Mister Five Percent
Fairly regularly I get a call from one of my clients who wants to reward a key employee by giving him or her a small ownership interest in their company. However, they fail to comprehend all of the ramifications of making someone an owner. Below I will discuss the pitfalls and alternate ways to reward your employees.
Usually the key employee in question has worked for the company for a while or is an important new hire. The logic is that by making them an owner, the employee will be more motivated to do a good job and stay with the company for the long term. But, there are many legal rights that an owner of a corporation or limited liability company has that may not make that the best idea.
One issue relates to the new owner’s right to vote with the other shareholders. If there is only one owner of the company and the employee is given say 5% of the company, the existing owner maintains control over the company. In most companies the majority rules so the owner that still retains 95% of the company will remain in control. However, many of my clients have two owners that each own 50% of the company. In that instance, if majority rules, both of the owners have to agree on all the important decisions concerning the company since neither has a majority on their own. Adding a new owner can upset that balance of power.
In our 50%/50% example above, say you were to give an employee 10% of the company. Then the other two owners would be left with 45% each. So now, if the 10% owner votes with one of the 45% owners they collectively have 55% of the vote, a majority. The result is that if the two majority shareholders disagree on a vote, then whoever the 10% owner votes with wins. In essence, you have made the 10% owner the one that really controls the voting power in the company, an unintended but critical change in the balance of power in the company.
Another issue is the new owner’s right to view financial records for the company. In most states an owner of a company has an absolute right to access the financial records of the company that cannot be taken away. For instance, California Corporations Code section 1601 holds as follows:
“The accounting books and records and minutes of proceedings of the shareholders and the board and committees of the board of any domestic corporation, and of any foreign corporation keeping any such records in this state or having its principal executive office in this state, shall be open to inspection upon the written demand on the corporation of any shareholder . . . at any reasonable time during usual business hours, for a purpose reasonably related to such holder’s interests as a shareholder . . .”
So as you can see, by making someone a shareholder, even a minority one, it allows them to delve into the revenue, salaries, expenses and other confidential financial information of the company. And this right goes on forever, even if the person is no longer an employee of the company. Most owners like to keep such information confidential.
There are also potential negative ramifications to the new minority shareholder. . For example, say your ISO is worth $2 million. If you want to give someone 10% of the company, you arguably have just given that person 10% of that $2 million value or $200,000.00. The IRS could argue that person has been given compensation in the amount of $200,000.00 of ordinary income that the new owner would now have to pay taxes on. So the new owner could be subject to a substantial tax liability as well.
One way majority owners try to structure the deal is to suggest that if for whatever reason the employee does not work out, then the minority shareholder would forfeit their ownership interest. Generally speaking though, this is not allowed unless you pay the employee for the reasonable value of the interest. And most people I know do not want to pay an employee what could be a substantial sum of money if the employee no longer works for them,
Another way these deals can be structured, at least in you have a limited liability company, is to allow the ownership interest to vest over time. This allows the parties to see if the relationship is going to work out long term before making the commitment to make the employee an owner. This can be written into an operating agreement for a limited liability company fairly easily. But, in an S type of corporation, vesting is not allowed since it is arguably a different class of stock ownership in the company. S corporations only allow one class of stock and if that rules if broken, so is the S election and the pass through tax status that goes along with it.
However, rather than trying to give the employee ownership my suggestion to my clients is to give the employee a contract that gives them almost the same rights as an owner. There are two main things that most people are trying to accomplish be giving an employee part of the company: First, is the right to be paid a percentage of the profits of the company; second is the right to a portion of the proceeds of sale if the company is sold. You can enter into a written contract to provide an employee both of these things. You can achieve your goal of keeping the employee motivated and loyal but as he or she is not an owner of the business, they do not have the right to review your accounting books and records. In addition, you can structure the contract to reflect that the right to any compensation terminates if the employee is terminated or chooses to leave the company. . This avoids the issue of having to repurchase the ownership interest that you would have to worry about if you outright provide an ownership interest to the employee.
The downside to this arrangement to the employee however, is that when the company is sold, he or she might have a bigger tax bill because their right to part of the sale price will be taxed at the higher ordinary income tax rates versus long term capital gains rates. But from the owner’s perspective there is tax detriment at all.
Giving employees ownership rights in a company is sometimes warranted and can be structured to mitigate risk for both the owners and employees. However, most of the time, there are better ways to motivate and retain good employees that won’t negatively affect your interest as owners of the company.
The information contained herein is for informational purposes only and should not be relied upon in reaching a conclusion in a particular area. The legal principles discussed herein were accurate at the time this article was authored but are subject to change. Please consult an attorney before making a decision using only the information provided in this article.