Once you give an employee stock, your relationship changes forever

Francesco Pompei, president of 60-person Exergen Corp., in Watertown, Mass., thought he was just dismissing a worker when he fired Steven Merola. In court, however, Merola's lawyer argued that his client was no ordinary employee: instead, Merola was a minority shareholder whose fiduciary rights had been violated by the firing. The ensuing court battle lasted eight years. "I hadn't the foggiest idea it would end up this way," Pompei says today of the long, costly legal dispute.

Pompei was fairly lucky. Even though two lower courts had decided in favor of Merola, the Massachusetts Supreme Judicial Court ultimately sided with the employer. (In the meantime Exergen had bought back Merola's stock.) But in several other cases, the owners of closely held companies have not done so well after dismissing employees who owned stock. "It could go either way in court," explains lawyer Kevin Scott, a partner with Fox, Rothschild, O'Brien & Frankel LLP, in Philadelphia. "The more lawyers can dress the client up as an oppressed minority shareholder, the better the plaintiff's chances are of prevailing."

Is your company at risk? The most likely target for this type of lawsuit is a closely held company that has granted stock selectively to a small number of key employees. Although sharing equity can be a great way for small growing companies to recruit and keep talented workers, too many business owners grant stock blindly, without writing sound shareholder agreements. Remember, if you grant equity selectively to an individual employee, your relationship changes forever. Though state laws vary, there are a number of ways such individual employee-shareholders may complicate your life. (Check with your lawyer for the details that apply to your situation and your state. In particular, a broad-based formal employee stock ownership plan, or ESOP, is a different animal.) Here are four:

They get to see the books. Even open-book proponents may recoil at disclosing the kind of information share-owning employees at closely held companies are entitled to see. Corporate records and financial statements are fair game; those sometimes include compensation figures. Minority shareholders are also privy to major corporate decisions, which in some cases gives them the right to sell back their shares. For example, if a company sells substantial assets, merges with another company, or changes its corporate charter, dissenting minority shareholders can go to court and demand cash for their stock.

They're harder to fire. Firing has never been easy. But wait until a shareholding ex-employee drags you into court. Unless you have a crystal-clear business justification for the firing, the courts might determine that you've breached your fiduciary duty to a shareholding employee by the dismissal. "The employee will argue in court that the company didn't fire me for cause but as an excuse to freeze me out of my investment," says Scott. Also, shareholding employees can go to court and ask that they be allowed to stick around until the dispute is resolved. If the court concedes, you're stuck with a morale problem.

They could make selling the company more difficult. While a minority shareholder alone can't block the sale of assets, he or she can refuse to sell shares. That, in turn, could make your company less attractive to a buyer. "You want to reward employees if you sell," says Milton Bordwin, a lawyer at Rubin and Rudman LLP, in Boston. "But you want the management control to stay with you."

They own the stock for good. Unless the employees sign an agreement stating otherwise, the stock is theirs forever. So make sure your shareholder agreement includes a buyback clause spelling out the circumstances under which the employees have to sell back to you.

Pointers: Turning Off the Vote

There are ways to let employees share in your company's success without putting your business at risk. Phantom stock and stock-appreciation rights are two methods that give your employees cash benefits as your company grows in value--without giving them actual stock. Other options include nonvoting stock or a profit-sharing plan.

If you've already shared equity, there are ways to turn voting shares into nonvoting stock. Michael Ho, a professor at Babson College, in Babson Park, Mass., suggests recapitalizing the company and issuing a new class of nonvoting stock, with higher dividends. "The idea is that minority shareholders, who don't care about the vote, might opt to flip over to a class of higher-paying dividend stock," says Ho.

If you do decide to give stock, says Kevin Scott, a lawyer with the Philadelphia firm of Fox, Rothschild, O'Brien & Frankel, many disputes can be avoided simply by putting both parties' expectations in writing up front. Here are five points that he recommends including in the shareholder agreements you make with employees:

  1. State that the employee's status is unaffected by the grant, that an at-will employee with stock remains an at-will employee.
  2. Give yourself the right to buy back the stock if the employee is fired, quits, becomes permanently disabled, goes bankrupt, or dies.
  3. Don't allow the employee to transfer or sell the stock without giving the company first right of refusal.
  4. Include a noncompete agreement. Shareholding employees have access to inside information.
  5. Recommend that employees have their own lawyers review the agreement. Otherwise, an employee might later say, "You put something in front of me that I signed. I was relying on the company's attorney."

Stephanie Gruner is a staff writer at Inc.


For a dramatic case study detailing the perils of sharing equity with employees, see " The Takeover" in the April issue of Inc..

These days, preventive law gets more and more important for small companies. Milton Bordwin, a lawyer at Rubin and Rudman LLP, in Boston, publishes a valuable general legal resource for small businesses. Called The Bordwin Letter: Preventive Law for Business, the newsletter comes out 10 times a year and costs $65. It points out the legal risks of almost any business activity and makes recommendations on how to avoid them. To order a copy, call 800-KNOW-LAW.

EXERGEN, Francesco Pompei, 51 Water St., Watertown, MA 02172; 617-923-9900 102

FOX, ROTHSCHILD, O'BRIEN & FRANKEL LLP, Kevin Scott, 2000 Market St., 10th Floor, Philadelphia, PA 19103-3291; 215-299-2000 102

MICHAEL HO, Babson College, Tomasso Hall, Babson Park, MA 02157; 617-235-1200 102