Having a piece of the rock is what separates employees from owners.  Generally speaking, owners share in the profits and appreciation in the value of a business, have certain voting rights, are owed greater legal protections by the business and fellow owners and have the right to see business information and financial records.  Employees typically don’t have any of these privileges.  So the decision to award equity to new or existing employees in a privately held business should not be made lightly—it’s more complicated than you might think.

Companies sparingly give out equity to make employees feel more like stakeholders and act more like entrepreneurs.  The basic premise: An employee who is also an owner will have added incentive to enhance the value of the business, including increasing revenue and minimizing expenses.  An employee-owner is also likely to be more loyal.

These laudable ideals don’t always require an equity stake; creatively structured bonus arrangements can sometimes produce similar results.  But bonus arrangements often reward short-term objectives rather than promoting long-term goals.  Nor do they generally reward employees for the growth of the business and/or create the “golden handcuffs” management desires.

So-called phantom stock plans and share appreciation rights plans can be exceptions.  These bonus arrangements are structured to defer the recognition of income and to emulate, respectively, a stock grant and a stock option.  Such plans pay bonuses based upon the growth in the value of the underlying equity and usually provide a payout only upon a liquidity event, such as a sale of the stock or business assets.

Like equity, these plans are meant to incentivize employees to act in the long-term interests of the business.  Yet they often fail to do so.  Because they do not substantially replicate and align with the interests of the actual owners, employees don’t feel or act like owners.  Since these plans aren’t real equity, the employee’s rights are generally defined only by the terms of the plan, which are usually crafted to favor the company.

For example, many plans allow the company to unilaterally change the terms of the plan, including the vesting period; to unilaterally decide the valuation of the employee’s equity-like rights if the employee dies, becomes disabled or retires prior to a liquidity event; and to automatically alter the payout provisions if the company’s cash flow shrinks.  An owner’s rights, on the other hand, are far more firmly protected by statute and case law.  For the employee, this fine print alters the certainty of the carrot at the end of the stick, making the employee feel less like an owner and more like an employee.  Also, while owners pay long-term capital gain rates upon the sale of the business, employees with mere contractual bonus rights will pay higher ordinary income rates.

Stock options awarded to employees in a privately owned business share many of these defects.  Except in startup and depressed business situations, the award of equity grants without vesting or restrictions may come with an unintended penalty: Employees pay taxes on them as if they were given a cash bonus to purchase the equity.  Similarly, equity grants awarded with restrictions—so-called restricted equity—usually result in ordinary income taxation for the employee whenever the restrictions lapse.  If the expectation is, as it should be, that the company will increase in value, then the employee will have to pay much higher taxes in the future.  Consequently, many-employees make a special election to accelerate the tax payment.

It’s hard to argue with the goals behind granting equity or equity-like compensation to employees.  But before any company moves ahead with equity grants, it must balance its desire to incentivize employees with the need to reduce complexity and litigation risks.