B usiness owners may from time to time consider giving stock or stock options to one or more employees. Often employees would like to own stock in the company as an investment. While there seem to be good reasons to give or sell stock to an employee, my advice is almost always to avoid bringing employees into the company as shareholders. My advice is based on a number of issues that make stock ownership by employees unattractive for both the business owner and the employee.

The reasons usually given for making an employee a shareholder are primarily psychological and motivational. The following are reasons frequently given in support of selling or giving an employee stock or stock options:

• It motivates the employee to work harder in order to build up company value;
• It makes the employee more responsible because of a feeling of ownership;
• It fosters employee loyalty, making an employee less likely to leave;
• It rewards the employee who helps build up the company;
• Stock can compensate a key employee when the company cannot afford to adequately compensate the employee with cash.

Even if these supposed motivators and rewards are effective in some situations, they may not be effective in your particular situation. In addition, the reality of what stock ownership really provides to an employee must be considered. Very often, cash is a better motivator and reward than any type of ownership interest. Wages, salaries, bonuses, or other cash compensation are often more appropriate incentive and reward than stock, since cash can pay bills, make purchases, and be invested in a variety of investment vehicles. Stock in a company may or may not provide meaningful value to an employee.

In many owner-operated businesses, the ownership of a percentage of stock may never add any significant value. In any event, the benefits of making an employee a shareholder must be weighed against the burdens involved in the transaction and in having an employee as a co-owner.

Issues for the Employer

A mong the reasons for opposing the giving or selling of stock or stock options to an employee are the following:

• Bringing in another shareholder, even with just 1% of the stock of the company, requires that steps be taken to issue or transfer stock, and that steps continue to be taken to comply with other corporation law requirements regarding shareholders. For example, the financial condition and all relevant information of the corporation must be disclosed to the shareholder investor and he or she will continue to have the right as a shareholder to attend meetings and vote for directors. With the addition of the employee shareholder, holding annual meetings and special meetings to vote on important corporate issues may become a burden.
• In addition, California Corporation Law requires that a corporation with 2 shareholders have 2 or more directors, and if there are 3 shareholders, there must be 3 or more directors. It may be necessary to bring in additional directors, and the majority shareholder can lose power over the Board.
• The extra time taken in a small corporation to comply with corporate formalities can be a nuisance, and the cost each year of attorneys’ fees related to corporate matters will probably go up, even if the new shareholders pose no significant problems.
• A shareholder with just 1% of the company may limit the company and can cause quite an increase in the costs of operating the corporation. For example, any shareholder can prevent the corporation from electing S corporation status. A company planning to bring an employee in as a shareholder will want to make sure the employee agrees to certain actions and signs a shareholder agreement prior to getting the stock. The cost of the shareholder agreement can be significant.
• Employers will need to make sure the terms of the shareholder agreement prevent transfers to third parties and require that the stock be sold back in the event the employee quits or is terminated.

• A valuation of the company is often necessary in order to determine the appropriate price for the stock issued or transferred to an employee. The cost of a valuation must also be considered in determining the desirability of rewarding an employee with stock, rather than providing cash compensation.

E ven from the employee’s standpoint, there are significant negatives to consider, such as:

• The stock ownership often is not a good deal as a financial investment. The employee in most circumstances would be a minority shareholder, and would get nothing extra from the ownership of stock, getting no return on his or her investment. The only ways to get a return on an investment are by getting dividends, selling the company, increasing one’s salary, or selling one’s stock in the company, none of which are normally within the power of a minority shareholder.
• The employee shareholder is usually restricted by agreement from selling the stock to outsiders without first offering it for sale to the corporation or the other shareholders. This and any other restrictions reduce the value of the stock as an investment.
• If the company goes out of business, the employee loses whatever money was put in (or whatever the value was believed to be).

Holding stock in a small privately held company is not the same as holding stock in a big publicly traded company or one that is going public. There is no market for the stock in a private company. Investors are generally not interested in buying the stock and becoming a minority shareholder. There is no way to sell the stock whenever you need cash. Other shareholders are the only clear market for the shares, and they may not have any reason to offer a high price for the shares. In a small closely held company, the only common situations in which the shareholder employee can sell the stock and make money are where:

• The company goes public;
• The corporation is liquidated at a time when the corporation has cash in excess of liabilities, so that all shareholders receive cash for their stock;
• Another shareholder wants to buy the employee shareholder’s stock; or
• The company is sold to a larger company that buys all the shares of stock. Even when the company is purchased, the transfer may be accomplished as a purchase of assets instead of stock, along with agreements for services. This is advantageous for the purchaser to avoid liability and increase tax deductions, but means that the stock ownership does not automatically provide significant rewards when the business is sold.

Alternative Methods for Getting Stock

I f the majority shareholders decide that bringing an employee in as a shareholder is the right thing to do, there are several ways the employee can get stock. The most typical methods are through a sale of stock, getting and exercising stock options, or by a stock bonus.

An outright purchase of stock by the employee is the easiest transaction, whether the stock is issued by the corporation or sold to the employee by the majority shareholder. However, many employees do not wish to actually make a purchase of stock in their employer.

Although stock options sound most appealing, a stock option requires the establishing of an agreement or program allowing stock to be purchased by the employee. The agreement or plan must define the option period during which the option must be exercised, the purchase price for the stock, and the payment terms. Again, a purchase price must be paid in order for the employee to obtain stock.

Since taxes are due on the exercise of a stock option where the option price is lower than the value of the stock, companies providing stock options often wish to create qualified stock options on which the IRS allows deferral of those taxes. The qualified plans are, for a number of reasons, often too costly or inappropriate for the small company. And the employee still must pay for the stock when options are exercised.

Stock cannot be purchased and options cannot be exercised by employees if they do not have funds to make the purchase.

The stock bonus seems to be a good way for employees to get stock without selling it to them. The stock is issued as compensation for services rendered. This sounds desirable, but actually presents a number of significant problems. Since the stock is issued as compensation, taxes are owed on the stock received by the employee, just as they would be on a cash bonus. Employees are often not happy paying taxes on stock received, when no cash has been received with which to pay those taxes.

Any of these approaches require compliance with state and federal securities laws, just like any other issuance or transfer of stock. Any issuance of stock must either be qualified with the Department of Corporations or completed in compliance with an appropriate exemption from registration.

When Stock is Appropriate for Employees

U sing stock or other ownership rights or interests as an incentive for employees is a common approach to business growth. It became much more popular in recent years, with the explosion of employment in high tech companies, and with the large amounts of investment funds in such companies.

Owners and employees of privately held businesses must look beyond the general idea of ownership as an incentive, and consider what an employee really gains by owning a small percentage of a privately held company, and when it is appropriate.

The stock or stock options for employees may be appropriate if the business is:

• large enough that the expense of stock option plans, valuations, and other costs related to the stock transaction are not a concern;
• a rapidly growing business providing a meaningful increase in stock value, which is the key to valuable stock options;
• the type of business that is likely to be acquired or go public; and
• one whose current owners are seeking management employees who will eventually take over and operate the business.

Even in this situation both the negatives and positives of stock or stock options must be considered.