By Jonathan Bench, Attorney at Harris Bricken
This is the season of the year where cannabis business owners start to take a hard look at their end of year finances to decipher how profitable the company has been and whether and how their employees and other key personnel should share in that profit alongside the owners. Some marijuana and hemp employers do this with bonuses and others with equity or quasi-equity.
It is common in closely held (privately owned) companies to have some key employees who are almost irreplaceable. Often these employees started with the company shortly after its formation and have earned their implicit trust within the organization. Other times companies that are transitioning from “mom and pop” status into a larger enterprise and know they need to attract and retain key talent by including equity or quasi-equity in a competitive compensation package.
All of these potential compensation methods have pros and cons. I discuss a few of these general considerations below:
Profit. This is always the place to start your deliberations. Basic economics teaches us that all parts of the profit pie must equal 100%. If you start out with 100% economic ownership and give away 5% of the company’s profit to 10 key employees, you just cut your take-home profit in half. This is true whether you are granting actual equity, options that will convert into equity, or quasi-equity that is really a bonus structured as if the recipient owned equity.
It is significantly easier to revoke a bonus or quasi-equity than options or actual equity, and it is significantly easier to revoke options than actual equity. Once someone owns an unalloyed part of your company, they are your full-on business partner, with their rights only circumscribed by your lawyer’s careful contract drafting skills.
Decision Making Power. For owners that are considering a creative compensation plan but are hesitant to relinquish any decision making power, all of these avenues potentially allow you to retain 100% of the voting rights in your company.
Quasi-equity confers only economic rights to profits, as described in the executive’s or employee’s compensation agreement. Options do not automatically confer any economic or voting rights until they are exercised, and then the equity received (typically corporation stock or LLC transferable interests and membership rights) dictates those economic rights and whether any voting rights are included. This holds true for straight grants of equity, as well, depending on the type of equity.
If the form of business entity permits, you can easily create a second class of ownership rights that does not carry any voting power. You can do this with a limited partnership (LP), an LLC, a C corporation, and even an S corporation. But if you want to get creative with your economic rights, you cannot do that with an S corporation (or an LLC or other entity that has elected to be taxed as an S corporation).
Optics. This is sometimes a hard conversation to have with cannabis business owners because they need to know: (a) the industry standard at any given point in time regarding executive and key employee compensation; (b) what their executives and key employees reasonably expect to be offered in a compensation package; and (c) what their executives and key employees will reasonably be satisfied with.
It is expensive to replace key employees. It is also expensive to replace or deal with the fallout from an offended employee or many offended employees. But chances are that you will have a good feel for the personality and motivations of your existing employees, and you will know whether they are reasonable and will be grateful for additional specialized compensation or not. And for prospective employees and executives, they will know that your opening offer will likely differ somewhat from the final offer. They will welcome the opportunity to discuss their value to your company.
Taxes. No one likes talking about taxes except CPAs, CFOs, and the rare attorney. But both employer and employee taxes should be at the forefront of your deliberations regarding creative compensation structures. As a general rule, many employees will be happier to not have to think too hard about the future tax ramifications of their compensation.
That means that once the employee understands all of the nuances, they may prefer a straight bonus or a quasi-equity award because those would generally be taxed as ordinary income, with the taxes paid through your normal payroll process, and the employee receiving the net balance. Employers generally prefer this method, as well, because the entire amount is a deductible business expense like all employee compensation.
Options are much more nuanced and generally would not trigger tax consequences until they vest, with additional ramifications once those options are executed. An equity grant means that the employee or executive will be treated just like the other owners and will be responsible for the tax consequences of receiving the equity and also for its appreciation and periodic distributions. That can make some employees nervous, but most experienced executives will understand that the possible upside comes with tax consequences. It should not faze them, but they should understand it with the help of their tax advisers.
Be Prepared. Whether you like it or are planning for it, many key employees, including non-employee directors, will expect some type of equity-related grant. You should be prepared to discuss this topic with them and your reasons for offering it or not.
Re-published with the permission of Harris Bricken and The Canna Law Blog