A Conceptual Guide to Employee Ownership for Very Small Businesses
For companies with fewer than 20 employees that will stay that size, that do not plan to go public, and that do not want or cannot do an ESOP
Many smaller companies want to share ownership with employees but find the legal costs and complexities of various common plans daunting. For owners wanting to sell to employees, an employee stock ownership plan (ESOP) has great tax benefits, but its costs and complexities may be daunting. For other owners who just want to share some kind of equity interest with employees, stock options or restricted stock may be good choices, but other companies want something simpler still, or, if they are limited liability companies, do not have actual stock to share. So what kinds of strategies are available for these companies?
Why Share Ownership?
Companies share ownership with employees for a variety of reasons. For some people, the reason may be simply "it's the right thing to do." For most others, however, there are purely practical reasons to share ownership. Employee ownership can have benefits for owners of businesses, employees, and their companies. Among these are:
- To attract and retain good employees. Many small businesses have trouble attracting and retaining good employees. Using employee ownership as an employee benefit can be an important way to address this problem.
- To buy out an owner. In almost every small business, the owner or owners will eventually want to leave. Often no family member or colleague can take over and there are no buyers willing and able to buy the business at a reasonable price. Selling the business to employees can be a way out of this dilemma.
- For shared entrepreneurship. Starting or running a small business is difficult. Many people find that sharing the responsibilities of ownership with others lessens these burdens.
- To raise capital. Employee ownership can help provide additional capital. Employee owners may be willing to contribute to the company by buying shares or taking lower wages in return for stock.
- To make the business perform better. Several reliable studies indicate that, on average, employee-owned firms perform substantially better than non-employee owned firms when ownership is combined with employee participation in decisions affecting their work.
- For tax benefits. Certain employee ownership structures qualify for tax benefits.
A Primer on Ownership
The word "ownership" is used in different ways by different people. Legally, ownership of a business is a bundle of rights to reap the benefits of that business and to make decisions about how the business is run. The basic rights in a business are the right to company income, the right to the surplus value of the company if the company is sold, the right to make decisions about how the business should run, and the right to sell all or part of the value of the business.
In non-employee ownership companies, employees receive the right to some of the company's income through wages, but not other rights. Employee ownership companies involve employees in some or all of the other myriad rights of ownership.
The particular way in which the rights of ownership are assigned to owners in the company depends on its legal structure. A business must be set up in one of three ways: as a sole proprietorship, as a partnership, or as a corporation. In a sole proprietorship, business property, liability, and income are treated as the personal property of a single person. These businesses will have to first establish a partnership or incorporate to share ownership with employees.
Ownership in Partnerships
A partnership is composed of two or more partners who carry on a venture for profit. Income is passed through to partners and taxed at personal income tax rates. Each partner is liable for all the debts and obligations of the partnership. A partnership can also have limited partners, who are not liable for debts and obligations but receive income like other partners. Limited partners cannot take an active part in the management or operation of the company, which generally means that employees cannot be limited partners.
Partnerships are problematic for employee ownership. Due to the legal treatment of partnerships, the more partners, the more chance there is that a partnership will run into problems. One problem is that the whole partnership can be committed to a binding contract by any one partner. Another is that the whole partnership can be liable for the wrongful acts of any one partner. Also, partnerships may require consensual decision making on many issues and may legally terminate with the departure of only one partner.
If there are only a few employees at the company who have a close working relationship with each other, a partnership might be a workable and inexpensive way to share ownership. When this is not the case, partnerships will not be a good option for employee ownership.
Ownership in Limited Liability Corporations (LLCs)
Limited liability corporations (LLCs) combine elements of a partnership and an S corporation. There is no stock; instead, owners have a "membership interest." The members do not have liability for the company's obligations unless they have signed personal guarantees. Profits are not taxed at the corporate level. Instead, members must pay taxes on these profits. Unlike an S corporation, however, where this must be pro-rata to ownership, in an LLC it can be divided in any way the members agree.
