What can be better than giving employees a benefit that doesn’t cost anything? Plenty if that benefit is company stock. In a cash-strapped economy it is often tempting for an employer to assuage the sting of decreased wages by making a grant of stock options or restricted stock.
With a privately held company, this is rarely a good idea. Unless the company wants the recipient of the stock to actually become a successor owner, or unless the stock is part of an overall benefit plan like an employee stock ownership plan or employee stock purchase plan, stock as a benefit can be a mistake. Why? I can name 10 good reasons:
1. Dilution – a grant of stock, or even a stock option, does have a cost. It dilutes the value of stock to the existing owners. Just as a gift of a kidney doesn’t involve cash, it still takes something from the grantor
2. Tax Trouble 1 – if the company is an S Corp, enough stock grants can end up pushing against the 100 stockholder maximum.
3. Tax Trouble 2 – if the benefit is a restricted stock grant, it may generate an unwanted tax burden for the employee when the stock vests. I know of situations where a stock unit vested, generated a sizeable taxable gain, and then the value of the stock plummeted. The employee ended up paying more in income taxes than the value of his shares.
4. Tax Trouble 3 – if an employer provides a stock option, and applies an incorrect valuation, the whole transaction can fall under the draconian penalties of IRC 409A. Here’s the scenario: An employer issues a stock option, making a best effort attempt at assigning a value for the untraded stock. If the IRS finds the value to be higher than that declared by the company, the IRS will claim the stock option was issued at a discount. This could lead to immediate taxation, plus interest, plus a 20% penalty, all landing on the executive.
5. Accounting – a stock option is tempting until one realizes that the company must currently book the value of the option. Particularly with a privately held company, valuing a stock option can be both expensive, and a complete guess.
6. Employee Disenchantment 1 – Twice I’ve had non-owner CFOs complain to me that their business’s owner is short changing them by rewarding them with small stock grants. Said one CFO “the owner uses the business as a personal checkbook, so I have no control over what that stock will really be worth.”
7. Employee Disenchantment 2 – the employee has a stock option that is in the money. But, to exercise the stock option, the employee needs cash. In a period of tight credit, this credit isn’t always forthcoming.
8. Owner disenchantment 1- the owner now has a new critic. If the employee becomes a stockholder, he or she is also privy to the company financials. I’m aware of an engineering firm where the employer is desperately trying to buy back all the stock from the employees. The engineers’ penchant for detail is causing the employer to respond to constant inquiries, complaints and challenges.
9. Owner disenchantment 2 – if the owner wants to sell the business to an outside buyer, the small amounts of stock scattered among the employees can cause a serious impediment to transacting the sale. The majority shareholder has lost the privacy of a negotiated sale, has increased legal expenses, and may scare off the seller. Some buy-sell agreements mitigate this risk by including a “drag-along” feature which gives a majority owner the right to force minority owners if the majority owner decides to sell.
10. No one wants a “lose/lose” benefit - With many privately held businesses, there is no upside to granting stock. If the stock does not increase in value, the employee is not only unmotivated, but possibly upset. If the stock value goes up, the owner is giving up valuable equity, and the employee may not appreciate the true value of that hard earned equity. Whether the value goes up, down, or stays the same, the owner has to explain it, defend it, and justify it to the employees.
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