Small businesses often look for ways to provide their employees with ways to participate in the successs of the small business. While stock options and restricted stock are popular ways to reward employees in public companies, these and other plans are also available to small businesses.
These plans help small businesses tie their compensation to their results and provide great flexibility for the small business. If results are great, then compensation increases. If results suffer, compensation decreases. Most of these plans also encourage great alignment between the employees and the small business and encourage the retention of employees.
The most popular ways small businesses allow their employees to participate in the success of the small business are as follows:
- Annual bonus plans. Many small businesses adopt annual bonus plans for their employees. Typically, these bonus plans set a target for important financial and other goals of the small business. Depending on the achievement of these goals, the small business provides payments to the employees. For example, a small business may provide a bonus plan that is targeted to pay its employees an amount each year equal to 25% of their income if one or more targets are met. Assume John is an employee making $50,000 a year with a 25% bonus opportunity of $12,500 (25% of $50,000). Perhaps the target is EBITDA (earnings before interest, taxes and depreciation). If the EBITDA for the small business is 110% of plan, the bonus to employees would be $13,750 (110% of the target bonus of $12,500). If EBITDA is 80% of plan, the bonus would be $10,000. Annual bonus plans are a great way of helping employees focus on the short term goals of the business.
- Long-term bonus plans. Long term bonus plans are also used by many small businesses. These plans operate like annual bonus plans but the targets are set for longer periods. For example, a long term plan may focus on financial and other targets over a three-year period.
- Stock Options (or membership interest options). Small businesses can provide their employees with ownership rights in the form of options. The way options usually work is that the small business sets aside a pool of a certain amount of ownership rights (for example, up to 10%) for employees. Over time, they grant these options to small businesses at an exercise price equal to the fair value of the small business at the time of grant. Options usually vest over a three to five year period and employees usually have about 10 years to exercies options. Options that do not vest or are not exercised are put back into the pool. For example a small business worth $2 million may grant an employee option rights to become an owner of 5% of the business with a vesting period of 5 years. The option rights wouldhave an exercise price of $100,000 (5% of $2 million). If the employee continues employment for 5 years, then the employee can purchase up to 5% of the business at an exercise price of $100,000 before the tenth anniversary of the grant. This allows the employee to participate in the growth of the business.
- Restricted ownership rights. Restricted ownership rights are similar to options, but without the requirement to exercise an option of an exercise price. For example, a small business may grant an employee the right to own 5% of the business. The employee receives 1% of these rights each year for each year of continued employment.