You are considering introducing Employee Ownership to your firm. What is the best type of Employee Ownership for you? That depends on many things: the current legal status of your entity, your budget, but perhaps most important of all, your objective. Here are some reasons why companies often consider Employee Ownership.
Incentivizes Employees
Managing people is far simpler if you convince them that their interests and company interests are aligned. Nothing achieves this more starkly than offering employees a piece of the pie they are baking. As I’ve written before, when we introduced an employee ownership plan at IdeaRocket it dramatically improved our workplace culture.
Lower Salary Spend
Many of today’s professional service and technology companies don’t need much cash for Fixed Asset investments; their companies are basically people on computers, so their big cash need is for salaries. By making Employee Ownership a part of the compensation package, these companies can lower their cash needs.
Fund the Company
While most Employee Ownership Plans issue stock or options as a benefit, once a market has been created it is possible to offer Employees the option of buying shares in the company. If companies need an infusion of cash and they have employees with the will and means to buy, this can be win-win for all.
Create a Buyer
Employee Ownership can also provide a way for a departing Founder to sell his company to insiders. It can also be part of a succession strategy, even if the Founder has no intention of selling her shares.
So what are the major types of Employee Ownership? Let’s start with some options that involve a true ownership interest and can potentially fulfill all of the above objectives. Then we will discuss some alternatives that give employees a taste of the company’s upside, but won’t deliver on all of these objectives.
ESOP
ESOP stands for Employee Stock Ownership Plan. It is a kind of benefit program where a company sets up a trust fund that can buy shares that it grants to employees. The beauty of this arrangement is that the company can contribute money to the fund in a tax-advantaged way, or the fund can borrow money in a tax-advantaged way. ESOPs are sometimes used to buy out a departing owner’s interests, but many larger companies use them purely as an employee benefit. The NCEO has an excellent discussion of the uses of ESOPs and their pros and cons here.
ESO
A common form of compensation in technology startups is the Employee Stock Option. Granting shares to the employees of a startup would be a taxable event that would likely not be welcomed by job applicants since startups are often risky ventures. Instead, companies choose to give their employees the right to buy a share at a set price, for a finite period of time. Usually these employees need to stay with the company for a vesting period before they can exercise their options. If the company succeeds and goes public – or is bought out by another company – then the options can be exercised and might mean a big payday. If the company fails, the options can go unexercised and the employee has incurred no tax cost.
Profit Interest in a Holding Company
There are some disadvantages to giving ownership shares to an employee. Flow-through entities generally cannot deduct the health insurance expenses of owners from their taxes. Given how necessary health insurance is to attract employees, and how important that deduction is to businesses, this can be a deal-breaker. To resolve this conundrum, sometimes companies offer a profit interest in a holding company. Another advantage of this legal structure is that it is more economical to set up than a C- or S-Corp.
Now let’s discuss some options that don’t involve a true transfer of equity, but do give employees a share of the spoils. These options are only likely to fulfill the first of the objectives listed above: they incentivize employees.
Phantom Shares
Phantom Shares, sometimes also called Shadow Stock, are a contractual commitment from a company to an employee that simulates many of the advantages of stock ownership. These shares might mirror the value of a stock, net revenue results or some other variable. They can be designed to provide a dividend, to allow employees to sell them back to the company at their will, or both. Phantom Shares are treated for tax purposes as compensation, and they are inherently a very flexible instrument.
Traditional Profit-Sharing Plan
Under a traditional profit-sharing plan, a company sets up a pool of funds that can be a percentage of net profits, if the company chooses. They then commit to a pre-defined method of calculating distributions from this pool to employees, the most common being the comp-to-comp method that divides the pool among employees based on their share of total compensation. If this plan follows certain IRS-defined rules, a profit-sharing plan can provide tax-advantaged contributions to retirement accounts. This is not to be confused with a 401(k) account, which offers employees the opportunity to contribute funds from their regular compensation.
Cash Profit Sharing Plan
If your employees don’t care much about the tax advantages of a Traditional Plan, or they would prefer to have the cash in their pocket rather than in a retirement account, a cash profit plan based on a percentage of the net revenue can be a simpler option with more attraction to younger employees. Since there are no IRS rules to follow, these plans are far easier to administer.
If you are interested in the benefits of employee ownership, talk to your lawyer and accountant about what is the best solution for you. Types of employee ownership vary widely in legal expense and tax consequences. Whatever you choose, remember that the job won’t be done when the papers are signed; communicating your plan to your employees will be crucial to unlocking its benefits.
