Structuring Your Equity Compensation Plans for Maximum Impact

If you’ve decided to offer equity shares to your key employees, the next step is determining the right structure for this benefit.

Thankfully, there’s no right or wrong answer. Which option works best will depend on your organization and your overall goals with offering equity compensation.

Equity Shares Versus ESOPs

There are typically two goals when utilizing equity compensation. One approach is to utilize equity as a way to retain your existing talent and recruit additional talent. The other goal is to eventually transfer control to the employee owners as part of a succession plan.

Byron McFarland, founding principal of The McFarland Group, which specializes in business succession and equity compensation planning, says this succession plan differs from an Employee Stock Ownership Plan (ESOP).

While every employee participates in an ESOP, regardless of their role, as long as they have worked the required number of years, owners can pick and choose who they want to reward with equity compensation plans.

McFarland compares providing your key employees traditional bonuses to the dating stage of a relationship, while equity compensation is the engagement stage of a relationship.

“The advantage of the engagement stage to a business owner is I haven’t changed who the owners are,” McFarland says. “I have diluted some of the value, but I’m doing that to reward the people who are helping to drive it.”

He says this is a good option for owners who want to compensate their employees, but don’t want to become legal partners.

Equity Share Structures

McFarland says two common options are providing phantom stock and stock appreciation rights.

Phantom stock allows you to share in the total value of the firm.

“Let’s say we have a firm that’s worth $5 million and I award you 2% of that in phantom shares,” McFarland says. “You have $100,000 in phantom shares. In three years, the firm goes to $6 million, your shares are worth $120,000.”

In that same situation with stock appreciation rights, the employee would receive 2% of that $1 million growth, equaling $20,000 instead.

“Phantom shares allow you to participate like you’re a founder,” McFarland says. “Stock appreciation rights bring you in at some point, wherever the company was when you were awarded them.”

McFarland says phantom shares are a good fit for loyal employees whom you want to make good on a promise or to recruit a well-regarded individual in the industry who is already well-paid at their current location.

Stock appreciation rights can be a good fit for a young leadership team that might not have been with the team long enough to merit all the rewards, but you still want to drive home you see they are part of your future.

J.T. Price, CEO of Landscape Workshop, based in Birmingham, Alabama, says they use a combination of equity structures based on tax and legal considerations.

Creative Roots Landscaping, based in British Columbia, Canada, has a share purchase structure that ensures new partners sit at the same table and eat the same meal as existing owners.

“In my opinion, this fosters trust and mutual respect,” says Ryan Markewich, owner of Creative Roots.  “It’s important that everyone is aligned in terms of ownership, and this structure ensures that.”

Seneca Hull, president of Franz Witte Landscape Contracting, Inc., based in Nampa, Idaho, says with their ownership partners, they “purchase” the stock through dividends from the stock “owned” until it is paid off. They do ask for a down payment as well, so the new partners have some skin in the game.

Sun Valley Landscaping, based in Omaha, Nebraska, uses a deferred compensation program based on profit combined with stock options to add equity compensation options.

“In short, the employee actually earns the money via company profits to then make a purchase of stock,” says Paul Fraynd, co-owner of Sun Valley. “They truly have skin in the game.”  

You also need to think through your payout structure. McFarland says they build equity plans with a window in them between now and the exit point, where the participants can sell a portion of their value in the future.

“What that does, it gives a sense of control to the participant,” McFarland says. “So now it contributes psychologically to the balance, where they say, ‘Yeah, this makes sense. I actually can control this.’”

Valuation Methods

McFarland says that conducting valuations is a vital way to keep score so employees know when they’re winning as a company and individually with their account balance.

“We recommend that the business owner have a valuation method that is understandable to the participants,” McFarland says. “You don’t need to have an appraisal done every year to determine value. The bigger you are, the more likely you are to use an appraiser, because you’re then subject to more scrutiny, and you don’t want to have people questioning the veracity of your determination of value.

McFarland says small businesses can have a valuation done by an appraiser once and then apply that formula year over year. Then, after three to five years, they can get another appraisal to see where they’re at.

Landscape Workshop sets the value of their shares at the current fair market value of the company.

“Then the employee’s units move up in value as the company increases in value,” Price says. “If the company wins, the employee wins.”

Similarly, Sun Valley does a market-based valuation every three to five years.

“Of course ‘market based’ requires plenty of subjectivity but we work closely with expert advisors to find a system that works for us and supports reality in the marketplace,” Fraynd says.

Markewich says they use a three-year weighted net profit number, multiplied by a 2x multiplier, and then add the book value of company assets. This is lower than the market value, so it is easier for employees to buy in. He says he’s even financed a portion of some of the new owners’ buy-ins to make it more accessible for them to join the ownership group.

“Our shareholder agreement also includes a provision that the valuation method can be changed as the shareholders see fit,” Markewich says. “Owners who are really trying to cash out might not like this structure, but it was fine for me because I wasn’t focused on getting the maximum value at the time. Instead, I wanted to make it easier for the people who helped build the company to share in the ownership and success they helped create.”

Addressing Departures

Make sure you have a game plan for if an employee who receives equity shares decides to leave your organization. McFarland says the best plans have a balanced approach to address forfeiture.

Fraynd says they have a buy-sell agreement that gives him the right to repurchase the equity from the departing employee.

“The goal is to avoid a situation where a former employee remains a passive shareholder indefinitely or, worse, tries to transfer their shares to someone we wouldn’t want as an owner,” Fraynd says. “We’ve agreed on the valuation method for a buyout to keep it fair. All owners in the business must dedicate their full working time and energy, and they are not free to sell them to whoever they want.”

At Creative Roots, Markewich says if someone on the leadership team leaves, the owners will decide whether to buy back the shares within the current ownership group or open it up to someone new who has met the criteria.

“We also cap the total amount any one individual can own,” Markewich says. “This ensures that ownership is spread out and that no one person can gain too much control.”

In the case of sudden life changes, where an employee leaves under favorable circumstances, like if a spouse accepts a new job, and then is eventually able to return to the business, McFarland says it is possible to re-enter the compensation plan.

Additionally, you should have a plan in place in case you decide to sell the business. McFarland says if a buyer has done their due diligence, they may wonder what ties your key employees to the business after it’s sold.

“What we do is, we would stage the payout for say 50% of their account balance at close, and then the other 50% would be paid subsequent to close, six months, 12 months, 18 months, or whatever period of time to allow the buyer to integrate them into the culture and evaluate them,” McFarland says.

Fraynd says you should only take this leap if you’re comfortable with a partner-like relationship.

“Offering equity to an employee is as much an emotional decision as a financial one,” Fraynd says. “You have to be willing to share a bit of your ‘baby.’ In my experience, when you do it with the right person for the right reasons, it’s incredibly gratifying and beneficial. It can feel very lonely as an owner, and adding people I trust and respect gives me confidence and motivation!”