This is the third post in a series about the legal and technical ways that a new owner is added to a business. The first post addressed onboarding an investor and the importance of getting an agreement in writing. The second post talked about adding a true “partner” to your business – someone who is going to be helping you with the management of the business. This third post is going to talk about offering a valued employee an ownership piece of the business.
In the past few years, I’ve seen more and more small business owners talking about offering ownership to one or more of their employees. It’s great that business owners recognize and value their employees who are committed to helping their businesses grow – and they want to reward them (and keep them motivated) with a piece of the pie. But giving employees (or allowing them to buy) some ownership in the business is more complicated than business owners initially realize. It’s actually the most complicated way to add an owner to the business.
That’s because there are specific laws that protect employees – on both the state and the federal level. So not only do you have the normal requirements for adding an owner, you now have additional ones to consider. This post is going to discuss some of the issues you’ll need to understand if you’re wanting to offer a valued employee a piece of your business.
First, let’s consider how the employee is going to receive the ownership. Will it be “given” to them or will they have to pay for it? If a percentage of ownership (LLC) or shares (Corporation) are “given” to an employee, they are usually considered as compensation for the services the employee provides. Which means that the value of that percentage or those shares could be subject to employment taxes – and the determination of that value could be really hard to determine (and sometimes expensive!).
If the employee is going to buy the percentage or shares, then what should be the purchase price? Again, you run into the valuation issue – what is your business worth? With the state and federal requirements, business owners need to be careful about overvaluing and undervaluing the ownership interests. There are deep pitfalls with those requirements for business owners who do not comply. So it gets to be a tricky balancing act when determining the purchase price.
As for payment of the purchase price, the same considerations apply that were discussed in the second post in this series. If the employee is not able to pay the entire purchase price in one lump sum, then some kind of promissory note needs to exist to document the obligation to make payments. And what if one or more of those payments are not made? What happens to the employee’s ownership in the business?
OK, now let’s take it a step further. Let’s say the transaction is complete and the employee owns a part of your business. What kind of management decisions is the employee going to be able to make? What if the employee quits or gets fired – can they keep the ownership? If not, how does it revert back to you? What if the employee has an accident, becomes disabled and can no longer work?
These are issues that should be dealt with in a contract between all of the owners – an operating agreement (LLC) or a shareholder’s agreement (Corporation). This contract should always be in writing and signed by all of the owners. It is a critical part of the structural integrity of your business.
Unfortunately, many times small business owners decide in the end that promoting an employee to an owner is too complicated to pursue. As a practical matter, there are alternatives to offer a valued employee that do not involve sharing the ownership of your business. If you are looking for ways to reward or motivate an employee, seek the advice of an experienced business attorney before making any moves. Some of those state and federal laws protecting employees can be quite complex. And, as always, whatever you do – get it in writing!