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:
2. Equity Plans – Stock Options and Restricted Stock ◄You are here
3. Stock Option Plans
4. Restricted Stock Plans
5. Company Buy-Back and Repurchase of Stock Options and Restricted Stock
6. Cash Plans, Phantom Stock Plans and Stock Appreciation Rights
7. Summary and Plan of Action
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.
(1) 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.
(2) 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.
(3) 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.
(4) 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.
(5) 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.”
(6) 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.
(7) 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.
(8) 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.
(9) 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.
(10) 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 an attorney to help you with all of your employee incentive and stock option plans. If you want to read more try my main page, Business Lawyer. From there you can link to other pages and articles of interest.