Startup companies often have trouble financially compensating their employees because of their low or non-existent profits in the first couple years of operation. As a result, many of these companies have turned to stock options in order to maintain and motivate employees. The question is, for small businesses, are stocks really the best option? Cash profit-sharing plans are an alternative that motivates employees to put forth their greatest effort so that the business is profitable and they receive the short-term, cash benefits. Read more about both options below.
Benefits and Drawbacks
As mentioned before, stock options are a favored form of compensation for cash-poor companies that have good growth prospects, such as internet startups. Some reasons that companies choose to implement a plan are to increase the feeling of ownership among employees, and compensating workers beyond a salary without using a lot of cash. Under an employee stock option plan, employees can purchase stock in their company for a set price and specified time frame. If they purchase stock and the price goes up, they can sell it for a profit.
The downside is that there is no guarantee that the price of the stock will appreciate, meaning that it could turn into a bad investment for the employee. Other drawbacks are that some programs require employees to pay cash to purchase the shares instead of having it included as part of their pay package. There are also limitations for when employees can sell the shares—there is often a vesting period where the employee must hold onto the shares to reduce turnover. Employees that leave during the vesting period often lose their stock options altogether.
Types of Stock Options
There are two basic types of employee stock options: nonqualified stock options and incentive stock options. Non-qualified options allow employees to purchase their company’s stock at a preferred rate. If the price of the shares goes above market value, the employee will be taxed on the excess amount when it is sold. This type of option gives the employee the most freedom in when to purchase or sell the stock. Incentive stock options (ISOs) are not taxed upon purchase, but the employee is subject to other taxes such as the alternative minimum tax (AMT). This is paid when the stock is sold, but if it is one year from when it was purchased or two years from when it was granted, they can take advantage of the lower rate applied to long-term capital gains.
Cash Profit Sharing
The other alternative that small businesses have is to offer what is known as a current or cash profit-sharing plan. This type of plan motivates employees to grow the business’ profit margins in exchange for compensation in the form of a periodic cash payout. According to Salary.com, the bonus is usually between 2.5 and 15 percent of an employee’s normal salary. This can be an excellent way to get employees to work harder, especially because people tend to think in terms of short-term rather than long-term gains. Some drawbacks are that employees may come to expect a certain amount from the profit-sharing plan, when it is possible that employees’ effort may not match the company’s profit for that period due to external factors.
Both employee stock options and profit-sharing plans will motivate employees to grow the business. If you are looking to keep employees for a long period of time, having stock options with a vesting period will incentivize employees to stay at the company, at least until they can redeem their stock benefits. The best part about offering stock options is that companies can compensate employees, sometimes more generously, for their work without using up valuable cash assets. However, it is true that people work for short-term incentives and that having a cash profit-sharing plan where employees receive a certain percentage of a company’s profits on a regular basis will get them to go the extra mile in order to take home a larger paycheck. If you are in a position to do so, why not give employees a choice of how they would like to be compensated? Having a stock option plan and cash profit plan will grant employees the perk of their choice, keeping them fully invested in the welfare of the business.
1) Johanson Berenson LLP: “A Primer on Employee Stock Options”
2) EBRI: “Profit-Sharing Plans”
3) CNN Money: “Employee Stock Options: Top Things to Know”
4) eHow Money: “Types of Employee Stock Options”
5) HowStuffWorks: “How do stock options work?”
6) eHow Money: “Pros & Cons of Exercising Stock Options”
7) Stock Plans: “Give the People What They Want”
8) Fairmark.com: “Incentive Stock Options in General”
9) EzineMark.com: “The Difference Between Stock Option and Profit Sharing Plans”