The Loyalty Equation: Structuring Equity to Keep Top Talent
It might be cliché to hear companies talk about their people as their most important asset, but any privately held business owner knows it’s the truth. The right people don’t just help your business function — they help it grow.
In today’s labor market, where demand for skilled professionals far exceeds supply, keeping the best people has become a strategic priority.
The numbers speak for themselves:
- 75% of companies report having difficulty filling full-time positions.
- The top reasons? A low number of applicants (60%) and intense competition from other employers (55%).
On the other hand, the companies that aren’t struggling to hire cite two major advantages:
- A strong workplace culture (59%)
- A compelling compensation and benefits package (59%)
Put simply, if you’ve built a team of A-players, it makes financial and operational sense to keep them. Replacing skilled talent isn’t just disruptive, it’s expensive.
Consider this:
- For skilled roles, replacement costs range from 1–2x the employee’s annual salary
- For technical positions, the cost is 1–1.5% of salary
- For executive roles, turnover can cost up to 213% of annual salary
In this environment, retention isn’t just a cultural decision, it’s a business one.
Over the following chapters, we’ll walk through the equity-based compensation tools available to privately held businesses, from stock options and phantom stock to profits interests and SARs, along with their pros, pitfalls, and what you need to consider from a valuation and tax perspective.
It’s not about giving away the company. It’s about protecting it by keeping the people who make it great.
Why Equity Incentives Matter in Private Markets
Public companies have long used stock-based incentives to reward and retain employees — stock options, purchase plans, restricted shares. It’s a well-worn playbook. But in the private capital markets, things get trickier. There’s no public stock price, no liquid market, and often, no clear roadmap for what “ownership” even means day to day.
In my experience helping clients at Sofer®, business owners usually come to us when they’re staring down one of three scenarios:
- They want to keep a top performer who’s getting noticed by competitors.
- They want to reward long-term loyalty in a meaningful way.
- Or they’re looking to groom a future partner or successor, but aren’t ready to hand over the reins, or the cap table.
What they don’t want is to accidentally create a tax mess, give away more than they intended, or lose control of something they’ve spent years building.
This is where equity incentives can offer a solution if properly designed.
In privately held companies, equity isn’t one-size-fits-all. Whether you’re talking about stock options, phantom stock, profits interests, or SARs, each one carries different implications for ownership, valuation, tax treatment, and future exit planning.
The right structure can help you retain and reward without compromising your ownership. But it has to be the right structure, and that starts with understanding the compensation landscape.
Stock Options
Stock options are one of the most recognizable forms of equity compensation, and for good reason. They give employees the right (but not the obligation) to buy company shares at a set price, known as the strike price, sometime in the future.
Typically, that price is based on the company’s fair market value of its common stock on the day the options are granted. While most options are tied to common shares, some companies issue options on preferred or other stock classes depending on their structure.
From an employer’s perspective, stock options are appealing because they align long-term incentives: employees win when the business wins. But as straightforward as that sounds, there’s a lot more complexity under the hood.
Why Employers Like Stock Options
Business owners often favor stock options because they don’t immediately give away equity or voting rights. Options can be structured to vest over time or be tied to performance milestones, creating a strong retention tool that keeps top performers engaged.
In private markets, where there’s no stock ticker and limited liquidity, the potential upside of equity often feels more motivating than immediate ownership. That ownership, however, may have little short-term value and requires employees to come up with the cash to buy in.
Where Things Get Tricky
To issue options in a private company, you’ll need a 409A valuation to establish the fair market value of the common stock—the number that sets the strike price and satisfies IRS requirements. But that valuation isn’t a one-and-done process.
Under IRS Safe Harbor rules, private companies must update their 409A valuation at least once per year to set strike prices for new grants. This helps maintain compliance and protects against audit challenges without requiring a new appraisal at every issuance.
Another challenge: employees often don’t fully understand what they’re being offered. Without clear communication, options can fall flat as an incentive. And then there’s the tax complexity—lots of it.
Tax Considerations: ISOs vs. NSOs
There are two primary types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).
With ISOs, employees may qualify for long-term capital gains treatment, but exercising can trigger the Alternative Minimum Tax (AMT) even if the shares aren’t sold. With NSOs, employees typically owe ordinary income tax on the spread between the fair market value and the strike price at exercise, even if they hold the shares.
Regardless of type, options generally don’t create a tax bill at grant. The taxable event usually occurs at exercise (when the employee buys the shares) or sale (when they cash out). If not structured carefully, this can lead to surprise tax consequences for employees and frustration for employers.
