How can owners incentivize without giving equity

Incentivizing employees may be one of the oldest conundrums of business strategy. Especially for closely held, owner-managed and family-owned businesses, there has rarely been a simple path to having high-level employees truly embrace increasing the value of the enterprise.

The trick is aligning the interests of the ownership and those of teams that are key to growth — without assigning equity that triggers the obligations of a legal partnership. One of the great misinterpretations among owners is that they create a clean system by presenting non-voting stock or equity on the condition of a buy back if the employee leaves. But as soon as the stock is granted, the majority owner owes them fiduciary duties.

There are, however, legal devices that have been developed to help owners create a more unified environment while maintaining 100 percent control. While there are nuances depending on where the company is incorporated, here are a few alternatives to equity ownership that will still inspire a connection to the organization’s overall success:

  • Phantom stock 

“Phantom stock” can be very effective in aligning interests without dispensing equity and can be used by corporations and LLCs alike.

The owner can set a value of a share of stock (or have a valuation done) and then create an accounting unit based on the share value as of the date the unit is granted to the employee.

When the employee then hits certain defined events — for example, annually or when the employee retires — the company will pay the employee the amount by which the share of stock increased in value. This sends a clear message to employees/managers: if they help raise the equity value of the business (as opposed to just their unit or department for example), they will share in the appreciation.

The good news for owners is that they don’t have to pay the cash up front. The “less good” news is that the phantom stock is treated as a liability on the balance sheet so you need to be careful with your bank covenants.

Also, for the employee, when the cash is paid it’s taxable as ordinary income to the employee and not as capital gains. To make employees happy, a simultaneous additional bonus can offset the taxes but that may increase the total payout significantly.

  • LLC advantage: non-voting interests

If you are a Delaware LLC you have an ace in the hole. You can create a membership interest to which no fiduciary duty is due and is totally a silent no voting, non-bothersome interest. These interests are powerful tools that are specific to LLCs incorporated in Delaware. They provide the flexibility to eliminate the fiduciary duty to all or some of the LLC’s members, essentially creating a position with no rights or privileges, only the benefit of the increased value of the interest.

Owners can also build in all the protections they want, such as buy backs and drag-along rights.

There are two principal kinds of interest that can be created. A capital interest is more straightforward and will be taxed when it’s first received. A profits interest is designed for greater growth potential, and is not taxed when it is granted to the employee. The employee gets an interest in the business, is not taxed when it is granted and gets capital gains treatment when it is sold — a trifecta for owner and employee.

  • Classic stock options

The classic stock option vehicle is also available to LLCs and corporations. To add protection for the owner and avoid the fiduciary duty that happens with corporations or non-Delaware LLCs if the option were to be exercised, it can be only exercisable and only vest if the company is sold or the stockholder voluntarily leaves the business. Owners can build in a buyback right to guard against an employee keeping stock if the employee leaves.

As with phantom stock, the business does not get taxed when the option is granted and the employee only has a tax when the option is exercised — on the sale of the business or when he leaves and his stock is repurchased.

Growth does not come easily, and owners need to find employees they trust who are motivated to move the business in the right direction. Putting an incentive plan in place with the right legal and tax structure will help keep the core team focused for the long term. 

Frederic Marx is a partner and former chair of the Business Law Group at Hemenway & Barnes LLP.