Our Web site has a separate article on equity incentives in LLCs.
Ownership in S and C Corporations
Most employee ownership companies are corporations. In a stock corporation, the corporation distributes the rights of ownership by issuing shares to "shareholders." Shareholders have limited rights and responsibilities, with the formal responsibilities of ownership conferred on a board of directors. In a corporation, shareholders can only lose the investment they make to buy shares; they are not liable for the corporation's debts.
C and S both have limited liability for owners, but C corporations pay taxes on profits and capital gains on asset appreciation. Owners pay taxes on dividends and on the sale of stock or assets. S corporations flow through the tax obligation to shareholders to pay at their personal tax rates based on pro-rata ownership.
Legal Structures for Employee Ownership
Ownership can be shared directly with employees through partnerships or corporations, and also indirectly through tax-exempt benefit trusts. However, if the company meets certain qualifications, it can receive important tax benefits. Cooperatives, employee stock ownership plans, and profit sharing plans are the most common tax-benefited ownership structures in small businesses, although others exist. Each of these options is detailed below.
The following may seem like a wide range of complicated choices, but most companies will be able to quickly narrow down the choices. For example, only companies that want to share control on a one-person/one-vote basis can use cooperatives, while profit sharing plans are unwieldy mechanisms for majority employee ownership. In choosing a plan, companies should consider set-up costs, potential tax benefits, and whether the requirements of the plan fit with the company's goals for employee ownership.
For a discussion on ESOPs, which may be viable for certain very small companies, see our articles on that topic. Here, we will look only at other forms of ownership sharing.
A partnership agreement can share decision making, profits, asset value, liability, and many other aspects and benefits of running a small business. A partnership can involve any number of partners, who may or may not be employees of the partnership. However, because of potential liability problems, such as the ability of a single partner to obligate the entire partnership to a contract, as well as the usual tax and liability advantages of incorporation, it is probably best to use partnerships to share ownership among only a small number of people. Partnerships will generally be the cheapest way to share ownership among less than five or six employees. Using self-help books, you can probably write a partnership agreement yourself and pay for legal counsel only to review the completed agreement.
Limited Liability Corporations
Ownership in LLCs can be shared by extending membership to additional employees or by giving employees an option to purchase a membership interest at a price fixed today for a number of years into the future (called a profits interest) or to buy membership directly, subject to certain restrictions (called a capital intrest). Tax rules for these approaches are somewhat uncertain, but generally parallel the treatment for the C or S corporations for restricted stock or stock options. Alternatively, companies can give people synthetic equity, essentially the right to a hypothetical number of membership units or the increase in these units, paid out in cash over time.
Our site has an article on equity compensation in LLCs.
Direct Share Ownership
Any incorporated business, no matter how small, can give or sell shares directly to employees. New shares can be created or they can be purchased from a previous owner. If employees acquire shares directly, they become direct owners, and can exercise all the rights associated with ownership, including a share of the company's equity value and voting rights. Employees can receive shares that give only voting rights, only equity rights, or both, and with any percentage of the total voting or equity stake. Employees can be allowed to resell their shares freely, or resale can be limited for any reasonable business purpose. If employees buy shares, the company must obtain an exemption from securities registration. Most private companies can obtain a so-called "Section 701 exemption" or another exemption from federal registration. However, an exemption from federal registration requirements does not always provide an exemption under state rules. Moreover, companies must still file anti-fraud disclosure statements to employees. This can cost several thousands of dollars on up.
With "restricted stock," companies can grant employees shares that are subject to restrictions. Under these plans, an employee receives a defined number of company shares that are subject to forfeiture and transfer restrictions unless certain qualifications are met, such as the employee staying with the company for a defined number of years, the company meeting specified profit goals, or the employee meeting individual goals. While the restrictions are in place, the employee could still be eligible for any dividends paid on the shares and could be allowed to vote them as well.
