Employee Incentives: Equity vs. Cash
Retaining key employees needs to be one of the most important aspects of running a business. Startups need to motivate employees to stay with them for the long run, while more established companies must continually incentivize employees to remain rather than move on to better companies or for higher compensation. Historically, U.S. employees tended to work for a handful of employers during their lifetime, however recent data suggests that employees will work for 15-20 companies before they retire. A May 2016 Gallup poll found that 60% of millennials are open to a different job opportunity, earning them the title ofthe “Job-Hopping Generation.”
Consequently, mid- and small-cap companies must proactively design plans that target the retention of key employees that they need for continued growth or the future sale of the business.
Providing the opportunity for stock ownership is one of the most motivating incentives a closely-held business can offer to a key employee. The most common equity plans are those that grant restricted stock to employees or give them a right to purchase stock in the future through incentive stock options (ISOs) or non-qualified stock options (NQSOs).
Advantages of granting equity:
• Key employees are tied to the company by making them part of the company’s ownership;
• Some types of equity plans, such as stock options, require employees to pay for ownership, thus investing themselves, literally, in the company;
• Stock ownership gives employees a strong incentive for increasing the value of the company and therefore, increasing their own benefits;
• Employers in certain industry sectors, such as technology, must grant equity incentives to remain competitive with their peers. For owners and employers, giving equity also has its drawbacks:
• Even a small percentage of stock ownership brings with it significant rights, including the right to access company books and records, the right to be informed about the financial condition of the comp-any, and the opportunity to vote on major company decisions;
• Future merger or acquisition transactions can become complicated when there are multiple noncontrolling equity holders;
• Providing equity requires legal, accounting, human resources, and management time and effort to determine the right plan, identify the key employees, value the company, and implement the plan;
• Equity is a long-term commitment to the employee, which makes it more difficult to unravel if the employment relationship is not working out.
Alternatively, some companies prefer cash-based plans rather than equity-based for their simplicity and ease of implementation. A cash-based incentive plan is one that provides cash or gives rights to appreciation in stock value rather than to the stock itself. The primary nonstock (or cash-based) incentive plans are: Nonqualified deferred compensation plans, stock appreciation rights (SAR) and “phantom stock” plans, or blended plans combining current cash bonuses with deferred benefits.
Cash-based plans are generally easier to put in place, allow companies to reward a greater range of employees, and provide more flexibility based on the company’s and employee’s performance.
Some disadvantages of cash-based plans:
• Employees may start to count on the cash incentive as part of their “base” pay rather than an incentive;
• Cash tends to get used up and may not be perceived as more permanent compared to shares of stock or a stock option;
• The most valuable employees may be more motivated by an ownership incentive than a cash incentive.
As in any management decision, the decision maker needs to consider the individuals being targeted, the company’s projections, and its overall business plans before selecting the plan best suited for its needs. Companies can also consider instituting a blended plan that mixes cash and equity incentives to get the best benefits of each. Regardless of the type of plan that may be implemented, establishing a incentive plan for employees requires time and effort by the owners and managers to ensure the incentives yield the intended result.
Business Insights is hosted by the Law Firm of Kumar, Prabhu, Patel & Banerjee, LLC (KPPB).
Sonjui L. Kumar is a founding partner of KPPB Law, and a corporate transactional lawyer representing companies in all aspects of corporate law, including cross-border transactions.
Disclaimer: This article is for general information purposes only, and does not constitute legal, tax, or other professional advice.
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