What Are The Options for Issuing Equity to Key Employees In Your Small Business?

Doug Bend is the Founder of Bend Law Group, PC, a law firm focused on helping small businesses and startups.

Our firm has advised hundreds of companies on their options for issuing equity to their key employees. One of the following four options is usually the best fit.

1. Profit Sharing Without Equity.

The first option is to recognize that there are potentially negative tax implications if you give your employee equity and to not grant them any equity at all. You could instead have an employment agreement to provide the employee with a percentage of the net profits from your business as a bonus. The employee would still get the benefit of getting a percentage of the net profits without having to go out of pocket to purchase their equity or potentially having to recognize as taxable income the fair market value of the equity.

A drawback to this approach is psychologically people are often motivated more when they own equity in a company than with a profit sharing plan even if the net take home is the same. Their is something innately appealing to owning a piece of the company that you work for.

2. Grant Equity.

If you grant your employee equity the employee might have to recognize as taxable income the fair market value of that equity just as if you had given the employee a car, a house or anything else of value. One of my favorite examples of this concept is if you were to get a World Series ring for working for a Major League Baseball team you would have to pay taxes on the fair market value of that ring. The same could go for the equity that you give to your employees.

You could pay your employee a bonus to cover that tax liability but the bonus would be taxed. For example, if you grant your employee $100,000 worth of equity and you wanted to cover that employee’s tax bill for getting the equity you might have to bonus the employee $100,000 so after the employee pays taxes the net amount is enough to cover the taxes they owe for being given their equity.

As such, a drawback to this approach is there could be two layers of taxation: (i) first when you pay the bonus and (ii) again when the empoyee pays taxes on the fair market value of their equity. Uncle Sam loves approach. Our clients? Not so much.

3. Sell the Equity To Your Employee For its Fair Market Value.

A third option is you could sell the equity to your employee for its fair market value. The advantage to this approach is the employee might not have an immediate taxable event.

A drawback is the equity would be less of an incentive as the employee would write a check to your company. “Thank you for the equity that I paid for?”

4. Sell Equity For its Fair Market Value Which is Paid with a Loan.

The approach that most of our clients like the most is to sell the equity for its fair market value but the purchase price is repaid pursuant to a promissory note.

An advantage to this option is the distribution payments the employee would receive from owning their equity could be used to make payments on the loan for the purchase of that equity. As such, not only will the employee might not have an immediate tax bill, but their equity could pay for itself from distribution payments.

5. Operating Agreement or a Shareholders Agreement.

For any of these options, it is a good idea to also have an Operating Agreement (if you have an LLC) or a shareholders agreement aka a buy/sell agreement (if you have a corporation) to provide the company with the option to repurchase the employees’ equity when there is a triggering event such as when the employee dies, becomes permanently disabled or is no longer working for the company.

The repurchase price could be: (i) the proceeds from a life insurance or permanent disability insurance policy, (ii) based on an equation (such as [x] times the prior years gross receipts) or (iii) an appraiser could determine the fair market value of the equity. The agreement could also provide that an appraisal would only be required if the parties cannot agree on the fair market value of the equity within a certain time period (often 30 days).

One of the advantages to this option is the employee would benefit if the value of their equity increases while they are working for the company but the company would have the peace of mind of knowing that it would have the option to repurchase the equity if the employee is no longer adding value to the company.

6. More Equity Could Be Purchased or Granted Overtime.

Lastly, with any of these options it is important to keep in mind that the employment agreement could provide that the employee would get more equity overtime in separate tranches. This could further motivate your employee to continue to work hard for your company knowing that their piece of the equity pie could increase.

As you can see, there is not a one sized fits all solution. You should invest in analyzing with your CPA and business attorney which option is best for you, your business and your employee. If you do not already have a great business attorney, please do not hesitate to reach to contact us at info@bendlawoffice.com or (415) 633-6841.

Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal or tax advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.