If you are a business owner in North Carolina, you have probably considered extending equity in your company to your employees. Before doing so, it is important to understand the different types of equity compensation and how they work.
Here, we provide a high-level overview of common types of equity compensation. Please note, however, that you should always seek the advice of an experienced attorney before making a decision particular to your business.
What Is Equity Compensation?
At its most basic level, equity compensation is essentially a means of offering employees an ownership interest in a business. Depending on your business’s structure (e.g., corporation vs. LLC), your options for offering equity interests will vary.
Equity compensation is offered as a way of attracting and retaining quality employees. In addition to a standard compensation package, equity compensation encourages loyalty and gives employees an incentive to stay with the company for the long-term or at least until their stock options vest.
While there are numerous types of equity compensation, each with their own nuances, here we will discuss a few common ones: corporation stock options, corporation restricted stock, LLC capital interests, and LLC profits interests.
Stock options give employees the right to purchase stock in a company, at a set price, in the future. The price is determined when the options are granted, meaning if the shares of stock increase in the future, employees will have the option to purchase the stock at a lower price. Employees can choose not to exercise their option to purchase the stock in the future if the stock price decreases in value (or for any other reason).
Businesses usually issue stock options through something called an employee stock option plan. Under this plan, a company will typically identify a vesting period (usually three to five years) in which the employee has the right to exercise his stock options. If the employee leaves before the vesting period ends, the employee gives up the right to purchase any stock options that have not yet vested, as well as any that have vested but that the employee has not yet exercised.
Unlike stock options, which vest over time and therefore do not grant an ownership interest in the company until a future date (and even then, only if the employee chooses to exercise his option to purchase), restricted stock is an immediate ownership interest in a business. This type of equity compensation is generally only offered to executives and directors of a company.
Restricted stock is “restricted” precisely because it carries certain conditions: this type of stock is non-transferable and can only be traded in accordance with SEC regulations. As such, if you are considering issuing or transferring restricted stock, be sure to consult with legal counsel before doing so.
LLC Capital Interests
If your company is an LLC, you cannot grant stock options or restricted stock. However, you can still grant equity interests in your business to your employees.
The first common type of LLC equity interest is a capital interest. This entitles a holder to a percentage of the LLC’s capital at the time of the grant. For example, if you receive a grant of a 1% capital interest in an LLC that is valued at $500,000, your interest on the date of the grant would be worth $5,000.
As with all types of equity compensation, there are potential tax consequences to both the business and the employee who receives the grant, so you should consult an attorney who specializes in business law to discuss the best approach for your business.
Profits Interest in an LLC
The second type of equity compensation for an LLC is a profits interest. This type of equity compensation entitles a grantee to a share of the LLC’s future income and appreciation of its assets.
For example, if an employee is granted a profits interest in an LLC equal to 1%, the employee will have the right to 1% of the LLC’s profits after the date he received the profits interest. This is their right to all future income of the business. In addition, the employee will have a 1% right to any appreciation in the LLC’s value. In other words, if the company was valued at $500,000 on the date the employee received the profits interest and a year later the LLC is purchased for $1,000,000, the employee would be entitled to 1% of the appreciation in value or 1% of $500,000 ($5,000).
Pros and Cons of Offering Equity Compensation
Equity compensation is an excellent tool for businesses looking to reward, retain, and incentivize employees. In addition to standard salaries, equity compensation allows a company to offer a more robust compensation package to its employees while conserving cash flow for other business purposes. Equity-based compensation packages also align employees’ interests with that of the business, thus incentivizing employees to be invested in the company’s future and to maintain a strong connection with the company.
Benefits notwithstanding, before offering any type of equity compensation, businesses should remember that they are giving away a piece of the ownership of their company when they do so. Equity is limited and as such, caution is warranted in parting with too much. Business owners should also be sure only to give ownership, which at times comes with certain voting rights in the business, to the most trustworthy employees.
Equity compensation is complex. Not only are you granting ownership in a portion of your business to others, but it carries substantial tax, accounting, and legal implications. As such, it is extremely important to consult your advisors before granting any type of equity compensation. At Wilson Ratledge, we specialize in advising small businesses with deciding whether and what kind of equity compensation plan is right for their business. Contact us today to discuss your business needs and see how we can help set you and your employees up for success.