Ohio Practical Business Lawyer & Attorney : Teri Rasmussen : Lane Alton & Horst Law Firm : Commercial Law, Creditors, Business Formation : Columbus, Central Ohio

Suppose you want to incentivize and reward motivated employees, but you've read my earlier post on The Ugly Truth About Giving Others (Especially Employees) a Piece of Your Business and you have been become understandably concerned about giving up even a sliver of ownership in the company.  What can you do?  One answer may be to offer some sort of "mirror" or "shadow" equity which allows participating employees to benefit from the growth of the company in the same way they would if they were truly equity owners, but lets you avoid some of the control and fiduciary duty issues that might arise if they really were.

Years ago (and often still), these sort of plans were often called "phantom stock" plans, a term I suppose many found slightly offputting.  After all, if it's "phantom", how can it be real and why would anyone want something not real?  So sometimes they came to be called "stock appreciation rights" or something similar.  In any event, the terms which may now be coming into vogue are "mirror equity" or "shadow equity" -- which does have a fairly nice ring to it.

Importantly, for both the company and the participating employee -- unlike the grant of actual ownership equity in the form of stock or membership interests -- with "mirror/shadow equity", there are NO tax consequences for either party until the employee actually receives a cash payment under the plan.  For the participating employee, this may be more beneficial than receiving actual restricted equity which cannot be sold for a period of time, but nevertheless counts as income upon which taxes must be paid. 

Essentially, "mirror equity" allows participating employees to have the benefits of equity ownership by granting them deferred compensation based upon such factors as longevity of employment and the financial performance of the company over time.  In many respects, it can operate in much the same way as a 401(k) program does with the same sort of vesting schedule decisions for the employer, i.e. it can be a gradual progressive vesting or a "cliff" schedule requiring a period of time before vesting occurs.  And, unlike a 401(k), the employer can selectively choose to allow only certain employees to participate and can grant differing amounts of mirror/shadow equity to various employees based on their particular performanace  and value to the company.  Thus, there is a great deal of flexibility and customization which can be included in whatever program the company decides would be advantageous.  

Here's how it works.  Participating employees are granted a "unit" of some kind whose value is tied in a specified way to the actual value of the company.  This might be exactly equal to a share of stock in the company or it might be tied to some other financial benchmark such as net income.  As the actual value of the company increases, so too does the value of the mirror/shadow equity. 

Depending upon the format of the plan, participating employees earn bonuses based on positive financial performance of the company according to the benchmark metrics selected.  The plan can provide for payouts annually, after a certain period of time, or tied to particular events such as the employee's retirement or the sale of the company.  Often, the value of any dividends declared is also added to the participating employee's mirror/shadow equity account.  Payouts may be made in installments or as lump sums.  Click here for a discussion of a specific example of how this might work in practice.   

Thus, from the participating employee's standpoint, they receive much of the financial benefit of actual ownership without having to expose themselves to the less rewarding "risk" aspects of actual ownership, including the possibility that there may be no buyer on the open market for ownership interests in a smaller privately held business.  From the owner-employer's standpoint, deserving employees crucial to the growth and success of the business are able to share in the financial success of the business, but ultimate control over the direction and future of the company has not been sacrificed.  In addition, payouts could also be conditioned upon compliance with applicable noncompetes or confidentiality provisions.

The one downside for both parties is that depending upon the complexity of the plan, benchmarks, and formulas selected, recordkeeping  and accounting may require some sophistication.  In addition, the Internal Revenue Service recently issued Section 409A regarding some valuation considerations that must be taken into account.  Click here and here to learn more about this.   

Overall, mirror/shadow equity provides an excellent way to reward and incentivize employees in a beneficial manner to owners.  Employees can enjoy the economic benefits of ownership while owners retain control of the company.

• Email This
• Print
• Comments
• Trackbacks

Thinking about rewarding a loyal employee by giving him or her a small ownership piece of your company?  Figure you'll still "call all the shots" because your ownership piece is so much bigger?  You may be unpleasantly surprised if you and your new business "partner" don't see eye to eye on how the business should be operated or what price it should be sold for.

Every business owner faces the question of whether to share ownership of his or her company with others.  Sometimes it happens early in the company's life cycle and is seen as a way to attract and compensate talent that might otherwise not be available to a young business.  It may also arise as the founder of the business approaches retirement and seeks a successor.  Other times it may simply seem like the "right' thing to do to reward and motivate loyal employees.