How Sofer® Helps
Sofer® Advisors provides 409A valuations that stand up to IRS scrutiny, ensuring option grants are realistic, defensible, and aligned with your goals. We help employers understand how much equity they’re really offering, what it means from a tax standpoint, and how to communicate that value effectively to employees.
Stock options can be a powerful motivator, but only if you get the details right.
Phantom Stock
Sometimes, business owners want to reward and retain key employees without giving up actual ownership. That’s where phantom stock comes in.
Phantom stock isn’t real equity—it’s a contractual promise. You’re telling an employee: “If the value of this company goes up, you’ll get a piece of that increase in the form of a future cash payment.” Think of it like a bonus that mirrors the value of real shares, without the complications of actually issuing stock.
It’s a clean way to create an “ownership mindset” without any of the dilution, voting rights, or changes to your cap table.
Why Employers Like Phantom Stock
If you’re trying to retain a top performer or reward loyalty, phantom stock can be a smart option. It’s flexible; you can tie it to time-based vesting, performance goals, or specific company events.
And because there’s no actual stock involved, you keep full control of the business. For private companies that don’t want to bring on new shareholders—or trigger complex valuation or securities issues—phantom stock offers a compelling alternative.
Where Things Get Tricky
What makes phantom stock attractive is also what creates risk: it’s a cash promise. That means at some point, your business will have to come up with the money, often at a time when you’re trying to preserve cash, like during a transition, buyout, or M&A event.
Payouts are typically based on increases above a defined threshold value—the company’s fair market value at grant—so it’s critical to get that baseline right from the start.
From a tax standpoint, phantom stock payouts are treated as ordinary income for the employee and a deductible expense for the business. While straightforward, it doesn’t offer the long-term capital gains benefits that real equity might.
And while employees benefit financially, they don’t actually own part of the company—no voting rights, no true stake—which works for some but not all.
How Sofer® Helps
Sofer® Advisors provides independent valuations of phantom stock plans at key points such as grant, vesting, and payout. Each engagement establishes the baseline or distribution threshold—the point above which future appreciation triggers payouts—ensuring accurate accounting and fair participant rewards.
We also advise on how to structure these plans so they’re realistic, transparent, and aligned with both cash flow and long-term business goals. With the right valuation foundation, employers can confidently reward performance without giving up ownership or liquidity.
Stock Appreciation Rights (SARs)
Stock Appreciation Rights (SARs) are a flexible way to reward key employees without giving away actual equity. SARs give recipients the right to receive the increase in company value over a set period, usually paid out in cash, though some plans may allow for stock settlement if properly structured.
Unlike stock options, employees don’t need to purchase anything. They benefit only if the business grows, keeping the incentive squarely focused on performance and value creation.
Why Employers Like SARs
For private company owners who want to offer long-term upside without giving up control, SARs can be a strategic tool. There’s no dilution at the time of grant, and you retain full ownership and voting rights. If settled in cash, SARs have no effect on your cap table at all. And if structured for equity payout, you can plan for any future dilution accordingly.
SARs are often easier to administer than traditional option plans, especially for smaller, founder-led businesses, and offer flexibility in how vesting and payouts are designed. Because they tie rewards directly to company growth, they help align employee interests with yours.
Where Things Get Tricky
SARs typically require a defensible 409A valuation at the time of grant to set the base value and comply with IRS rules, and another valuation at payout to determine how much appreciation has occurred.
Because SARs represent a cash or equity liability, businesses need to plan for the eventual cost, often during liquidity-sensitive moments like transitions, acquisitions, or leadership changes.
The value of SARs also depends on growth. If the company’s performance stalls, the incentive may lose its appeal. Like any long-term incentive, SARs work best when they’re part of a clear, well-communicated retention strategy.
Tax Considerations
SAR payouts are taxed as ordinary income when received by the employee and are generally deductible by the company as compensation. Unlike Incentive Stock Options (ISOs), there’s no opportunity for long-term capital gains treatment, so it’s important to weigh the tradeoffs.
How Sofer® Helps
When business owners are considering SARs, they often ask, “What’s this really going to cost me, and how do I do it right?” That’s where Sofer® steps in.
We handle the 409A valuation work you’ll need both at grant and at payout, so you’re not left scrambling when it’s time to deliver. Just as importantly, we help you compare SARs to other incentive strategies and ensure the structure supports your long-term business and retention goals.
Profits Interests
If your business is structured as an LLC taxed as a partnership, and you want to offer meaningful upside to key employees without triggering a big tax bill upfront, profits interests are worth a serious look. These grants provide recipients with a share of future profits and appreciation, without giving them a piece of what’s already been built.
That distinction matters. You’re not gifting existing value; you’re aligning the employee’s reward with the growth they help create going forward.