Taxation of shares is complicated, and the advice of a tax attorney may need to be sought in specific cases. However, the following rules should generally apply:
- The taxable value of shares transferred to employees is their value minus any amount paid by the employees for the shares.
- The company can deduct the taxable value of shares given as a benefit of employment in the year that employees claim the value of shares received as part of their income taxes.
- If employees receive shares that they can sell, they must pay taxes in that year. If they receive shares that have restrictions on resale, however, they have two choices: either pay taxes in that year, or wait and pay taxes in the year that transfer restrictions expire.
- If the shares are restricted shares and the restrictions create a "significant risk of forfeiture" because the conditions may not be met, then the employee has a choice about taxes. He or she can file an "83(b) election" and choose to pay ordinary income tax on the gift value of the shares (their value minus any amount paid for them) at the time the award is made. Once the shares are received, the employee would then pay no tax until they were sold, and then would pay capital gains tax on the difference between the value declared for the 83(b) election and the sale price. If the employee fails to meet the conditions, however, and receives no shares, the tax cannot be recaptured. If the employee does not file this election, then when the shares are received (not sold) the employee pays ordinary income tax on their value minus any consideration paid for them.
These tax obligations must be considered carefully. Being able to deduct the cost of shares substantially reduces the cost of direct employee ownership for the company. On the other hand, few employees will be able to or want to cover the cost of taxes on shares for which they may receive no financial benefits for many years.
As for cost, direct ownership usually requires less specialized legal services than other employee ownership options. A typical set-up cost is $3,000-$5,000. With thorough preparation this cost may be much less. In general, the simpler the share arrangement, the cheaper it will be to set up.
Stock options give an employee the right to purchase shares at a price fixed today (the grant price) for a defined number of years into the future (the exercise term). Options usually are subject to vesting, so an employee might get, for instance, the right to purchase 25% of the shares available under the option grant after two years, 50% after three, 75% after four, and 100% after five. The exercise term is most commonly 10 years.
There are two kinds of options: nonqualified stock options (NSOs) and incentive stock options (ISOs). Anyone can receive an NSO; only employees are eligible for ISOs. Under an NSO, the employee can receive the right to purchase shares at any price (although some states require the price not be less than 85% of fair market value, something usually set by the board or an appraiser in closely held companies, and offerings under 85% can create tax issues). Almost always, the offering is a fair market value price. Once vested, the options can be exercised (that is, the employee can buy the shares) any time until they expire. When the employee does buy the shares, the spread between the grant and exercise price is tax deductible to the company and taxable as ordinary income to the employee.
With an ISO, when the employee exercises, if the shares are held at least one year after exercise and two years after grant, the employee does not have to pay tax until the shares are sold, and then pays capital gains taxes. The company, however, does not get a tax deduction. Employees cannot receive more than $100,000 in options that become exercisable in any one year (that is, become fully vested), must be granted options at not less than fair market value for the option (or 110% for 10% owners), and cannot hold the options more than 90 days after leaving employment. If the terms of an ISO are not met, they are treated like an NSO.
Closely held companies issuing options must decide on how to make a market for them once they are exercised. Some companies say that the shares can only be sold, or even that the options can only be exercised, on going public or being acquired; others provide internal markets by having the company repurchase the shares or allowing other employees to buy the shares.
Generally, options do not show up as a cost on the company's income statement until they are exercised, at which time the spread becomes a compensation cost. There are some exceptions to this, however, when companies make changes in existing option plans.
Options do not provide employees with any control rights (unless the company creates these rights) until the shares are purchased, and even then the company can provide that only non-voting shares can be bought. The number of shares that will be in employee hands at any time because of the exercise of options is usually quite small as a percentage of total shares. Option plans are particularly popular with fast-growing companies that plan to be acquired or go public, but as long as companies can provide a market for the options, there is no technical or legal reason for a closely held company not to offer them.
