I often find myself counseling caution to business owners that want to use equity to reward or attract key employees. The reason, quite simply, is that if the relationship sours, the employee not only has to be fired but you then have to deal — at best — with a disgruntled former employee as owner or, more likely, he or she likely will have to be bought out.
It’s Not Easy to Fire the Owner-Employee
To get a sense of how difficult these circumstances can be, let’s look at Ross Holding and Management Co. v. Advance Realty Group (Ross Holding v. Advance Realty (Del).pdf), a case recently decided in Delaware construing New Jersey law. Advance Realty Group managed real estate properties on the East Coast and awarded membership interests to key managers. The managers received “Class A” general ownership units and “Class B” units reserved for management. Reading between the lines of the opinion, it seems that a new investor came into the business and the old management team got their walking papers.
The departing managers redeemed their “B” units for cash and also signed general releases of any employment related claims. The “A” units were carved out for later redemption. When the redemption failed to happen, the former managers brought suit alleging various claims of wrongdoing and mismanagement.
Release Did Not Cover Claims Brought As Owners
Construing New Jersey law, the Court held that most of the claims would survive a motion to dismiss because they were brought not as former employees, but as holders of “A” units, including acts that allegedly occurred before the managers were let go. The releases given by the former management team simply did not extend to their claims as equity holders.
Thus the current management of Advance Realty found itself subject to claims concerning the sale of properties, alleged self-dealing and the like. Moreover, it likely discovered that the former management team knew far more about the business than would a passive investor, which would certainly make it more difficult to prevail.
Pitfalls of Equity Awards
When dealing with a small limited liability company, or a corporation for that matter, in which employment is bound up with ownership, you don’t simply fire one of the owner-employees. In many corporate oppressed shareholder cases, that termination amounts to per se oppression unless there are regular dividend payments. In limited liability companies, the rights may be less clear, but former employees can be well motivated and the litigation costs may be substantial.
There are a couple of approaches that one might take, none of them very satisfactory. One is the use of a tiered equity structure – the so-called limited equity owners. These non-owners have some of the rights of owners (voting, ability to bind the business, etc.) but no right to participate in the upside of the business through equity. The other way is to set the equity for the employee-owner in advance at a modest amount. (I was once a limited equity owner of a law firm and my interest was worth the princely sum of $100.)
The better view is simply to beware. You don’t want to grant anyone equity unless you are willing to take on the burdens, and hopefully rewards, of having them as a full owner of the business. In many cases, if it doesn’t work out, the business will have the same headaches as it would if they were one of the founders.