The Real Pros and Cons of Equity Compensation Plans

Offering equity compensation to key employees can be a game-changer for your business, but it’s important to go in eyes wide open on what equity does and doesn’t mean for your organization.

When the rubber hits the road, don’t be blindsided by some of the legal and tax implications of equity compensation plans. Check out industry professionals’ insights on this benefit.

Pros of Offering Equity

Providing equity shares has multiple benefits, from strengthening your recruiting and retention efforts to being a way to repay those who have helped grow the business.

“Equity compensation is one of the most powerful ways (along with sustained 401(k) contributions and matches) for an individual employee to build wealth,” says J.T. Price, CEO of Landscape Workshop, based in Birmingham, Alabama. “It aligns the long-term interests of the company and the employee. It is also a powerful retention tool for high performers.”

Paul Fraynd, co-owner of Sun Valley Landscaping, based in Omaha, Nebraska, says another benefit of equity compensation plans is being able to not overspend on salaries but still reward key employees.

“It’s a win-win: they share in the value they help create, and we keep our payroll sustainable,” Fraynd says. “This is the same math owners use every day for themselves.”

Byron McFarland, founding principal of The McFarland Group, which specializes in business succession and equity compensation planning, says when your leadership team has a financial stake in the business, they are in alignment with the owner’s goals and can take tasks off their plate.

“I would say for an owner, if you’re using an equity compensation right, then you would enjoy time freedom,” McFarland says. “If you can get to a point where all you’re doing is acting as the chairman of the board, as an investor in your firm, then you’ve bought complete time freedom.”

Fraynd agrees that the moment someone becomes a minority owner, there is a shift toward greater accountability and long-term thinking.

“In our case, giving employees equity absolutely reinforced an ownership culture,” Fraynd says. “These individuals have always been accountable, but now it’s on another level. Equity encourages an ownership mentality across the leadership team.”

Seneca Hull, president of Franz Witte Landscape Contracting, Inc., based in Nampa, Idaho, says providing equity shares is a great idea if you want your business to continue past you.

Cons of Offering Equity

Yet equity compensation plans aren’t without their drawbacks and challenges. One major consideration is tax and regulatory compliance. Fraynd says it took them almost a year to craft their first deal as they thought through every angle to protect everyone’s interests.

McFarland says even if you wrote on a bar napkin that your right-hand employee would receive 5% of the company, this would violate the Internal Revenue Code 409A, which governs all deferred compensation.

“They need to have a formal document that satisfies all the compliance rules of 409A, which is you got to determine when the payout occurs in advance,” McFarland says. “You can’t have an open-ended payout. You can’t have changes in the method of payment or the frequency.”

Fraynd says providing equity shares does dilute your ownership.

“I picked some of the best people in our industry to help grow our company,” Fraynd says. “By sharing in the upside, we will have a more valuable company and I firmly believe it will mean more value for me in the long run (a smaller percentage of a much bigger pie).”

Hull notes it also takes a lot of time to educate people on how a business is run.

“They may be really good at their job, but understanding financials, banking, etc., is foreign to most,” Hull says. “But it helps in the long run.”

Ryan Markewich, owner of Creative Roots Landscaping, based in British Columbia, Canada, agrees that ownership needs to be taught. Just because you offer equity doesn’t mean the person will automatically become a high-performing entrepreneur. He stresses new owners need to understand this is a long-term investment that requires resilience and a willingness to make sacrifices when needed.

“It’s not a get-rich-quick strategy, and you won’t have control of when you get an exit or extra money,” Fraynd says. “It requires a great deal of trust and deeply held beliefs and values from both sides to work.”

Price says another one of the challenges of equity compensation is that not every employee properly understands its value.

“We spend a lot of time communicating the value of equity, but we are not always successful in helping team members understand just how valuable this is,” Price says.

Advice for Others

Equity compensation can be a powerful recruitment/retention tool, but Markewich stresses you need to have a quality culture first.

“Don’t do it just to trap good people; do it because you want to share ownership with those who are truly aligned with the company’s mission,” Markewich says. “Take the time to understand how your business makes money and the realities of the marketplace.”

McFarland stresses that for equity compensation to be effective, you need to reinforce to your team how their roles contribute directly to the business value.

“Be clear on your vision for the organization going forward, being able to articulate that vision clearly,” McFarland says. “Here’s where we’re going, here’s why it’s important to you as the owner, and what’s in it for them.”

Fraynd says if you are considering offering some of your key employees equity shares, you need to be comfortable with the influence even a minority shareholder has.

“For instance, I do share more information now and discuss plans with these employees since they are an owner – but I view that as a positive change toward transparency, not a loss of control,” Fraynd says.

McFarland recommends ensuring the employees you have in mind understand to practice discretion about their shares to avoid conflicts.

“You have to choose truly special people,” Fraynd says. “Those who embody your values and who bring exceptional results. This is not the typical employee, and you have to be sure you truly know (and like) this person as a professional.”

Price recommends designing your equity plan carefully and only including employees who create value and value the equity ownership. Work with your accountants and lawyers to avoid reinventing the wheel with your equity compensation plan.

“Work with advisors to draft a solid shareholders’ agreement, as there are a lot of decisions to be made,” Markewich says. “It’s 100% doable, and I have never regretted the decision.”

“Sharing equity is a long-term commitment to a leader in your company,” Fraynd says. “I would ask someone struggling to get over this, if you trust them to run your business for 10+ years, why wouldn’t you trust them to be your business partner for the rest of your career? You have to have a solid foundation of values, mission and vision to even start thinking about this.”