The Entrepreneur’s Guide to Equity Compensation
Fourth Edition. This guide offers a comprehensive look at employee ownership practices and practicalities. Learn about stock options, stock grants, ESOPs and other plans; critical issues like dilution, disclosure and minority shareholder rights; and what is needed to create a successful equity-sharing program. Please contact us to order a copy.
Written by Paul Honeycutt and Ronald Smith, this article was published in the Summer 2011 Employee Ownership Insights Newsletter. It discusses the different equity compensation tools available to business owners.
When starting a business, it is important to think about what the future of your business looks like. This goes beyond the products or services you plan to sell and the model you have for generating revenue. It extends to the question of who will hold ownership of your company. Planning how you want to use ownership interests (or "equity") from the beginning of your company can help you maximize growth opportunities and minimize the chance that you, a founder, will part with your equity too quickly.
To the extent that your business will seek investors to provide the cash needed to support growth, company founders can expect that they will need to give up some equity in exchange for the cash investment. However, you'll need more than a business idea and some cash to build a successful company.
Ultimately, the success of your venture will be determined not by your efforts alone but by the performance of the cast of people — employees, partners, or associates — that you assemble. So, if there is a strategy that can help you get more out of the people on whom you depend and also boost your organizational horsepower, you owe it to yourself to take a serious look. A policy of sharing equity with employees that is designed and used wisely can be just that strategy. A generation ago, this practice was called "equity compensation" and generally was limited to senior executives of large businesses. Today, the practice of putting company equity into the hands of all the people on whom the company counts to do the work has become increasing widespread ― especially in innovation-based new ventures. It's a strategy and vision that we call employee ownership.
You can examine 10 different companies that issue equity to employees and find that each of those companies is adhering to a distinct and different strategic vision. For some companies, awarding stock to employees is primarily a way to limit cash outflow. Thus, an employee may be willing to work for a company at a relatively modest salary if the total compensation pot is sweetened with an equity award that may produce an attractive payout in the future. Equity awards also can generate tax deductions for non-cash expenditures ― another way to limit cash outflow.
At other companies, the strategic focus is on using equity awards to incentivize employees. This strategy reflects a belief that employees motivated most effectively by the dangling of a financial "carrot." Still other companies will speak of "aligning the interests of the employees with those of the founders and investors."
The various strategic outlooks on employee ownership can be laid out as a continuum, as in the graphic below.
At one end of the spectrum is the use of equity for simple tactical advantages such as cash flow management and the creation of carrots to use as employee incentives. These tactical uses do not significantly transform the traditional employer-employee relationship. At the other end of the spectrum is the practice of employee participation in ownership, used as the foundation for redefining the role of employees as partners in enterprise. These companies adopt a strong team-based culture, in which everyone in the company embraces shared objectives, tracks individual and collective progress, and commits with passion to the team vision ― supported by the knowledge that the company is partly theirs. This cultural philosophy works very well at startup ventures, where "nine-to-five" jobs typically don't exist, and passionate devotion to achieving organizational success is a practical necessity.
Note that these differing strategic objectives are not necessarily mutually exclusive. A company that is committed to a team-based philosophy of shared ownership, for example, may at the same time seek to structure its employee ownership program with tactics that improve cash flow by minimizing corporate taxes and limiting cash compensation.
To many, it seems intuitively true that employees will bring a different attitude and care more about the company's success if they own a piece of the business, and that this different attitude will translate into greater diligence, higher quality work, and ― especially ― productive collaboration with teammates to accomplish important goals for the company. Others, however, are skeptical, suspecting that most employees won't truly change their behaviors, believing that employees are employees, end of story.
Fortunately, we don't have guess or appeal to our gut instincts to form an opinion about this. It turns out that a good number of academics have become interested in this question, and they have gathered extensive data in an effort to compare how companies that share ownership with employees perform relative to companies that are otherwise similar, but do not share equity. The outcome of this research ― consistently ― is that sharing ownership does indeed correlate with superior business performance. A summary of this diverse research can be found on the National Center for Employee Ownership's website in "Research on Employee Ownership, Corporate Performance, and Employee Compensation."
Agreeing that employees should have a share of the company equity is the easy part. More challenging is the question of exactly how much equity employees should have, both individually and collectively. Abundant experience has shown that what works best ― in terms of creating incentives, assuring fairness, recruiting and retaining talented people, etc. ― is to distribute equity among individuals in proportion to their contribution to the success of the venture.
That's easier said than done. Indeed, it's never done perfectly. However, it's a principal that provides direction for the equity allocation process. A few pointers based on experience may help.
