Cash flow is tight for many companies, and cash may be needed to take advantage of opportunities today that will maximize future growth and profits. But cash isn’t the only way to reward employees. One idea is to give your key employees an ownership interest.

Many employers will attest that with proper incentives, employees perform at higher levels, recognizing the financial awards that may lie ahead. They approach their jobs with “owner hats.” This motivation can be contagious and have a ripple effect throughout the employee ranks.

Yes, you give up something by sharing ownership, but your hope is that you get more in return—greater productivity by all will increase the value of your ownership interest. And you will still be the controlling shareholder, so do you really have much to lose?

The answer is yes, unless you first think about possible consequences and make sure you protect yourself and your company.

Minority Shareholders
Just because you may own 95 percent of your business does not mean you can do what you want. The laws of the state where your company is incorporated will give certain rights to your minority shareholders. These rights go beyond voting rights. Minority shareholders may have the right to demand that officers, directors or majority shareholders of the company not act contrary to its interests.

The parties in control are “fiduciaries,” who are charged with acting in the best interests of all shareholders, including minority shareholders. Also, minority shareholders may be entitled to corporate records. They may have the right to maintain their ownership interest or, if they are squeezed out, the right to receive fair market value for their interest (and the legal ability to challenge the valuation method). The irony is that action you have taken to enhance your profits may, in fact, drain your profits.

Employment Termination
Before you compensate key employees with ownership shares, build in your ability to recover the shares if the employment arrangement ends. Have the employee sign an agreement in exchange for the shares. Encourage the employee to consult legal counsel to avoid subsequent claims of misrepresentation or coercion.

The agreement can give you the option to repurchase the shares upon the employee’s termination of employment, or can provide that your repurchase of the shares, or the company’s redemption of the shares, is mandatory at such time. The agreement also can prohibit any transfer of the shares by the employee during employment.

The agreement should specify the method for determining the repurchase price (such as an adjusted book value or a multiple of earnings), as well as the payment terms (such as installments for a fixed period). A minority discount may be appropriate. You should carefully discuss these provisions with your accountant or lawyer.

Also, be sure to state in the agreement that you can terminate your employee at will. This is important, as some states may otherwise give a minority shareholder/employee protected employment status. This also may be an opportunity for you to seek other commitments from your employee, such as a covenant not to compete or a confidentiality agreement.

Alternatives to Stock Grants
If you prefer not to share ownership of your company with your employees, you can motivate them with phantom stock. Phantom stock gives them the value of stock ownership without the associated legal rights. A phantom stock arrangement may provide a cash distribution at a certain date based upon the share value at that time. Payment may be in one lump sum or installments over a period of years.

Another idea is to grant stock appreciation rights. This is a right to receive payment at a future date measured by the appreciation in the company value over a designated period of years. The terms of phantom stock or stock appreciation rights should be set forth in a written plan or agreement. Again, this is an opportunity to seek noncompete or confidentiality commitments from your employees.

Final Advice
Talk with your legal and tax advisors before making any promises to your employees. It can be easier than you think to inadvertently create a contract. You may only learn you have done this after your employee leaves. Also, new tax laws may treat these arrangements as “deferred compensation plans,” which must be structured properly to avoid an inadvertent tax consequence. If your business is an LLC, then special tax issues may apply to a grant of a membership interest. And finally, if your goal is the short run and not the long run, an easier alternative is an annual cash profit sharing payment—always a winner.

Margo C. Soulé is a partner with Sonnenschein Nath & Rosenthal LLP, practicing in the fields of employee benefits and individual wealth accumulation planning. She can be reached at (816) 460-2642.