Three Questions to Ask Before Designing an Equity Compensation Plan

Why the Plan Isn't the Starting Point

Most owners who come to us about equity compensation have already decided they need a plan. They've heard about phantom stock or stock appreciation rights. A peer in their Vistage group mentioned it. Their key person is getting restless, and they want to do something before it's too late.

We get it. The instinct to act is real, especially when the stakes involve people you've worked alongside for years.

But we've learned something over two decades of designing these plans: the owners who get the best results aren't the ones who move fastest. They're the ones who slow down long enough to answer three questions before putting anything on paper.

These aren't technical questions about plan structure or tax treatment. Those come later. These are the questions that determine whether an equity plan is even the right tool, and whether you're building something durable or creating a future headache.

What Problem Are You Trying to Solve

This sounds obvious. It isn't.

When we sit down with an owner and ask, "What are you trying to accomplish with this plan?" the first answer is almost always some version of "retain my best people" or "give them skin in the game." Reasonable goals. But broad enough to hide real problems underneath.

Retention is a symptom, not a diagnosis. If your VP of Operations is looking at other opportunities, the question isn't "How do we keep her?" It's "Why is she looking?"

Sometimes the answer is compensation. She's been underpaid relative to market for years, and equity can close the gap in a way that also aligns her with the company's future. That's a good use of an equity plan.

But sometimes the answer has nothing to do with money. She's looking because her role is unclear. Or because decisions that should be hers keep getting overridden. Or because she doesn't see a future path in the company. No equity plan fixes those problems. If you hand someone phantom stock while the underlying issue is authority or clarity or trust, you've spent real money and created a false sense of security. The person still leaves. They just leave with a payout. Or worse, they stay and disengage.

We've seen equity plans used as a substitute for hard conversations. An owner who knows they need to restructure roles, address a toxic manager, or make a leadership change will sometimes reach for an incentive plan instead. It feels productive. It avoids conflict. And it doesn't work.

Where Equity Fits

Equity compensation works when the underlying problem is one of alignment, long-term retention, or readiness for an ownership transition:

• Alignment: You want key leaders making decisions as if they owned the business. Tying their compensation to business value changes how they think about profitability, growth, and risk.
• Retention: You need your best people to stay for five, seven, ten more years. A vesting schedule creates a financial reason to commit that cash bonuses can't replicate.
• Transition readiness: You're planning to sell, whether to management or to an outside buyer, and you need your leadership team locked in and motivated through the transition. Our equity compensation resource kit walks through how these plans connect to a broader transition strategy.

And Where It Doesn't

Equity compensation won't fix a broken management structure. It won't make an underperforming employee perform. It won't substitute for clear roles, honest feedback, or a succession plan. If the problem is organizational, the solution is organizational. Start there.

How Many People Should Be in the Plan

Once you've confirmed that equity compensation fits the problem, the next question is scope. Most owners' instinct here is too generous.

That makes sense. You care about your people. You built this company alongside them. Leaving someone out feels unfair. But including too many people in an equity plan creates its own problems, and some of them are worse than the ones you're trying to solve.

An equity plan works because it's meaningful. If every employee gets phantom stock, it stops being a retention tool and starts being a benefit. Benefits are expected. They don't change behavior. They don't make someone think like an owner. They become part of the furniture.

The employees who should participate are the ones whose decisions directly affect business value. The leaders who would be hardest to replace, whose departure would hurt the company's transferability, whose continued presence makes the business more attractive to a future buyer or successor.

That's a small group in most closely held businesses. Three to seven people. Sometimes fewer.

What Happens When the List Gets Too Long

We've worked with owners who rolled out equity plans to 20 or 30 employees. Within two years, the problems were predictable:

• Entitlement replaced motivation. Employees who hadn't contributed to value growth still expected payouts. The plan became a source of resentment for top performers who carried more weight.
• Administrative burden grew. Tracking vesting, communicating plan details, handling departures. All of it scales with headcount. What started as a retention strategy became a management project.
• The dilution conversation got uncomfortable. When it came time for a transaction or a payout event, the total obligation surprised the owner. The plan they thought was affordable had grown into a material liability.