Phantom Stock and Stock Appreciation Rights (SARs)
For many smaller companies, these plans will be the most suitable because they are very simple. Phantom stock pays employees a cash bonus equal to a certain number of shares; SARs pay employees a cash bonus on the increase in the value of a certain number of shares. Employees are granted a certain number of phantom stock units or SARs, almost always with vesting requirements. They pay no tax at grant. When the awards vest, then employees do pay tax at ordinary income tax rates, while the company gets a deduction. In effect, phantom stock is the equivalent of restricted stock and SARs the equivalent of non-qualified options, except in that both typically pay out only at vesting and that there is no 83(b) election available for phantom shares.
Companies can also choose to settle the award in shares. For instance, a company might first set aside enough to pay the taxes on an award, then give the employee a number of shares equal to the remainder.
Cooperatives are a type of company in which control is on a one person/one vote basis. Cooperatives can be set up as partnerships or corporations, and in some states, there are worker cooperative statutes. Whatever form a cooperative takes (most are set up as corporations), they qualify for special federal tax benefits. Cooperatives are the oldest form of employee ownership in the United States, dating from the early 1800s. Although they are not common in larger businesses, they make up a large portion of small employee-owned businesses.
Formal voting control must be on a one-person/one-vote basis. Usually most employees must be shareholders, although as many as half can sometimes be excluded. Generally, a cooperative cannot pay dividends, and must pay out any excess earnings not held in the company to employee shareholders based on salary, time worked, or some other work-related basis. However, if non-employee owners have a small percentage equity share and return on investment is limited, these owners can still be rewarded through dividends.
Persons who sell shares to a worker cooperative are exempt from capital gains taxes if the gain is reinvested in U.S. securities. Cooperatives are exempt from double taxation on dividends to employees that are based on time worked or salary rather than equity. Most small businesses will not need to pay out dividends anyway (see discussion in Financial Benefits in a Corporation), but this exemption gives cooperatives more flexible tax planning options than other corporations, letting them treat profits like either an "S" or a "C" corporation without changing their legal structure.
Set-up costs for cooperatives are even cheaper than direct ownership plans for two reasons: worker cooperative laws in many states make it simple to incorporate and qualify as a cooperative; and, there are professionals and organizations offering inexpensive services or financial support for cooperatives.
Typically, a worker cooperative makes employees owners after a probation period. Employees than either buy shares of stock that have real equity value that fluctuates with the company's value or they purchase a membership share, which has a fixed value that may or may not have interest added on to it as the employee accumulates seniority. When an employee leaves, either the cooperative or another employee buys the share (if it is real equity), or (if it is a membership share), the cooperative pays off the employee and a new employee buys a share at the base price.
Most cooperatives establish an internal account to which profits are allocated, usually to all cooperative members based on hours worked or some other equitable measurement of their contribution. These profits are deductible to the company, but taxable to the employee. When employees leave, they are paid out their account balances, usually with interest. In the interim, cooperatives may also pass some of the profits directly through to members, perhaps to help them pay taxes they owe on the profits allocated to their accounts.
Purchase or Bonus?
A basic decision to be made is whether employees will receive their ownership stake by buying shares, receiving them as part of their compensation, or some combination. There are trade-offs involved with either approach. What works will depend on the desires and financial needs of the employees, the current owner, and the company, as well as how quickly all parties want to transfer ownership.
From the viewpoint of the company, it is advantageous if employees are willing and able to pay for shares (assuming securities registration can be avoided). It may be necessary for employees to put up money in order to complete a buyout, to convince lenders that employees will be committed to the employee-owned company, or because the company is not able to purchase or give away the shares. However, there has not been great success with employee ownership that relies on employees to put up their own money to buy shares. Lower and middle income employees have little extra income to spend on long-term savings of any kind, much less on risky investments in small companies. Employees can always refuse to buy or accept stock (unless it is a mandatory condition for employment). In most cases where ownership is for sale to employees rather than given as a benefit of employment and buying stock is not mandatory, only a few highly paid employees will participate, if any. Also, selling stock to employees who are not experienced investors may sometimes impose a legal obligation on the company to make sure that the employee is making a prudent investment, something that is not always easy to guarantee.
