Giving Stock to Key Employees – Good Idea or Bad Idea?

by James L. Rudolph, Esq.

As a small business grows, it is not unusual for a critical or key employee to ask the owner for stock in the company, or for an owner to believe that providing stock to key employees is appropriate, and may even be necessary to keep the employee. For a restaurant that wants to keep a great chef, or any business that wants to retain an effective manager of operations, giving stock could look like an attractive way of retaining a key employee while enhancing the employee’s motivation as an equity partner.

However, business owners should understand that there are very significant legal duties owed to minority shareholders, and when relationships sour, it is not uncommon for minority holders to flex their legal muscles, alleging that majority owners have violated any number of their legal duties. That is why small business owners are well advised to consider other means of rewarding, retaining and motivating their top talent.

Majority owners have legal duties of loyalty, good faith and honesty in dealing with minority shareholders. These duties have been interpreted by the courts to impose a variety of obligations on majority owners. As a result, minority owners have certain rights that ordinary employees do not have when, for example, the majority owner sells the company, terminates the shareholder-employee, decides to go out of business, or takes monetary or other benefits (often called corporate opportunities) that are not offered to all stockholders.

The courts have imposed a number of disclosure obligations relating to certain business events and decisions. For example, most states require that owners provide shareholder-employees with certain types of business information, including periodic financial information, in connection with their stock ownership.

It should be noted that experienced Massachusetts legal counsel can help devise creative ways to retain and motivate key employees without endangering the business, or unduly restricting the owner’s discretion to operate the business as he or she deems appropriate.

Owners might retain employees through the carefully crafted use of incentives such as:

• Pay increases or bonuses tied to the employee’s or the company’s performance;
• Key-employee life insurance or health insurance benefits;
• Vehicle, entertainment, or other expense allowance; auto insurance and travel expense reimbursements;
• Deferred compensation plans; and
• Other solutions fitted to the needs and means of the business owner.

In some cases, key employees will even value low-cost or no-cost solutions that give them more public notoriety or credit, such as touting the name of the chef or key manager on websites, printed materials and signage.

No doubt, there are certain business owners who do feel they have no choice but to give stock to key employees. (Unfortunately, some of my clients who have done so, later said they should have listened to me.) These are some of the things we recommend if stock is given to an employee:

1. Be sure that if the employee is terminated, the company can buy back the stock, usually at a formula pre-determined in a stockholder’s agreement. (I advise using book value or some other formula as opposed to fair market value.)
2. Give the company the right to buy back the stock at a lower price from any employee/stockholder who is terminated for cause.
3. Restrict the employee-stockholder’s right to transfer the stock without the consent of the majority of stockholders. This may become especially important if the employee gets divorced.
4. Keep a majority (51%) interest in the company. There is a big difference between owning 49%, 50% and 51% of the stock.
5. If the company has a policy of reimbursing the owner for certain expenses, have the employee acknowledge and agree to these expenses continuing to be paid.
6. Have the shareholder’s agreement specifically waive any fiduciary duties that the shareholders may have by law to each other.

In any event, an owner needs reliable counsel to craft the right solutions for the situation, and to provide confidentiality and non-compete restrictions where necessary and appropriate.

Jim Rudolph of Rudolph Friedmann LLP has spoken at legal seminars and published articles on the subject of the rights of minority shareholders, and he has counseled numerous majority and minority owners of small business enterprises.