This is the time of year when cannabis entrepreneurs begin to scrutinize their year-end finances to see how profitable the company has been and whether and how their employees and other key people, along with the owners, should participate in that profit. Some marijuana and hemp employers do so with bonuses and others with equity or quasi-equity.
In tightly run (privately owned) companies, it is common to have some key employees who are almost irreplaceable. Often these employees started the company shortly after they were founded and earned their implicit trust in the organization. In other cases, companies move from mom and pop status to bigger corporation knowing they need to attract and retain key talent by adding equity or quasi-equity to a competitive compensation package.
All of these potential compensation methods have advantages and disadvantages. I discuss some of these general considerations below:
Benefit. This is always the place to start your reflections. Basic economics teaches us that all parts of the profit cake must be 100%. If you start with 100% beneficial ownership and give 5% of the company’s profits to 10 key employees, you are simply cutting your takeaway profits in half. This applies regardless of whether you are granting actual equity, options that convert to equity, or quasi-equity which is actually a bonus structured as if the recipient owns equity.
It is much easier to withdraw a bonus or quasi-equity than options or actual equity, and it is much easier to withdraw options than actual equity. Once someone owns an unalloyed part of your company, they are your full-fledged business partner, whose rights are limited only by your attorney’s careful contract drafting skills.
Decision-making power. For owners considering a creative compensation plan but reluctant to give up decision-making powers, all of these options allow you to potentially retain 100% of the voting rights in your company.
Quasi-equity only grants economic profit rights, as described in the compensation agreement for the manager or employee. Options do not automatically confer economic or voting rights until exercised, at which point the equity received (usually corporate shares or transferable LLC interests and membership rights) determines those economic rights and whether voting rights are included. Depending on the type of equity, this also applies to the direct granting of equity.
If the shape of the business unit allows, you can easily create a second class of ownership that does not have voting rights. You can do this with a Limited Partnership (LP), LLC, C Corporation, and even an S Corporation. However, if you want to get creative with your economic rights, you can’t do so with an S company (or an LLC or any other entity that has chosen to be taxed as an S company).
optics. This is a difficult conversation at times for cannabis business owners as they need to know: (a) the industry standard at any given time for executive and key employee compensation; (b) what their managers and key employees reasonably expect to be offered in a compensation package; and (c) what your managers and key employees will be reasonably satisfied with.
Replacing key employees is expensive. It is also expensive to compensate for or treat the consequences of one or many offended employees. Chances are, however, that you have a good feel for the personality and motivation of your existing employees and know whether or not they are appropriate and grateful for additional specialized compensation. And for prospects and executives, they know that your opening offer is likely to be a little different than the final offer. You will appreciate the opportunity to discuss its value to your company.
Taxes. Nobody likes to talk about taxes except CPAs, CFOs, and the rare lawyer. But both employer and employee taxes should be in the foreground when you consider creative remuneration structures. Typically, many employees will be happier not having to think too hard about the future tax implications of their compensation.
That means that once the employee understands all the nuances, they may prefer a direct bonus or quasi-equity bonus as these are generally taxed as ordinary income, with taxes paid through your normal payroll process and the employee the network maintains balance. Employers generally also prefer this method because, like all employee benefits, the entire amount is a deductible business expense.
Options are much more nuanced and generally would not have any tax consequences until they vested, with additional consequences once those options are executed. An equity participation means that the employee or manager is treated like the other owners and is responsible for the tax consequences of preserving the equity as well as for its increase in value and regular distributions. This can make some employees nervous, but most seasoned executives will understand that the potential upward trend has tax implications. You shouldn’t be concerned about it, but with the help of your accountant, you should understand.
Be prepared. Whether you like it or plan on doing it, many key employees, including underemployed directors, are expecting some sort of stock-based grant. You should be ready to discuss this matter with them and your reasons for the offer or not.