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Finding Incentive Alternatives for Family Businesses

Volume 2, Issue 11
June 15th, 2014
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vol-2-iss-11-last-article-300x216If you own a family business, it is a given that you’re not going to issue equity outside of the family. As a result, stock options may not seem to be of any value to non-family member employees. In addition, family employees’ knowledge that they will eventually inherit the business is usually seen as their incentive to perform.

However, attorney Andrew W. Steen of the law firm of Davis Wright Tremaine says there are other equity incentives that you can usefully deploy.

“Equity incentive does not have to come just in the form of traditional stock options,” he pointed out. “There are countless permutations of ways to align an employee’s interests with the growth of the business.”

If you wish to avoid giving true equity to non-family members, Steen says that phantom stock or stock appreciation rights can provide the economic equivalent of equity without actually issuing stock.

Both alternatives are seen as contract rights intended to give the employee value that is commensurate with the value of the company stock.

The Ghost in the Machine

These “phantom stocks” and stock appreciation rights can provide employees with the economic equivalent of equity without actually issuing stock, Steen stresses.

Stock appreciation rights grant an employee the contractual right to receive cash or stock equal in amount to the increase in the price of the stock.

He describes phantom stock as a contractual right of the employee that mirrors a restricted stock grant. The employee receives an account credited with a certain number of hypothetical shares and, at some point in the future, the company pays the employee an amount equal to what the employee would have received from selling the same number of real shares.

In both scenarios, the company can subject these rights to a vesting schedule that can be based on time, performance, operation benchmarks, etc.

This schedule can help create specific incentives, he says. “And in neither situation does the employee ever get true equity in the company or any voting or other rights that would go along with equity”

When it comes to family members, he says the value of equity incentives may lie in the ability to fashion a vesting schedule.

“The patriarch or matriarch may not want to hand over the company to the next generation until after they have proven themselves,” Steen notes. “But the next generation does not want to make the commitment and put in the labor with the family business without the assurance of a smooth ownership transition.”

With an equity incentive vesting schedule based on time, the family member will incrementally own more and more of the company over time.

“For some family members this may be a much better incentive because their commitment and labor are being rewarded continually over time, rather than in anticipation of a future hand off of ownership and control,” Steen observes.

This may require something of a shift in viewpoint, he admits. “In other words, we should not be so quick to dismiss the notion of equity incentive just because yours is not the typical corporate situation.”

Steen believes there is a lot of flexibility and there are a number of different ways to align employees’ interests to the growth and success of a family-owned business.

“Of course, in evaluating alternatives, be sure to first consult with your tax advisors closely, for issues such as when the rights are taxable to the employees and whether there are any issues under Section 409A of the tax code,” he urges.

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