Companies have been more successful at involving a broad range of employees in ownership when employees are given shares as part of compensation. Part of the success of the ESOP has been that it relies on company funds to buy shares, and employees have no immediate financial obligations. When the company assumes the obligations, the difficult process of convincing employees of the value of stock investment and helping them raise the money to buy shares can be avoided.
Generally, then, asking employees to take on the burden of buying shares may not work, except when employees have high incomes or they are highly motivated, for example, when starting a company from scratch or in an employee-initiated buyout.
The company might also split the costs of buying shares with employees, either by combining employee and employer purchases (for example, by agreeing to buy a certain number of shares each time the employee buys shares), or by offering employees shares at reduced prices. Discounts are not taxable to the employee if they are less than 15%; otherwise they are taxed like any other income. Alternatively, the company might make buying shares easier by allowing employees to pay for them over time or to borrow against the shares they purchase.
Remember, asking employees to assume tax obligations before receiving financial benefits of ownership is similar to asking them to purchase shares. Although this might be desirable from the company's viewpoint, this may put too large a burden on employees. Also, employees can always refuse to accept or retain the shares, thus compromising the potential benefits to the company of employee ownership.
Will Control Be Shared with Employees or Only Equity Ownership?
One of the first decisions to make is whether or not employees will have controlling interest in the company. Does the sort of employee ownership you have in mind involve only equity rights, or will it involve employee control as well? It makes sense to think of there being two basic kinds of employee ownership companies: those with equity benefit plans and those that are employee-controlled.
In a company with an equity benefit plan only, employees receive an equity stake in the company but do not as a group have voting control over the company. Such plans are often set up as a retirement or savings benefit and as a way to let employees in on the equity growth of the company while creating an incentive to stimulate productivity. In such plans, ultimate control remains with either a top manager or an outside owner (although perhaps subject to some legal rights of the employee owners).
In an employee-controlled company, employees as a group have voting control over the company. Ownership may not even involve significant equity rights, but any outside owners are minority or nonvoting owners. Employee ownership in such a company is a means of sharing control and dividing up corporate income among employees.
It is important to be clear on which approach you intend to take for your employee ownership. Formal voting control brings with it important legal rights. Most decisions are made on a day-to-day basis, not through formal corporate mechanisms. Experience has shown that employees are conservative shareholders, supporting recommendations made by management. But business owners should not give voting rights to employees with the expectation that they can retain all control for themselves. Whoever has voting control of the corporation has the right to choose and remove directors and corporate officers. If conflicts arise, these mechanisms may become important. Also, people often assume "ownership" includes control. If the desire is to create a mechanism by which employees can share in equity growth but not to control the company, then this should be clear to everyone involved from the beginning. Finally, the type of employee ownership structure chosen depends on which approach you will take. Not only must voting rights be structured differently, but different financial arrangements may be required according to who controls the company.
The only practical way that the equity value of shares can be translated into a financial benefit for employees without selling the entire company to an outside buyer, is for the company to agree to repurchase shares.
In equity benefit plans, an agreement must be made to repurchase shares, or employees are being given essentially worthless shares—not a very motivating benefit. There are also strict repurchase requirements for ESOPs. In order for share ownership not to seem like too distant or uncertain a reward, repurchase should be guaranteed, by contract if necessary, and done within a reasonable time after an employee leaves the company.
In an employee-controlled company, however, repurchasing shares is not absolutely necessary because employees can get financial benefits by other means. Controlling owners can decide to reward themselves through wages and bonuses, rather than by increasing their equity stake. If shares are not repurchased, the main importance of the shares then is to divide up control and to split up the surplus from a sale of the whole company, not to provide a financial benefit through equity. But the company must specify that it will not repurchase shares in its agreements with employees.