First, it is generally impossible to predict far ahead of time how valuable a given individual's contribution to company success will be. When you hire a person to join the team, what will that person's contribution turn out to be five, seven, or 10 years down the road? An individual with the most impressive résumé may turn out to be a big pain in the butt; while a young person with little more to offer than eagerness and enthusiasm may end up a hero. The moral? Don't try to assess a person's value to the company at the outset and then award one large block of equity on that basis. It will almost certainly turn out to be either too much or too little. Instead, make smaller grants of equity on an annual basis, with the amount tied to the person's contribution for the year. That way, over a number of years, the equity accumulated by an individual will come to mirror that person's long-term contribution to enterprise success.
Second, there is no such thing as a "standard equity award" for any given type of position or role in a company. Eager entrepreneurs sometimes come to us asking what, say, a director of business development at a startup IT company is supposed to receive in the way of an equity award ― as though we have a chart on the wall that lists the "correct" standard stock award. Instead, we have found that putting an appropriate amount of stock ownership in employees' hands is an objective that will unfold over an extended period of time. However, as discussed below, there are principles and techniques that can be applied to guide the equity award process. One such principle is dynamic equity (aka the "grunt fund" approach). Another is the technique of creating a forecast of company ownership over a five- to 10-year period into the future. Using a modeling tool, you can project out the likely long-term impact of any proposed system of equity awards.
Per the Guiding Principal section above, allocation of equity among founders should be based on their individual contributions ― past, current, and anticipated ― to the venture. Contributions come in various forms, including financial investments (such as cash), tangible property (such as office space), and intangible property (such as a patent or other intellectual property).
What is the value of each of the contributions? The value of cash and tangible property is obviously easier to determine than that of intangible property. This is a good topic to discuss with a tax professional.
Has one founder committed to the business full-time, while another founder commits only part-time because he or she still has a "day job?" Who plans to do what for how long? You may have a clear idea now of what your roles will be, but over time, things may change. To factor this in, you may want to consider having a vesting schedule for each founder's shares. This enables each founder to receive what he or she expects if he or she remains involved in the business over time as planned, while protecting the company if an individual decides to leave, or otherwise become significantly less involved in, the business.
Consider involvement in the business as another kind of investment. This may help you to properly allocate shares now and in the future based on the total contribution that is expected from each founder. If a vesting schedule is desired, you can use the amount of time each founder is expected to contribute each year as a way of setting up the schedule.
Finally, what about contractors or others who contribute something toward the venture's success? Should everyone who contributes something to the venture receive equity? It may be tempting to offer equity as a kind of "currency" that you can use to buy anything the venture may need, from legal services to a new computer. The best wisdom, however, suggests that equity should be awarded only to those who will have a long-term, ongoing role with the company, and where it will be important that the recipient maintain an ongoing emotional commitment to the venture. Thus, an individual who works with your firm as part of your team on an ongoing basis will be a good candidate to receive equity, notwithstanding that he or she is technically an "independent contractor" rather than a legal "employee." Conversely, an attorney that you hire to provide a one-time or occasional legal service, and who is thus not an ongoing part of your venture team, would not be an appropriate candidate to receive equity — even in times when cash is short and the ability to pay them without consuming cash is tempting!
A new venture is (with rare exceptions) launched either as a corporation or an LLC (limited liability company). In either case, in the U.S, the company is brought into legal existence through the filing of incorporating papers with the secretary of state (or other designated office) of any state. These articles of incorporation (as they are called in the case of a corporation) will specify a maximum number of shares that the company will be allowed to issue (that maximum can be anything the filer choses, so filers typically choose a very large number, like 10 million). These theoretical (not yet existing) shares are referred to as the authorized shares. Typically, the individuals who originally found a company will issue only a small fraction of the authorized shares to themselves. The result is that, for the time being, those founders own 100 percent of all issued shares, but have a large reserve of authorized shares that are available for issue at whatever point in future the founders decide they want to issue shares (for example, to a money investor or to employees). When new shares are issued (to an investor, employees, or whomever), the percentage of the company owned by the pre-existing owners will necessarily drop. For example, four founders may have started out by issuing themselves 100 shares each, meaning that the company has 400 shares issued, and each founder owns 25 percent of the issued shares. As some point, they reach an agreement with an investor to issue 100 shares to the investor in exchange for a sum of money paid into the company. Those 100 shares will come from the large reserve of authorized shares. The result is that there are now 500 shares outstanding, and each founder, still holding 100 shares each, now has a 20 percent interest in the total number of issued shares. This reduction in the shareholders' percentage of ownership that results from the issuance of new shares is known as dilution.
Under traditional approaches to equity participation, shares are divided among the founders and early investors around the time of the founding of the company. Some companies may reserve shares in a pool for future employees.
