March 29, 2024

You’re the Boss Blog: Giving Employees a Stake in the Outcome

Sustainable Profits

The challenges of a waste-recycling business.

Compensation is one of the most complex and challenging topics I have come across during my eight years as chief executive of TerraCycle. By definition, it is a highly personal topic that is charged with emotion for employees and can involve their personal aspirations, their sense of self worth and pressures they feel at home.

I have always been a proponent of offering employees a stake in the outcome. When I started TerraCycle, I couldn’t pay anyone. To get people to commit to full-time work, I gave them stock options. As a result, I succeeded in getting a lot of fine people to work for the company, and we ended up with lots of stock-option holders who are not involved with the company today (almost a decade later).

Stock options give employees the right to buy stock in the company at a set price but at a later point in time, presumably when the market price of the company’s stock has risen in value. Because TerraCycle is not a public company, the price of the stock options are determined by a 409A evaluation, which is done by an independent company. Once the stock is purchased, an employee can transfer or sell it if there is a liquidity event in the company, and they can earn dividends if they are declared.

A number of the early employees who were granted stock options have decided to exercise some of their options for stock. In other words, they paid the exercise price of the option and bought stock in TerraCycle, effectively giving them the same status as one of our traditional equity investors. In general, investors can gain a return through dividends (which we have not yet declared) and through a sale of their stock (so far TerraCycle has bought back about 3 percent of the business via stock-repurchase tenders).

While stock options allow companies to create incentives for employees that don’t involve cash, they also create a complicated and costly administrative burden. The law requires the company to engage a third party to run an annual analysis of the value of the shares. The company must also inform option holders when their stock options are about to expire and respond to requests for information. And if most of the option holders exercise their options, the company can end up with many small shareholders. If your company has too many, it automatically becomes a public company for regulatory purposes, subject to the rather costly and cumbersome burdens of Sarbanes-Oxley.

To put this administrative burden into perspective, TerraCycle has 100 employees and about 100 shareholders and our shareholder administration (employees and investors together) probably consumes the equivalent of two full-time employees plus five-figure annual legal fees.

If you give stock or options to large numbers of employees, as TerraCycle did, and have a large investor shareholder base (as TerraCycle does), you will eventually constrain the company’s ability to offer additional option packages to future employees who truly deserve a stake in the company. Each year, we  watch carefully as old options expire, which helps bring stock back to the business and reduces the list of potential shareholders. We are not anywhere near being at risk of being classified a public company, but we are constrained to the point where we can’t issue additional options to more than a few employees, and given that I want everyone at TerraCycle to have a stake in the outcome, that’s a problem.

That’s why I recently challenged my executive team to find an alternative solution that wouldn’t face these constraints, a way for TerraCycle to give all employees, now and in the future, the benefits of stock options without creating burdens and constraints for the company.

To offer a benefit that is similar to receiving dividends, we plan to implement a profit-sharing program in 2012 for all employees. To offer a stake in the outcome if and when the company is sold, we turned to an incentive plan called “phantom units” that gives employees the ability to participate in the sale of the company as if they are shareholders without actually being shareholders.

Phantom units are a contractual right the company gives an employee to participate in the sale of the company. Phantom unit holders don’t receive dividends or get to vote, but they do get a payment, equivalent to that of a common share, at the time of a change of control or sale of the company.

In lay terms, here is how our program will work: Employees will get a grant of phantom units proportional to their salary every year of their employment. Each unit will entitle them to receive a share of the company equivalent to what a common stockholder receives. If and when the company is sold, each unit of phantom stock will be equal to a common share. Financially, the employee doesn’t have to pay an exercise price for the phantom shares, but if the company is sold, the proceeds are taxed as ordinary income instead of as capital gains.

In other words, after eight years of figuring out how to give a stake in the outcome to all employees and creating a mess in the process, we have found a formula that gives employees the benefits of stock options with significantly fewer headaches.

Tom Szaky is the chief executive of TerraCycle, which is based in Trenton.

Article source: http://feeds.nytimes.com/click.phdo?i=6b6709e6b2a52a60b15747ba7432a8d6