Employee-controlled companies should carefully consider whether they will repurchase shares. Not repurchasing shares can save the company money, and it can reduce costs to new employees of becoming owners, since the value of shares that are not repurchased will be less. On the other hand, employee-controlled companies may want to repurchase shares to provide an equity benefit for the same reasons as other employee ownership companies want this kind of incentive. Also, repurchasing shares may motivate each employee to work more for the long-term benefit of the company.
If the company does decide to repurchase shares, it should take steps to make repurchase manageable. The company needs to plan carefully for its repurchase obligation and put aside funds for this purpose. The company must also decide what conditions will be placed on repurchase (where these are not already set by an ESOP). Will repurchase be made only if the employee reaches retirement age or any time the employee leaves the company? Will shares be repurchased if the employee is fired? If the employee quits? If the employee is laid off? The answer will depend on the way the company wants this financial benefit to motivate employee owners, provide job security, or serve other purposes.
The company needs a method for determining the monetary value of shares for several reasons: so the sellers will know if they are getting a reasonable and fair price; so employees will know their tax obligations if they receive shares; to meet requirements for ESOPs; and, to determine the price at which the company will repurchase shares.
The "value" of a business is the value that it would sell for in a competitive market. This value is not always easy to determine. It reflects tangible things like assets, cash holdings, patents, property, and intangible things like goodwill, market conditions, and employee experience. But how do you actually get a number for this value? For a small company there are several practical approaches; it can use book value (the net value of assets over liabilities), use another formula, or hire a professional business appraiser (often costing $5,000 or more). ESOPs must get a formal valuation from an appraisser and have it updated annually. Although the cost is high, even when the plan is not an ESOP, a formal valuation is a good idea to prevent later legal disputes.
Selling to Employees
The basic objective of selling to employees is to find a way that provides the owner with a reasonable value while allowing employees to purchase the company with pretax dollars. An ESOP is an ideal mechanism for this, but if it is not practical for one reason or another, there are ways to sell to employees than can meet these criteria, albeit not as effectively.
The simplest model is for employees to come up with their own money to buy the company. The owner gets capital gains treatment on the sale; the employees, however, must use after-tax dollars to make the purchase. In practice, few companies have employees capable of buying more than a minority stake with their own assets. If this is not possible, a few options can be considered:
- The owner can take a note: In this case, the employees come up with some cash up front and pay the rest, with interest, over time.
- The company can loan money to employees: If there is sufficient cash, the company can make a loan to employees. If not at an arms-length rate of interest, however, the difference is taxable as current income to employees.
- The employees could forego bonuses over some years to buy out the owner gradually.
Earnouts, Noncompete Agreements, and Consulting Agreements
Many sales of smaller companies contain some kind of earnout provision. Employees buy part of the company directly, with the seller getting the remainder as some percentage of future profit or sales. The company can make these payments, but they are not tax deductible. Depending on how the earnout is structured, it may be taxed as ordinary income, not capital gain.
Noncompete and consulting agreements can also be used to provide compensation to the owner, but the company must be able to justify the cost as reasonable for the value received in order for them to be deductible. Both are taxed to the seller as ordinary income.
Leases of Assets
Finally, sellers can separate ownership into the operating functions of the business and its assets (real property, patents, etc.). The company can pay for the leased assets out of pretax dollars; the income is ordinary income to the owner.
Who Ends Up Being an Owner?
With any of these arrangements, ownership is usually parceled out pro-rata to employees' investments. If some employees cannot afford to buy in, but the company wants them to have some ownership interest, it could allow them to take wage reductions over time or forego bonuses. The income might be used to buy newly issued shares so that the company's capitalization increases, or it could be used to buy shares from the original employee group.
The seller can agree, for instance, to be paid out of the future earnings of the company, partially in return for consulting or as payments on a note. Both require ordinary income tax for the seller, however. The seller could lease assets to the employees with an option to buy, while selling goodwill or other intangibles. This would limit the amount of after-tax money employees would have to pay to buy shares because they could pay for the leased assets with corporate tax-deductible dollars. In general, while these approaches are available, they do not save a great deal in legal costs, however.