Equity Compensation Plans and Alternatives for Family Businesses

To provide long-term incentives to top employees and align their interests with their employers, many businesses offer some kind of equity compensation. However, when a business is owned by a family, the decision to provide equity to a third party becomes more difficult. This article discusses what alternatives are available to family businesses regarding equity (or equity-ish) compensation.

Actual Equity

Family businesses may opt for a traditional equity compensation plan. This type of arrangement often takes the form of stock options or restricted stock. The end goal of this type of arrangement is that the recipient has the ability to acquire true equity in the company and become a partial owner as a result. Thus, as the company does better, the executive's ownership interest increases in value. However, if the executive in question is not a family member, the family owners may be hesitant to convey actual equity.

One primary reason family business owners may be reluctant to transfer ownership interests to non-family executives is a desire to keep decision-making activities within the family. In most situations, the awards to non-family executives will not be large enough to dilute the voting power of family members. Plus, the organization can be structured to have different classes of equity—both voting and non-voting. (On this point, note that even a corporation that has elected to be treated as an S-corporation, and as a result can only have one class of stock, can still have a single class that includes both voting and non-voting shares.)

However, equity holders have rights under state law to a certain level of information about the company, and (perhaps more importantly) will have an expectation to be kept informed of company decisions and how they are made. For some family-owned businesses, this degree of transparency may represent a departure from past practices and an unwelcome change.

Another reason a family-owned business might prefer to keep ownership within the family is to avoid addressing potentially cumbersome transfer restriction and buy-back provisions. Stated another way, if non-family members are going to become owners, the family owners will generally want to implement a shareholders' agreement or buy-sell agreement to regulate what non-family owners can (and cannot) do with their equity at the end of their employment.

These agreements typically provide the company (or the family owners) the right to redeem the non-family owners' equity, and restrict the rights of non-family owners to sell the equity to individuals other than family members. These agreements can be quite complicated, so to avoid such complications, many family-owned businesses avoid the problem by declining to use equity as incentive compensation.

In addition, the conveying of equity to employees will inevitably raise issues under federal and state securities laws. These laws typically have available exemptions for the transfer of equity as a form of compensation, but securities compliance is one more potential problem that must be addressed before using traditional forms of equity compensation.

This is not to say that using equity as incentive compensation in a family-owned business is a bad idea—the point is that the concept raises some issues unique to a family-owned business. A thorough analysis should precede any implementation of an equity incentive program.

Phantom Equity

Given the potential concerns associated with using actual equity as incentive compensation, family businesses may want to seriously consider phantom equity. The term "phantom equity" encompasses a wide range of programs that are designed to convey a benefit similar to actual equity, but without conveying a true ownership interest.

For example, phantom equity could be conveyed through stock appreciation rights (SARs), which are designed to pay recipients the increase (if any) in the value of a share of stock from the time the SAR is awarded until the time it is redeemed. The program can specify under what circumstances SARs will be redeemed (such as after the passage of a certain number of years, upon a termination of employment, etc.).

Another approach would be restricted stock units (or RSUs), which are designed to pay, in the future, the value of a designated number shares of stock.

Long-Term Incentive Plans

Another option for family businesses is to simply pay executives under a program that tracks the performance of the company over a period of time (sometimes called the "performance period"). Often referred to as long-term incentive plans (LTIPs), these arrangements provide a formula based on some objective determination (such net profit, gross sales, or EBITDA), and then pays out a benefit based on the company's success during the performance period.

Again, these programs can take a variety of forms, and are typically tailored to the specific company's industry and goals. The key is to tie the potential payout to the measureable outcomes that the owners want the executives to focus on the most.

Conclusion

By offering an equity compensation plan, or one of its close relatives, companies can simultaneously create value for themselves and their employees. All of these arrangements raise tax and other legal issues that need to be addressed, as well as potential accounting considerations.

If you would like to implement such a plan at your family business, be sure to consult qualified legal, tax and accounting counsel in order to navigate the many federal and state regulations that govern such plans.