Why Employers Like Profits Interests
When structured properly, profits interests don’t create a taxable event at the time of grant. The recipient reports no immediate income, and you avoid gift tax exposure. That makes them an appealing way to reward contributors without the shock of an unexpected tax bill.
They’re also highly flexible. You can tie them to individual performance, company milestones, or tenure. And because they represent only future value, owners often find them more comfortable to issue than capital interests or common equity that includes existing value.
Where Things Get Tricky
Profits interests are only available to LLCs taxed as partnerships, not corporations or LLCs electing S-corp or C-corp status. They also need to be structured carefully to meet IRS safe harbor requirements, or you risk creating unintended tax exposure. Come exit time or buyout events, things can get complicated quickly if the terms weren’t defined clearly at the start.
How Sofer® Helps
We work with business owners to ensure profits interests are structured and valued correctly from the outset. Our valuations establish the baseline (the distribution threshold) so recipients only share in future growth, not existing value. We then revisit that work at key milestones to ensure it continues to hold up under scrutiny.
Whether you’re planning for growth, retention, or succession, we make sure your profits interest grants align with IRS expectations, business strategy, and long-term value creation.
Warrants
Warrants don’t get as much attention as stock options or profits interests, but they’re a powerful tool—especially when used strategically. I tend to see them show up more in negotiations with outside advisors, consultants, or early investors.
Unlike options, which are typically part of a formal employee compensation plan, warrants are often one-off agreements that live outside your standard comp structure.
At their core, warrants give the holder the right to purchase company stock at a fixed price in the future, often after certain performance benchmarks or time periods have been met. They’re flexible, which makes them attractive in deal-making scenarios where cash is tight but you want to offer some upside.
Why Employers Like Warrants
For business owners, the appeal is clear: you can bring in talent or expertise without immediately giving up cash or equity. You also get a chance to customize terms based on the relationship, something you can’t always do with more regulated comp vehicles. And because they’re typically exercisable down the road, you’re not diluting ownership upfront.
Where Things Get Tricky
Used too liberally, warrants can quietly balloon into a cap table problem—especially if you haven’t tracked or valued them properly. In my experience, recipients often don’t fully understand what they’ve received or how it works. That misunderstanding can come back to bite during a liquidity event or tax season.
How Sofer® Helps
Warrants aren’t plug-and-play tools. They require a valuation at issuance and again at exercise. We work with owners to make sure the strike price is defensible, the vesting terms are realistic, and the overall structure aligns with your long-term goals. We’re also on hand to revalue warrants when it’s time for someone to cash in, so you’re always ahead of tax and compliance issues.
Choosing the Right Strategy
Not long ago, I worked with the owner of a multi-location professional services firm who had a big decision to make. One of his senior team members, someone who’d been instrumental in building out a new revenue stream, was getting calls from competitors. The owner didn’t want to lose him, but he also wasn’t ready to give up equity or take on unnecessary risk.
His first question to me: “What’s the smartest way to keep him without creating a mess later?”
That’s the heart of these conversations. Choosing between stock options, phantom equity, SARs, or profits interests isn’t just about tax code. It’s about what the business is trying to achieve.
We looked at a few key variables:
- Did he want to retain full ownership control? (That ruled out options and warrants.)
- Was he okay with a future cash payout? (That brought phantom stock into play.)
- Was his business a C-corp or an LLC? (Turns out, they were an LLC so profits interests were a fit.)
- Did he want to tie the reward to tenure or performance? (Performance, specifically revenue benchmarks.)
In the end, we settled on a profits interest plan tailored to the firm’s goals. It was tax-efficient, aligned incentives, and kept the top performer engaged.
There’s no one-size-fits-all answer here. Whether we’re creating a formal plan like stock options or designing a custom phantom structure, our role is to help owners understand the tradeoffs—control, taxes, timing, and valuation—so they can make the best long-term decision for the business. The structure has to fit both where you are now and where you’re headed.
Let’s make sure it does.
Making the Right Move for Your Business
At the end of the day, there’s no silver bullet when it comes to equity incentives. Every business is different. Different goals, different structures, different people to retain. That’s why these decisions can’t be made in isolation.
Valuation, tax strategy, and long-term planning all intersect here. If one piece is out of sync, it can create unintended tax consequences or weaken the incentive you’re trying to offer. The best plans protect both the company and the employee, and make sure everyone understands what they’re getting and why it matters.
That’s where we come in.
At Sofer® Advisors, we help business owners cut through the complexity. We partner with your legal and tax teams to structure the right plan, provide defensible valuations, and ensure it’s all aligned with where you’re headed.
If you’ve got someone worth keeping, let’s make sure your plan is just as valuable.