Many people feel instinctively that, ultimately, a company's ownership should be apportioned based on how much each person has contributed to the success of the venture. So, many startups begin the discussion early on with a simple even split among founders. That seems reasonable at first, until the founders quickly realize that each person's contribution is not exactly the same. Whether intentional or not, each founder brings to the organization their own level of experience, business acumen, connections in the industry, commitment to the mission, and more. One of the founders even may have spent time and resources on the business prior to bringing on other founders. In some cases, a founder who starts off fully committed to a venture may suddenly pursue a different career path or may be unable to make the same time commitment to the organization as the others. Time worked may not fully capture the contribution of team members. The question becomes ― how do you calculate each person's contribution?
The concept of dynamic equity (also referred to as a Grunt Fund) has gained in popularity in recent years. Unlike traditional equity, dynamic equity builds in the fact that contributions to the business going forward will not come from the same individuals and in the same proportions as existed in the beginning. Over time, dynamic equity will change as, for example, an early financial investor doesn't make any additional contributions whereas various employees are hired and continue to work to grow the company. In such a case, the percentage owned by the early investor would decrease while the percentages owned by each of the employees would increase. To properly calculate each individual's share of the dynamic equity, you have to assign values to all contributions (even intangible property) and decide whether the character of the contribution (such as cash versus something else) should change the weights of the contributions.
However you value the contributions, the total contributions of an individual shareholder divided by the combined contributions of all shareholders determines the percentage owned by that individual.
Equity compensation comes in a variety of forms, including stock options, stock grants, stock purchases, stock appreciation rights (SARs), phantom stock, tax-qualified employee stock purchase plans (ESPPs), non-qualified purchase plans, and employee stock ownership plans (ESOPs). Each of these vehicles for delivering equity interests has its unique advantages that may be especially suited to particular situations. Unfortunately, each vehicle also has its own unique set of disadvantages. If only there were a vehicle that offered a diverse set of advantages, and no disadvantages! Instead, selecting the vehicle or vehicles that will be right for your venture will involve evaluating the trade-offs involved in moving from one possibility to the next. To explore the various vehicles, take a look at our handout.
There are a variety of other considerations that should be evaluated as you work through decisions on what your venture's equity-sharing system should look like; these include:
- Cost: Will the costs of implementation and administration of the program be within the venture's budget? Are there costs to employees and, if so, are they steep enough to restrict participation?
- Taxes: What are the tax implications — both positive and negative — for the company and the participating employees? Some equity awards can produce a large tax bill for the receiving employees without providing cash to pay those bills. This is particularly relevant when there is no ready market for employees to cash in shares to cover the potential tax liability.
- Accounting: How will the proposed methods affect the company's financial statements?
- Fairness: How will employees perceive the program? Will it be consistent with the company culture? Will most employees perceive it as fair? A program that is perceived as unduly enriching some while excluding others will embitter and discourage employees who see it that way.
- Employee liquidity: It's all well and good to put equity interests into employees' hands so that they can participate in the economic growth of the venture. However, that participation will ultimately be valuable only if the employees have a viable opportunity to monetize their equity at some point. New venture leaders will need to have some reasonably acceptable answer when employees ask about how and on what terms they will be able to cash in their equity.
- Securities laws: The issuance of stock to employees is regulated by extensive federal and state law. Most plans established by new ventures will readily meet the requirements of the law, but compliance with certain government filing requirements and disclosure standards may be required. So, don't try this without the involvement of a knowledgeable attorney!
To start putting together a model of what your company's ownership may look like in one year, five years, 10 years, etc., you need to begin by deciding whether you are going to use dynamic equity. If so, the model will be less straightforward but will enable you to use equity when and how you need it to grow your business going forward.
Next, consider what employee skills you will need that you don't already have and what team members you will need as you grow. Of course no forecast is perfect. But even if your estimates and timelines prove to be off the mark, you will have created some ability to plan for the business by estimating what the future equity needs for employees may be. You can help retain flexibility by also including a vesting schedule with any direct grants of shares you make to employees or contractors.
You also should think about the different kinds of investment you might want, or need, for your business that would come from outsiders. Investors often will ask for shares in exchange for their investment in a business. While this is not as common for a debt investment, there is such a thing as convertible debt, so you should consider the possibility that all future fundraising could involve equity.
Valuation — how much your company is worth as a whole and on a per share basis — will impact many decisions you make as you grow your business. This isn't something you come up with out of thin air as it relates to what someone would be willing to pay for the company. Therefore, it is important to discuss this with advisers, such as your tax professional and attorney, who may recommend that you seek the services of a professional appraiser.
For more information on terms related to equity compensation, see our glossary
The Beyster Institute offers unbiased, reliable guidance for the purpose of helping you get the best results from employee ownership. Please contact us to discuss how our consulting services can help your business.