley pre-IPO companies love
stock options. But the equity is still worth a lot to
you, the owner of the company, because you’ll be sharing
ownership of your company with other people. Your
ownership will be diluted, and you will now have
minority shareholders. Minority shareholders can be a
real pain in the neck, as I explain next.
-
Minority shareholders are a pain in the neck because:
They have rights under CA law.
They demand things from you, and if you don’t give in,
they threaten to sue you.
You have to submit certain corporate actions to their
vote.
You have to open your books and records to them.
When you ultimately sell your company, you might want to
do so by a sale of 100% of the company’s stock, at which
point you’ll need the minority shareholders to consent.
You, as a majority shareholder, will owe fiduciary
duties to your minority shareholders.
Are you willing to
grant these rights to your employees? Many small business
owners hear this list of rights and decide, “I’ll just give
them cash instead of equity.” A shareholder is a
mini-partner, and partners can give you more headaches than
anything else. I always say, “you don’t need enemies so
long as you have partners.”
-
Have a plan about the maximum
aggregate equity percentage you will give to employees
over the next 5 or so years. Know where you are
going. When you grant equity, you dilute the percentage
interests of all existing shareholders, including you.
Be sure that you are willing to do this. Think about
dilution over the short term and over the long term.
The best way to do so is to determine the maximum
percentage of stock that you are willing to give to the
employees as a group, over the next 5 to 10 years. Then
allocate this number among the types of employees. In
this way, you control how the plan dilutes your
ownership interest in the company.
-
Be Stingy. Given that your
company is closely held, it is extremely important that
you selectively grant stock – you can’t give stock to
just any employee. For you, options are not a
cash substitute, and you can’t go around giving options
to everyone. You must strictly control the process of
granting equity. Besides avoiding the problems that
shareholders can give, you also want to avoid all of the
administrative hassles that come with a lot of
shareholders. Also, if you’re an S corporation, your
cap is 35 shareholders, and you can’t have non-resident
aliens as shareholders.
-
Vesting. When you give
stock options or restricted stock, the employee doesn’t
really get the stock (i.e. vest in it) until he has
worked for you for a number of years.
-
Get your stock back when the bum
quits. This may be the key to equity incentives
for closely held corporations. I discuss this at length
in
Article 5 - Buy-Back and Repurchase of Stock.
-
Do it right the first time.
It’s expensive to have me fix a bad plan; it’s
cheaper to do it right the first time.
You should hire a securities attorney to help you
with all of your employee incentive and stock option
plans. If you want to read more try my main page,
Securities
Attorney. From there you can link to other
pages and articles of interest.
Call me to schedule a legal consultation:
510-796-9144 |
