Employee Stock Plans More Popular

Entrepreneurs prize their hard-earned status as “owners.” In recent years, however, many of them have experienced shrinkage in the business equity they treasure.

Q. I own 100% of the stock in my firm. My son is now encouraging me to share some equity with key employees, claiming that it will increase their performance and the profitability of the company. Looks like a win/win situation. Is there any downside?

A. Stock ownership plans are gaining in popularity for the reasons you mentioned. A recent study conducted by Segal Co., a benefits consultant, revealed that the average equity holdings of the “top dog” in a small firm with less than $10 million in annual sales has dropped from more than 50% to less than 40% in just five years.

The 1998 INC Magazine survey of the 500 fastest-growing entrepreneurial firms shows that less than 25 percent of the principals of these firms still retain all of the equity. Thirty percent of them presently have less than half of the outstanding equity.

It’s apparent that more and more entrepreneurs are coming to the conclusion that sharing pays off. (You can learn more about the “upside” of employee ownership by contacting the National Center for Employee Ownership at www.nceo@nceo.org.

There are, however, some important potential downsides that you should consider before you distribute shares. Adverse personal tax and dilution effects can result in some circumstances, so make sure your accountant carefully reviews any proposed stock issuance. For example, except in the case of a formal ESOP (Employee Stock Ownership Program), the use of shares owned directly by you could trigger some very unfavorable capital gains or gift tax consequences.

Perhaps most importantly, be aware of the fact that a holder of just one share in your firm is entitled to all of the fundamental rights of ownership, including access to company information and the ability to vote on key issues. While in some states you can enjoy a few prevailing rights if your ownership percentage is large enough, disgruntled, dissatisfied and disaffected owners of stock in your company can put you through some trying “hoops” that wouldn’t be there if you owned all of the stock.

Keep in mind, if holdout minority owners have enough of a stake, they can demand terms and returns that might hinder - or even prevent - your future plans to sell the company and cash out.

A well-crafted shareholders agreement prepared by an experienced corporate attorney can prevent most of the negatives that come with third-party stock ownership. Also, absent any agreement to the contrary, owners can sell their stakes to anyone at any time. Just think of the grief that a competitor or an ex-daughter-in-law could create if they owned shares in your company.

That’s why, according to attorney Scott Friedman, author of “The Successful Family Business,” a shareholders’ agreement and formal stock restrictions are a must when shares in a privately-held company are distributed. Make sure that, before they get anything, all share recipients enter into a formal and binding agreement that limits and controls the sale, gifting or transfer of the shares they will hold.

This agreement should also stipulate that their stock cannot be encumbered in any way. You don’t want a bank seizing shares in your company simply because they were used by an employee to collateralize a loan that ultimately went into default.

Any stock option program your firm offers should also be subject to the terms and conditions of such an agreement. All stock certificates issued should carry a prominently written “legend” that alerts potential third-party acquirers of your company’s outstanding shares to the restrictions that constrain them, and to the rights relating to their transfer that you and your company have retained.

Certainly, you will want to retain the right to buy back shares that other holders might wish to dispose of in the future. This right should stipulate how such a transaction would be executed and financed.