How do you find and retain employees who have the capacity to “think like an owner?” One answer is equity based compensation - a powerful tool if you know how to use it.
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Equity based compensation helps to incent owner like behavior, and can reduce the immediate cash outflows in your business, while still providing valuable consideration for work performed – for all these reasons and more, such compensation is integral to the equity management process. This type of plan is very different than most forms of compensation, as equity compensation is not typically a reward for past behavior, but instead focuses on rewarding future behavior.
Equity compensation plans may provide actual equity in the company (such as stock grants), or simply rights to any increase in the value of the firm (such as phantom stock plans or stock appreciation rights). These plans focus an employee’s attention on the future success of the entire company and often result in participants adopting an “owner’s mentality” in order to realize their long-term reward. Here’s a short list of some of the more popular equity compensation strategies:
Stock Purchase Plans
Internal stock ownership plans, like the non-qualified ISOP, are a relatively simple and inexpensive way to reward top employees and get them to invest in the future growth of the company they work for. Stock purchase plans may be coupled with a cash bonus plan, which allows the employee to earn a bonus, and to subsequently reinvest that bonus in the company. For that reason, this approach is not designed to be an effective method for raising additional capital. Under these non-qualified plans, employees are given the opportunity to buy shares of stock in the company, often with advantageous terms.
Stock grants are a simple way to reward employees as shares of stock can be offered in lieu of a cash payment. This allows companies to provide compensation, while controlling when it is expensed. With stock grants, a time period is typically set, after which, an employee can receive their shares of stock. Stock grants provide motivation as the shares mature and appreciate in value over time, as well as helping to assure the retention of talented employees.
Stock Option Plan
A stock option plan is another form of non-cash compensation. Under a stock option plan, employees are given the right to purchase a defined number of shares at a price determined at issuance. Employees with an option may elect to exercise their stock option at any permitted time to purchase shares. The most common practice, however, is to exercise the options after the company’s stock has increased in value (in excess of the value of the options).
For example, if an employee received an option for 10 shares at $1,000 each, and the company’s share price increased to $2,000, the employee can exercise their option and immediately sell them back to the company or other shareholders, thus realizing a gain. The goal of stock options is to defer the need to compensate employees using the firm’s cash reserves, and incent them to take actions that will improve company value.
Phantom stock is a way to reward employees when the company performs well, but does not require actual equity/shares in the company to be given up by the owner or company. These types of plans are essentially cash bonus plans that tie the size of the bonus to the performance of the company. Most phantom stock plans pay out a bonus based on the value of a stated number of shares, to be paid out at the end of a specified period.
You don’t have to be a $10 million firm to make use of these strategies. Independently owned, closely-held financial service practices with values of over $1 million need to be thinking about these strategies and seriously consider them as business building tools. To be sure, your competitors are.