Company equity can be a lucrative tool to encourage loyalty and incentivize performance from valuable employees. Unlike larger companies, closely held businesses have unique dynamics and limited shares or membership interests, making the decision to share ownership significant and impactful. Equity can give employees a sense of ownership, aligning their interests with the company’s long-term success. However, issuing equity to employees also comes with legal and operational considerations, particularly when deciding whether to issue actual shares or explore alternative methods. Our last blog centered around issuing equity to owners. In this blog, we’ll explore the motivations for offering equity to employees, the legal steps involved for both LLCs and corporations, and some practical alternatives for closely held businesses.
Issuing Equity in an LLC
Limited Liability Companies (LLCs) and corporations have different processes for issuing equity. In an LLC, equity is typically referred to as “membership interest” rather than “stock.” There are two primary ways to issue equity in an LLC:
• Granting Membership Interest: In this method, the employee is given percentage ownership in the company, entitling them to a share of profits and potentially voting rights. This approach is similar to traditional stock but requires careful planning.
• Profits Interest: This form of equity gives employees a share of future profits but doesn’t give them an immediate ownership stake. Profits interest is often tax-advantaged since it can be structured to avoid immediate taxation for the employee. It is popular in LLCs because it grants equity without immediate ownership dilution or the creation of new shares, which helps maintain control among existing members.
When equity is issued, the business must update the operating agreement to reflect the new ownership structure, address the member’s voting rights, and include buy-back or vesting provisions to protect the business if the employee exits the company. In making these updates and decisions, a business should also account for any unintended consequences (for example, issuing different “classes” of membership will compromise a company’s S-Corp tax election) and ensure compliance with IRS guidelines on taxation. Accordingly, businesses should take care to involve the proper professionals in the equity-issuing process.
Issuing Equity in a Corporation
Corporations offer a different structure for issuing equity, typically through issuing shares of stock. Small corporations can issue stock to employees in various forms, including the following:
• Stock Options: This is a common way to grant equity in corporations. Stock options allow employees to purchase shares at a set price in the future. Employees often find this appealing if they believe the company’s value will increase. Options are typically subject to a vesting schedule, which incentivizes employees to remain with the company for a certain period in order for their options to vest.
• Restricted Stock: With restricted stock, an employee receives shares but must meet certain conditions, to fully own them without various restrictions. If these conditions aren’t met, the employee could forfeit the stock. This method can be effective for closely held businesses that want to reward long-term loyalty and performance.
• Incentive Stock Options (ISOs): ISOs are stock options available to employees that allow deferment of taxes until the shares are sold and qualify for capital gains rates.
Like their LLC counterparts, corporations should involve the proper professionals (namely, CPAs and lawyers) when issuing stock. The foregoing plans must comply with IRS rules, and corporations often need a formal board approval process. Additionally, the corporation should update its shareholder agreement to address voting rights and potentially establish buy-back provisions. If the corporation did not authorize difference class of stock at incorporation, the company will also need to amend its Secretary of State documents to allow for any decision to issue voting and non-voting stock.
Compliance and Regulatory Considerations
SEC and Blue Sky Laws. One of the most critical compliance considerations when issuing equity to employees is SEC compliance. Offering equity-based compensation plans—both in a corporation or an LLC—can trigger SEC and other regulatory requirements, even for private companies.
Under the Securities Act of 1933, any issuance of stock, options, or equity interests is generally a securities transaction. Closely held and small companies can often rely on exemptions under Regulation D to avoid public registration if they meet certain qualifications, but they still must register for the exemption. Certain plan disclosures are also required depending on the size of the issuance.
State securities laws also require private companies to file certain notices or qualify for state-specific exemptions when issuing securities to employees, even when federal exemptions apply. Compliance with both federal and state laws is necessary to avoid potential penalties.
IRS. To avoid penalties, deferred compensation plans, including stock options and SARs (described below), must meet IRS Section 409A rule and other general tax laws governing the taxation of income. It is vital that companies consult a tax professional if they decide to issue stock to employees.
Alternatives to Issuing Equity
For companies that want to incentivize employees without transferring ownership or dealing with the administrative burden and compliance risk of issuing equity, there are several alternative options that offer compelling benefits. These alternatives can help preserve the owner’s control over the company while still aligning employees’ interests with company performance. Common alternative options include:
• Phantom Stock. Phantom stock is a type of bonus plan that provides employees with the financial benefits of stock ownership without actually transferring any company shares. Instead, employees receive a cash payout equivalent to the value of the company’s stock or a set number of “phantom” shares at a specified future date or event.
A phantom stock plan outlines the conditions for when and how employees will receive their payout. These conditions often include a vesting period, meaning employees must remain with the company for a set amount of time before receiving any payout. Payouts are typically tied to a company valuation at the time of the vesting event, giving employees a vested interest in the company’s growth.
Although it avoids ownership transfer, phantom stock plans still require formal agreements defining the vesting schedule, payout terms, and specific events that trigger the payout. Phantom stock is generally treated as taxable income for the employee when paid, and the company can usually deduct the payout as a business expense.
• Stock Appreciation Rights (SARs). SARs are similar to phantom stock in that they provide employees with a cash bonus tied to the company’s stock value increase without giving them ownership or voting rights. However, SARs differ because they pay employees based only on the increase in the shares value over a pre-established period, not the full stock value. For example, if an employee receives SARs when the stock is valued at $5 per share and later exercises them when it’s worth $15, they receive $10 per share. Accordingly, the company can narrowly tie the employee’s reward to value that is generated during the employee’s tenure. This approach helps preserve equity for existing shareholders while still providing financial motivation for employees to help the business grow.
SARs are often granted with a vesting schedule, and employees can “exercise” them after the vesting period, receiving a payout based on the increase in the company’s stock value. SARs can be paid in cash or sometimes as additional shares, depending on the company’s preference and resources.
As is the case with phantom stock, companies should draft a clear SARs agreement to help prevent misunderstandings and ensure employees know the conditions for their payout. Companies offering SARs should consult with legal and tax professionals to structure the plan in a way that aligns with tax requirements and maximizes benefits for both the business and the employees.
• Performance-Based Bonuses. Performance-based bonuses are a simpler, direct way to incentivize employees based on individual, team, or company-wide performance goals. While bonuses don’t give employees a stake in the company, they can still be highly motivating, especially if structured to reward employees for the company’s overall success.
Bonuses can be easier to manage and implement compared to equity or equity-like plans and are ideal for businesses focused on short-term achievements or without the desire for long-term financial commitments tied to company ownership. Performance-based bonuses also offer flexibility, allowing companies to adjust bonus amounts based on annual performance, profitability, or available cash flow.
Well-structured bonus plans should clarify any expectations, including payout timing and qualifying conditions, to manage employee expectations and minimize disputes.
Key Takeaways
For businesses, issuing equity is a strategic tool that can strengthen employee loyalty, increase productivity, and attract talent. However, it requires careful planning and legal oversight. Frequently, alternatives like phantom stock, SARs, or performance-based bonuses sufficiently serve the company’s goals and are preferrable to actual transfers of ownership. Companies should consider the decision to issue equity with care and under the advice and counsel of legal and tax professionals.
Contact Skufca Law at (704) 376-3030 today to learn more about issuing equity to employees in a closely held company and other questions related to starting a business. Next up in our Starting a Business series, we will discuss issuing equity to investors and how it is treated in an LLC versus Corporations.