Employee Incentives in a Family Owned Business

You may believe that your family-owned business has no use for stock options.  You are not going to issue equity outside of the family, so stock options are of no value with respect to non-family member employees. And your employees that are family member are going to inherit the business, so that is their incentive to perform and grow the business.

But what if there are other tools you could be using? Equity incentive does not have to come just in the form of traditional stock options. There are countless permutations of ways to align an employee’s or consultant’s interests with the growth of the business. Consider just a few of the following:

If the concern is to avoid giving true equity to non-family members, phantom stock or stock appreciation rights can provide the economic equivalent of equity without actually issuing stock. Both are contract rights that are intended to give value to the employee commensurate with the value of the company stock.

• Stock appreciation rights are a contractual right of the employee to receive cash or stock in an amount equal to the increase in the price of the stock over time.
• Phantom stock is a contractual right of the employee that mirrors a restricted stock grant – the employee receives an account credited with a certain number of hypothetical shares and, at some point in the future, the company pays the employee an amount equal to what the employee would have gotten had she sold the same number of real shares.

In both scenarios, the company can subject the rights to a vesting schedule, which can be based on time, performance, operation benchmarks, etc. This schedule can be helpful in creating specific incentives. And in neither situation does the employee ever get true equity in the company or any voting or other rights that would go along with equity.

With respect to family members, the value of equity incentives may be in the ability to fashion a vesting schedule. The patriarch or matriarch may not want to hand over the company to the next generation until after they have proven themselves, but the next generation does not want to make the commitment and put in the labor with the family business without the assurance of a smooth ownership transition. With an equity incentive vesting schedule based on time, the family member will incrementally own more and more of the company over time. For some family members this may be a much better incentive because their commitment and labor are being rewarded continually over time, rather than in anticipation of a future hand off of ownership and control.

In other words, we should not be so quick to dismiss the notion of equity incentive just because yours is not the typical corporate situation. There is a lot of flexibility, and there are different ways to align employees’ interests around the growth and success of your family-owned business. 

Of course, in evaluating alternatives, be sure to first consult with your tax advisors closely, specifically for issues such as when the rights are taxable to the employees and whether or not there are any issues under Section 409A of the tax code.