FUNDAMENTALS OF CORPORATE LAW: EMPLOYEE INCENTIVE PLANS
August 18, 2011
by James Forrest
One of the key areas of law affecting businesses is the set of rules and regulations governing employment, both at federal and state level. In addition to offering advice regarding compliance with labor laws to facilitate a fair workplace, business attorneys can prove critical to a company’s growth through advising c-level executives regarding compensation issues.
Every entrepreneurial enterprise should approach compensation from a perspective of creating an ownership mentality in each of its employees. Young and maturing businesses simply don’t have the luxury of running on auto-pilot, so one weak link in the chain can hamper growth and well-being. Creating an ownership mindset that permeates a company at every level ensures that a company’s engine, its labor force, is optimally engaged for both the short-term and the long haul of creating business success.
There are multiple, creative ways that management, with the help of effective counsel, can tailor incentive plans that spurs enthusiasm and engagement from the employee while protecting the financial interests of the company. The first and most obvious way to create an ownership mentality is through conferring ownership itself through offering true equity positions to employees. For some key employees, having a stake in the company is a huge motivating factor. Others would rather remain employees and not take on the responsibilities or headaches that come with ownership. Another concern is that true equity dilutes the original shareholders, some or all of whom may be unwilling to diminish their own positions.
Another creative means of driving incentive plans is through the issuance of stock options. Employee stock options (ESOs) are often a very effective form of non-cash compensation meant to drive the growth of the company and keep employees focused on the future. Companies issue stock options with a strike price based on current valuation (usually fairly low), and employees can redeem them (or strike) in the future on or after a specific grant date and purchase equity based on the prior (often low) valuation. Both the pro and con of issuing stock options is that employees bet a portion of their compensation on the company’s success. While this can create a culture of almost rabid ferocity in chasing corporate revenue goals, companies who fail to hit certain milestones can find themselves with disgruntled employees holding “under water” options that may never realize any compensatory value.
Corporate attorneys can also assist business owners with issuing phantom stock, a mechanism that utilizes a stock option framework to issue cash bonuses (rather than actual equity) over time. Phantom stock confers no real equity in the company, so the owners face no issues around their own dilution of control. The phantom stock simply runs parallel to the actual, real stock in the company, mirroring its value, and, much like stock options confers rights to employees for future cash bonus compensations based on the company’s valuation.
Finally, entrepreneurial businesses can benefit greatly from employees driven by contracts involving commissions and profit sharing. These types of contracts are particularly effective for the front-line employees who bring customers into the company. They see an immediate lift in their respective incomes, and these types of contracts are both easy to structure and easy to understand. Commissions, which are immediately tied to sales as employees bring in customers, and profit sharing, which immediately binds employee performance to both revenue and expense management, generate an “I make money when you make money” mentality shared by both employees and management.