Introduction
As the veterinary industry continues to evolve, practices are seeking innovative ways to attract and retain talented professionals. Equity interests, such as employee stock options and profits interests, have emerged as compelling forms of compensation. In this article, we delve into the two primary methods used to grant equity to veterinarians: Employee Stock Option Plans and Profits Interests. We will explore the mechanics, benefits, and considerations of each approach, shedding light on how these strategies can foster a mutually rewarding relationship between practices and their valued employees.
Employee Stock Option Plans: Traditional Compensation with Potential Downsides
Employee Stock Option Plans (ESOPs) have long been employed to offer equity to employees, including associate veterinarians and veterinary practice staff. ESOPs enable employees to purchase a specific number of shares or units in the practice entity at a predetermined price within a limited timeframe. While ESOP terms can vary, the fundamental elements remain consistent:
- Option to Purchase: Employees are granted the option to buy shares or units at a specified price over a defined period.
- Vesting Schedule: Options are typically vested incrementally as employees reach specific years of service, with a limited window to exercise the options.
- Preferred Price: The purchase price is often set below the actual value of the shares or units.
While ESOPs are popular, they come with potential drawbacks for both the practice and employees. First, employees must have the financial means to purchase the shares or units, even if the practice provides a loan for the purchase. As discussed below, the treatment of a loan for the purchase may have adverse tax consequences for the employee. Additionally, if the practice forgives the loan, the owner relinquishes part of their ownership without receiving compensation in return.
There are tax implications for employees when purchasing shares or units below their fair market value. The difference between the purchase price and the actual value is considered taxable income. If the practice lends funds to the employee for the purchase and later forgives the loan, the forgiven amount is also taxable income for the employee.
Second employees assume entrepreneurial risk with ESOPs, as the practice’s value may not increase or could even decrease over time. However, this risk can motivate employees to work harder toward enhancing the practice’s profitability. In addition, employees often hold minority stakes, thus majority owners control dividend distributions, unless otherwise specified in the Shareholders’ or Operating Agreement. So, employees are at risk of not receiving an economic benefit from their investment until much later.
Profits Interests: A Compelling Alternative with Attractive Benefits
Profits Interests provide an alternative form of equity compensation, particularly for veterinary practices structured as partnerships or limited liability companies (LLCs). Unlike ESOPs, Profits Interests grant employees a real ownership stake limited to a portion of the practice’s future profits. Here’s why Profits Interests can be an enticing option:
- Equity Grant: Employees receive ownership benefits without the need to purchase interests upfront. Instead, interests in future profits are granted in recognition of the employee’s services and contributions.
- Flexibility in Distributions: Profits Interests offer options for distributing benefits. One approach is granting yearly distributions of profits alongside a share of proceeds from a liquidity event. Coupling this approach with a vesting schedule can enhance employee loyalty and retention.
- Tax Advantages: Profits Interests enjoy more favourable tax treatment than their ESOP counterparts. At the time of a grant, there is no taxable income for employees. When a practice is sold, employees who held the interests for more than a year can benefit from lower capital gains tax rates.
The flexibility in structuring distributions is a key advantage of Profits Interests. Yearly distribution proportions can be based on the number of Profits Interest units relative to all authorized units, ensuring equitable rewards. Alternatively, a fixed floor amount can be established, with profits above this threshold allocated to general equity owners and Profits Interest holders proportionately. This approach safeguards a return on investment for general equity owners while compensating employees for their services.
It is important to note that Profits Interests can only be granted in limited liability companies or partnerships. For professional corporation practices, the creation of a separate entity or partnership structure may enable the granting of Profits Interests, subject to specific state professional corporation laws.
Conclusion
Equity compensation options offer veterinary practices valuable tools to incentivize and retain talented professionals. ESOPs and Profits Interests each have distinct advantages and considerations. While ESOPs provide a traditional means of granting equity, they come with potential downsides such as financial obligations and tax implications. Profits Interests, on the other hand, offer a compelling alternative with attractive benefits, including flexible distribution structures and favourable tax treatment.
By exploring these equity compensation strategies, veterinary practices can optimize their approach to reward and motivate employees while building a mutually beneficial path to success. If you have any questions on how to incorporate ESOPS or Profits Interests into the structure of your practice, the National Veterinary Law Group at Mandelbaum Barrett PC is available to help.