Picking the Right Participants

When we help owners define participation, we look at a few things:

• Impact on value: Does this person's work directly affect revenue, profitability, or operational capacity?
• Replaceability: If they left tomorrow, how long and how much would it cost to replace them?
• Future role: Will they be critical during a transition or sale? Would a buyer or successor need them?
• Ownership behavior: Are they already acting like an owner, thinking about the business beyond their job description?

If someone doesn't meet most of these criteria, there are better tools. Bonuses, profit sharing, career development, recognition. These aren't lesser rewards. They're different ones, matched to a different role in the company.

What Happens When Someone Leaves

This is the question nobody asks until it's too late.

Owners spend weeks designing the plan, deciding who participates, setting the vesting schedule, choosing the plan type. Then someone quits. Or gets fired. Or retires early. Or dies. The plan document either doesn't cover the scenario, or covers it in a way the owner didn't think through.

The departure scenario is where poorly designed equity plans fall apart.

Vesting, Forfeiture, and the Details That Matter

Every equity plan needs a clear answer to this: what happens to unvested awards when someone leaves?

The standard approach is forfeiture. If you leave before your shares vest, you lose them. That's the whole point of vesting, the mechanism that turns an incentive into a retention tool.

But even forfeiture has nuance. Does the person forfeit everything, or only the unvested portion? What if they leave for a competitor versus retiring? What about termination without cause?

We've seen plans that treated all departures the same: voluntary resignation, retirement, termination for cause, death. That's a mistake. Each scenario carries different implications, and your plan should reflect that. A 30-year employee who retires shouldn't be treated the same as someone who quits after 18 months to join a competitor.

Does the Company Have the Right to Buy Back Shares

For plans that involve actual equity (restricted stock, for example), the departure question gets harder. When someone who holds real shares leaves, the company needs the right to repurchase those shares. Without a buyback provision, you can end up with former employees or their estates holding ownership in your company indefinitely.

Buyback provisions need to address:

• Price: At what value does the company repurchase? Book value? Appraised fair market value? A formula?
• Timing: Does the buyback happen immediately, or over time? Can the company fund it from cash flow, or does it need financing?
• Trigger events: Which departures trigger a buyback? All of them? Only voluntary ones?

These aren't theoretical concerns. We've worked with owners who discovered, after a key person left, that their plan had no buyback language. The former employee still held shares, still had rights, and the cleanup took months and significant legal fees.

Disability and Death

Nobody wants to think about these. But a good plan must address them. What happens to vested and unvested equity if a participant becomes permanently disabled? What about death? Does the equity pass to their estate? Does the company buy it back? At what price, and on what timeline?

These provisions protect everyone: the owner, the participant, the participant's family, and the business. They're uncomfortable to discuss during plan design. They're far more uncomfortable to sort out after the fact.

Get These Three Right Before You Design Anything

If you've read this far, you'll notice we haven't talked much about plan types, tax treatment, or vesting schedules. That's intentional.

The technical design of an equity plan matters. But it's the last step, not the first. We've seen too many owners jump straight to "Should we do phantom stock or SARs?" before they've answered the questions that determine whether the plan will work.

What problem are you solving? If equity won't fix it, don't use equity.

Who should participate? If the answer is "everyone," reconsider. The power of equity compensation comes from its selectivity.

What happens when someone leaves? If you can't answer this in detail, your plan isn't ready.

Get these three right, and the technical design becomes a matter of execution. Get them wrong, and even the most sophisticated plan structure won't save you.

We've been designing equity compensation plans for closely held businesses for more than 20 years. The plans that work aren't the most complex or the most generous. They're the ones built on clear thinking about purpose, scope, and contingencies. The rest is mechanics.