Closely held businesses face a unique challenge when it comes to talent: how do you attract and retain your best people without giving away ownership or control? Unlike public companies, these businesses often need to preserve ownership structure, manage limited liquidity and navigate succession planning while still competing for top performers.
Consider a second-generation family manufacturing company. The operations manager, a 20-year veteran who knows every machine and every customer, has just received a compelling offer from a competitor. Leadership faces a difficult question: How do we keep this person invested in our success?
The good news is there are proven alternatives to traditional equity that let key employees share in the company’s success without diluting ownership. Below, we examine three widely used strategies: annual incentive programs, long-term incentive programs (LTIPs) and phantom equity.
What Are Annual Incentive Programs?
Cash bonuses paid on an annual basis are the most straightforward option. They can reach a wide range of employees and can be tied to metrics that matter most to your business, whether that’s hitting revenue targets, improving safety records or achieving customer satisfaction goals. Most are structured to require employment on the payout date, which provides some retention value. And when structured properly, annual bonuses avoid the complex compliance requirements that come with deferred compensation while still giving the company an income tax deduction for the year of payment.
What Are Long-Term Incentive Programs?
If annual bonuses are about rewarding this year’s performance, LTIPs are about building long-term commitment. These programs can include cash awards, equity compensation or both. They’re particularly effective for retention because employees must typically stay with the company for three to five years before they fully vest in the benefits.
For closely held corporations, nonqualified stock options and stock appreciation rights (SARs) are popular choices. Both motivate employees to focus on company growth because they only pay out if the company’s value increases. But there’s an important difference:
- With a stock option, the employee can purchase company stock at the price set when the option was granted, then sell it back later to capture any gains. The catch is that the employee becomes a shareholder, which many closely held businesses prefer to avoid.
- With an SAR, the company simply pays the employee cash equal to the stock’s growth in value. No actual shares change hands. For closely held businesses that want to reward employees without adding shareholders, SARs are often the better fit.
For both options and SARs, the increase in the value of the stock is taxed as regular compensation when the award is exercised.
Restricted stock awards work differently. They recognize both past and future contributions. But like options, they make the employee a shareholder, which limits their appeal for many closely held businesses.
One practical note: any equity-based award requires the company to set aside enough shares to back the awards. If that’s not feasible, phantom equity (discussed below) offers a workaround.
For LLCs, profits interests are the go-to choice. They allow employees to share in the company’s future appreciation without the complication of actual employee ownership. Even better, if structured properly, payouts can be taxed as capital gains rather than ordinary income. That’s a significant benefit for employees.
What Is Phantom Equity?
Phantom equity lets employees share in the company’s financial success without becoming actual owners. Here’s how it works: instead of granting real stock or membership interests, the company creates bookkeeping “units” that track the value of a share. After an employee vests (based on time, performance goals or both), they become eligible for a cash payout tied to those units. The payout typically occurs upon a triggering event such as a change in control or the employee’s departure.
Think of it as a way to give key employees “skin in the game” without actually putting them on the cap table.
There are two types of phantom equity: appreciation-only and full-value. Appreciation-only phantom equity limits the payout to the increase in value between the grant date and the payment date. For example, if the value of a share of company stock is $100 on the date a stock appreciation unit is granted to an employee and the value is $150 on the date of payment, the employee receives $50 per stock appreciation unit. Full-value phantom equity pays out the full value of the unit, including the value at the date the unit is granted. Using the same example, the payout of a full-value phantom unit is $150 per unit.
There are some compliance considerations to keep in mind. Phantom equity typically qualifies as deferred compensation under Internal Revenue Code Section 409A, which imposes specific design and operational requirements. Plans that pay out on termination of employment may also trigger ERISA provisions, which is why these arrangements are usually limited to a select group of highly compensated employees.
The tax treatment is straightforward: employees aren’t taxed until they receive the cash, at which point it’s reported as ordinary compensation on their W-2. The company gets a corresponding tax deduction.
Which Approach Is Right for Your Business?
It depends on your goals:
- If you need a simple, flexible way to reward performance across the organization, annual bonuses are easy to implement. But, they offer the least retention effect.
- If retention is your priority, perhaps because you’re preparing for a transition and need key people to stay through the process, an LTIP with multi-year vesting may be the strongest tool.
- If you want to tie a key employee’s financial interests to long-term company performance without diluting ownership or adding shareholders, phantom equity offers the best of both worlds.
Many closely held businesses use a combination of these strategies, tailored to different employee levels and business objectives. The key is designing a program that fits your company’s ownership structure, cash flow and long-term plans.
That second-generation manufacturing company we mentioned? Leadership now has a framework for the conversation: What does the operations manager value most? What can the company realistically offer? And how do they structure an arrangement that keeps their best people invested in the company’s future without changing its ownership?
Lathrop GPM’s employee benefits and closely held business attorneys are available to discuss these strategies and help design a compensation program tailored to your business.