Giving Stock to Employees

Posted by Thomas E. Sowers on

Owners of closely-held corporations often consider making stock or stock options part of their employees’ compensation packages.  Because of the struggle many closely held companies face with attracting and retaining key personnel, granting or selling stock to employees seems like a good way to accomplish both of these goals.  For many start-ups not able to pay as well as more mature companies, stock options (or other grants of stock) are often a very necessary part of attracting key employees.  For more established closely-held companies, many view granting equity as a key component in the retention of certain employees.  Many companies also consider giving stock as a way to incentivize employees to perform better.

The two most common types of employee equity awards are stock options and restricted stock.  Stock options involve granting an employee the right to buy shares of the company’s stock at a set exercise price (the exercise price is typically the fair market value of the share of stock).  The options will vest over time and be exercisable for some period of time (five to ten years, usually, with ten years being the most common length of time).   A restricted stock award generally involves an outright grant of shares to the employee, which often involves selling the restricted stock to the employees at a nominal price.  Like stock options, the restricted stock award will usually vest over a period of time (four or five years is a common vesting period).

When evaluating whether to award stock or options to employees, a privately held company should consider the following:

Alternatives.  Alternatives to granting equity to employees exist. Stock appreciation rights (SARs) and phantom stock are two commonly used non-equity alternatives.  Both of these alternatives can have the desired effect and will not create the issues that granting employees true equity ownership in a company creates (see “Legal Implications” below).

SARs generally involve the grant of the right to receive payment based on the growth of the value of the employer’s stock. SARs are typically granted to an employee at fair market value and upon the occurrence of a triggering event (such as a sale of the company or the termination of the employee’s employment, including death or disability), the employee would be entitled to receive an amount equal to the appreciation of the SARs from the date of grant to the date of the triggering event.  So SARs are non-equity awards to employees that resemble stock options because the value is based on the appreciation of the underlying share unit.

Phantom stock, on the other hand, involves a non-equity award to the employee of the right to receive the full value of a share of the employer’s stock, typically upon the occurrence of the same trigger events described above for SARs.  In this way, an award of phantom stock resembles a restricted stock grant because the value of the award is based on the value of the underlying share of stock (rather than the appreciation of the underlying share).

Legal Implications.  When determining the type of equity-based compensation to use (equity-base compensation includes the non-equity SARs and phantom stock because it is based on the value of the company’s equity), employers should be mindful that the award of restricted stock to employees creates legal issues for the employer that the award of SARs and phantom stock do not create (this would also be the case with an award of stock options if the options are exercised).  To begin with, the majority shareholders in a closely-held Georgia corporation have a fiduciary duty to the minority. 

A majority shareholder’s fiduciary duties to minority shareholders can be described as a duty to act in good faith when managing corporate affairs and a duty to treat the minority shareholders fairly and equitably.  In a closely-held Georgia corporation, if a majority shareholder breaches his fiduciary duty to the minority shareholders, the minority shareholders can bring a direct action against the majority shareholder.  In addition, in Georgia, the breach of the majority’s fiduciary duty to the minority shareholders can lead to an award of punitive damages. 

One common area where the majority’s fiduciary duties may come into play is the compensation of the majority shareholders. If the majority shareholders determine the amount of their own compensation, then it could be challenged by a disgruntled minority shareholder as being excessive and, therefore, taking away proceeds that would otherwise be available to the shareholders.  Also, expense reimbursements and company loans to majority shareholders (if the terms of the loan are too favorable to the shareholder and not market) could also be challenged.

In addition to the fiduciary duties created by granting stock to employees, there are general statutory corporation law requirements of which the company should be mindful.  Under the Georgia corporations code, a shareholder of a Georgia corporation is entitled to inspect certain board resolutions, minutes from all meeting of the shareholders, all shareholder communications, as well as company financial records.  Also, the Georgia corporations code contains many requirements of corporations regarding corporate formalities such as the requirement to hold annual and special shareholder meetings and deliver certain information to the shareholders.  Any closely-held corporation not properly following these requirements would be wise to follow them once shares have been given to employees.   

Thus, by bringing in minority employee-shareholders, the company would be creating a situation where a disgruntled employee-shareholder would have rights to access certain information of the company and, because the employee now has legal standing to sue over certain issues (such as compensation level of the majority shareholders), the employee could become a nuisance if he or she wanted to.  Also, bringing in minority shareholders will very likely increase a company’s administrative and legal costs in order to properly comply with the corporate formalities required by the Georgia corporations statute, as well as to create and implement the plan and communicate with recipients under the plan.  For example, a valuation of the corporation is often necessary in order to determine the appropriate price to assign to the stock or options being awarded to the employee. 

All of the above highlights that a very important part of granting equity ownership to employees involves thinking through the important terms of a shareholders agreement (or other agreement) to be signed by all employee shareholders.  The agreement should spell out issues relating to the transferability of the equity.  For example, the mechanics required before an employee is ever allowed to transfer the shares granted him (if ever). Also, a company would be wise to give itself an option to redeem the vested shares of any employee whose employment with the company is ending.  Other provisions such as a drag along provision requiring the minority shareholders to sell their shares in a transaction desired by the majority shareholders, are important to keep the minority shareholders from interfering with a potential deal.

Other Considerations.  Here are some of the other key things for an employer to think through when determining whether to grant equity-based compensation to employees and the type of equity-based compensation to use:

First, granting equity-based compensation makes the most sense and has the greatest chance of properly motivating employees or helping retain them – if the company is growing rapidly and there is a realistic chance that the company goes public or is purchased in the not too distant future.  Due to the illiquidity of the stock, an employee is not likely motivated to wait for an exit event that seems far off in the future.  

Second, when determining which type of a equity-based compensation to grant, the primary question the company should answer is whether the purpose of the award is to incentivize the employee or to retain the employee.  In general, awards that are based on the underlying value of the stock will have a more retentive effect.  This is because even if the company suffers through a down period and the value of the stock decreases, the executive would still be leaving money on the table by leaving prior to the vesting of all of the award shares. 

On the other hand, if the purpose of the award is to incentivize the employee to perform better, then for executive level and higher management level employees in a position to influence a company’s value, SARs or stock options may be a good choice of equity-based compensation because their value derives from the appreciation of the stock unit, which, again, the higher level employee will have an ability to influence.  If the reason for the award is to motivate, for many employees, particularly those below the executive level, cash is often a better motivator than equity-based compensation.  This is because many employees will fail to see any value from an award of stock options due to the illiquidity of the stock and the SARs. 

Third, in order for an award of equity-based compensation to truly motivate, it must be of significant value relative to the employee’s compensation level.  If the purpose of the award is to retain the employee, the amount of the award needs to be enough to make the employee think twice about leaving. 

A lot of factors need to be considered as to whether to grant equity-based compensation to employees, and the type of equity-based compensation to use for a particular situation. As discussed above, there are legal implications associated with grants of stock to employees.  Also, the costs and time needed to create and implement the plan, and to comply with other legal requirements, should all be factored in to whether to grant equity-based compensation.