Should you share equity with key employees? Few questions have produced such polarized responses. I’ve personally debated this subject with a number of entrepreneurs and advisers I trust and respect, and I’ve found that equally smart people have opposite views. I have rarely come across such a divisive issue with two such seemingly opposite philosophies. There seem to be two camps and no definitive “right” answer. Let’s explore the basic arguments of both.
The “share equity” camp
Some entrepreneurs are quick to share equity with their key employees. They argue that nothing better motivates employees and aligns them with the long-term value of the business. The “share equity” camp says that you can pay employees below market rates if you’re willing to share equity, which preserves your cash. They argue that employees will be more loyal if they have a piece of the action. Finally, employees with equity enjoy the favorable tax treatment of a capital gain when you sell instead of the higher tax treatment of bonus income.
The “do not share equity” camp
There is another school of thought that sharing equity with key employees is a mistake. These entrepreneurs argue that, beyond the obvious dilution of your stake, sharing equity is risky because employees are not sophisticated enough to understand equity. They contend, too, that being a minority shareholder in a privately held company is next to worthless given that the majority shareholder may never choose to sell and can manipulate the numbers in order to avoid paying dividends to minority shareholders while paying themselves handsomely. The “do not share equity” camp asserts that the small potential bump in employee loyalty and alignment is far overshadowed by the complexity of creating and managing a set of minority shareholders.
In the four companies I’ve owned, I’ve tried both, and I admit I’m in the “do not share equity” camp. I’ve found that people who are given equity have no appreciation for the cost of creating that value. If people buy equity, that’s different, but in my experience, people who are given equity change their day-to-day behavior little or not at all, yet the resulting complexity and dilution can be daunting.
I prefer retaining 100% of the equity and using a Long-Term Incentive Plan (LTIP) for motivating and driving employee loyalty. In an LTIP, a portion of the employee’s bonus is set aside in a pool they can withdraw from over time. There’s a sample plan you can use as a template here.
What camp are you in? Do you share equity with your employees? If so, what has your experience been?
I am in the share camp. Part of the reason is that is what is done in Silicon Valley but the other part is just from watching lots of great companies get built by a lot of sweat equity from key employees. Again, this is Silicon Valley and people work their tail off. My views have changed a bit overtime so that now I try to save more as a “bonus” out to key employees. When you have employees working 18 hour days, interrupting vacations, you need to treat them like an owner.
Great point Rene. It would be fun to look at the growth rate of companies that shared equity with those who didn’t plotted over time. Would make for an interesting graph
Stock options might work in both camps. There is no effective dilution to the entrepeneur if there is a larger ‘pie’ to be shared which results from the alignment of the objectives of employees and owner. If the entrepreneur is trying to induce loyalty or attract quality employees, and there is a exit strategy with a reasonable time horizon, stock options allow key employees to ‘feel’ like an owner without the legal & corporate baggage of carrying minority shareholders. Subject to a myriad of rules of course, option gains are taxed at only 50% in Canada (equivalent to capital gains treatment on sale of shares). They provide the promise of equity should the big exit (sale, IPO) materialize, and provide currency for cash-strapped start-ups to attract talent.
Cathy: Great point. I’ve seen options work too. I guess the one knock on using options is the potential to create an an employee base always pushing the owner to sell before he/she is ready. Thanks for adding the options idea to the conversation.
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