Whatever the reason, it is important to understand what sharing ownership really means under Ohio law.  Selling or giving even a very small ownership stake to someone else can restrict your rights to control the company and its operations in ways you may not have intended or even considered.  This is because under Ohio law, owners in small privately held companies owe one another a "fiduciary duty" to treat one another fairly.

It may seem logical to reward longstanding loyal employees with "skin in the game" by giving them an actual ownership interest in the business they have served so well for so many years.  Giving your new business "partner" access to financial data and other company books and records may seem like an excellent way to further motivate and recognize a deserving employee.  You may also feel you need to do this to attract key talent at a crucial point in the company's life cycle when you might not otherwise be able to pay a competitive compensation.  

In a business context, however, allowing others to hold even a very small ownership stake may come with rights and responsibilities you weren't counting on.  Are you willing to have this individual hold up the sale of the entire business?  What about letting your new co-owner influence and affect when the company repurchases some or all of your ownership stake?  What happens when this person leaves the employment of the company voluntarily or at your insistence?  If your new co-owner becomes intolerable to work with, ending the relationship is no longer as simple as saying "you're fired!"  Even something as ordinary as employing an owner's children in the business can be a problem if the same opportunity is not available to all owners.      

Fiduciary Duty of Owners to Each Other. Under Ohio law, owners of small businesses with only a few shareholders, members, or partners have a "fiduciary duty" toward one another.  Essentially, every owner must treat every other owner "fairly" when it comes to the company's business and financial affairs and opportunities.  The interests of the company must come before that of any particular owner. 

Using one's controlling ownership interest to cause the company to take action(s) unfairly favoring the majority owner at the expense of those with only a small ownership interest is not an option.  "Sweetheart" deals with other businesses resulting in financial benefits only to those with the largest ownership share become suspect. 

Effect on Exit Strategies.  Adding another owner can also affect exit strategies.  By statute, minority shareholders in a corporation have the right to demand the "fair cash value" of their shares upon the sale of the corporation or substantially all of its assets.  This becomes important if the corporation is struggling and the minority shareholder believes the majority stakeholder is selling out for too little.  It can also be an issue if the majority owner is perceived to be getting a "juicy" consultant arrangement with the new owners.  Receipt of any extra "premium" payment for the control a majority owner's ownership share provides may also be successfully attacked in some cases.  Similarly, having the business to buy back the shares of the founder's widow at a premium might seem fair, but if the same opportunity is not given to owners with smaller equity stakes, a breach of fiduciary duty may have occurred. 

Firing Your New Business "Partner".  Have you considered how your new shared ownership of the company complicates terminating that person's employment should that become necessary or desirable?  While you may not be immediately aware of it, granting an employee an ownership interest can subtly change the at-will nature of that employment.  You may no longer be able to terminate that person's employment for no reason other than you felt it was time. 

Now courts will require demonstration of a "legitimate business purpose" for terminating a fellow owner's employment, no matter how small the ownership interest held.  Termination must be based on a good reason.  It cannot be merely the product of a strategic move by the majority owner to "squeeze" the minority out of the company on overly favorable terms to the majority stakeholder.     

Firing your fellow owner because he or she cheated on your child/sibling or because they have simply become insufferable is unlikely to qualify.  Even something like declining productivity may not be enough in some cases.  Vehement disagreement about what direction the company should take which results in the majority owner believing his employee-owner is not satisfactorily pursuing the proper course may, or surprisingly often, may not be sufficient grounds for terminating the employment of a fellow owner.

LLC Applications.  Nor is this a problem restricted to corporations.  While no statute exists, courts have generally applied the "fiduciary duty" rule to limited liability companies, as well as corporations. 

Why Does It Work This Way?  Why do courts restrict the rights of the principal owner of a business this way?  Courts protect owners with only a small equity stake in the business because, unlike shareholders of large public corporations, they have no readily available market in which to sell their ownership interest and recoup their investment.  In addition, courts recognize that owners in privately held businesses often depend on their continued employment with the company for their livelihood, regardless of the size of their ownership interest.

Things to Think About Before Sharing Ownership.  So what can you do if you still want to include your employee in ownership?  Make sure you understand what you are also giving up before you bring someone else in as an owner.  The key is often to make sure everyone understand the ground rules from the beginning.  Explain in detail, in writing as well as orally if possible, how this will affect the employment relationship.  Be clear and specific as to what your expectations are concerning such matters as possible sale of the company or repurchase of your ownership interests.

A shorter version of this article was recently published in Columbus Business First, the Central Ohio Business Authority. 

• Email This
• Print
• Comments
• Trackbacks (1)