In a prior article I talked about some of the major downsides to giving your employees equity in your business, which include having to deal with minority partners you have to share decision-making and profit sharing. You also create taxable events for your employees when you give them equity, as well as the potential to have to buy them out eventually.

The good news is that you don't have to give you employee's equity to give them a sense of ownership in the company - as well as a chance to share in the rewards.

While there is no perfect situation for every company, there are a couple of alternatives that might work for you that fall under the umbrella of what we might call "Phantom Equity." Both approaches have their pluses and minuses.

Stock Options

Stock options are a common form of compensation, especially in publicly traded companies. An option is really just a way for an employee to buy a stock at a specific price at a certain time - something that's called the "strike price." If your company's stock is selling for $50 on the market, you can grant your employee an option for $50 (or at a slight discount), which they can hold onto as the company's value grows.

Setting the strike price in a privately held company is more difficult because there is no established market price for the business. One option to set the value of the business is to hire a third-part valuation or accounting firm to analyze the firm's operations and assign a potential market value to it. But this can be an expensive process that often creates uncertainty for everyone involved.

A simpler and still effective way to set a value of the business can be through a simple multiple of earnings. If the market price for companies similar to yours is roughly seven or eight times the earnings over the past 12 months, then you can set the options for your employees at that rate or even slightly below, say six times earnings. This then allows your employees to buy and sell the options at a known price.

The options you hand employees are then awarded on a "vesting" schedule, say two to five years, where they earn a percentage of their options each month or year over time. This is designed to create an incentive for your employees to stay with the business long enough to see their options vest - at which point they can exercise them.

The whole idea is that the value of the firm should grow over time in a way that when an employee's options also become more valuable over time.

When an employee chooses to exercise an option, however, they do have to come up with the cash to meet the cost of the option. For example, if you gave an employee $100,000 worth of options for shares that are now worth $1 million, they still have to put up the $100,000 to get the underlying shares. Some companies will allow employees to sell enough of their stock first to cover their options - which means they sell $100,000 worth of their stock and end up with $900,000 free and clear.

Another catch is that when the employee sells their shares, it's a taxable event - which means they might have to sell even more stock up front to cover the extra tax bill headed their way. But, if they hang onto their remaining stock for more than a year, they can significantly reduce their future tax burden because any gains they make from selling their stock will shift from short-term to long-term earnings - with the tax rate dropping from roughly 40% to 20%, depending on their tax bracket. That can add up to a lot of money.

Stock Appreciation Rights

Another variety of phantom stock is called a stock appreciation right, or SAR, that is similar to an option in that you aren't giving an employee any equity. Rather, you are giving them the rights to any appreciation in the underlying equity, which also vests over time. Using the example from above, let's say you give an employee a SAR representing $100,000 in equity value. Then, several years later, the stock's value has jumped to $1 million. If your employee chooses to exercise that SAR, he or she could collect $900,000 - the amount the stock appreciated since you granted them the SAR.

One downside of using SARs is that whenever an employee cashes them in, they are hit with a short-term capital gain - which means they need to pay the full 40% tax rate on their gains.

It's worth stating that SARs are more popular with private companies while stock options tend to work better in public companies.

And whenever you award your employees phantom stock, it's also fairly typical to include a clause that states that if the company is sold, then all options immediately vest and the employee can sell their shares to the new owner.

That can be a very fulfilling day for both you and your employees because everyone gets to enjoy in the rewards of all your hard work and keeps them aligned to the longer term value of the company.

Both of these approaches to phantom equity are effective ways to align your team an avoid the issues with actual equity grants.

Jim Schleckser is a popular keynote speaker on the topics of business growth strategies and CEO effectiveness.

Published on: Aug 22, 2017
The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.