The Puget Sound area is at full employment and finding good employees has never been more difficult. In most cases, the only way to find good employees is to hire one from another company. Of course, your company isn’t immune to poaching from others. So what to do? Many clients have been asking me recently about offering equity (ownership) to key employees as a means of retaining them. Or offering equity to induce good people to join their firm.
Offering equity can take many forms. Stock can be sold or given to employees. Stock options or stock rights can be issued with a vesting schedule to retain employees. There are also phantom stock, profits interests and other quasi-equity arrangements. An ESOP is another possibility.
Is offering equity to employees a good idea? Maybe. Let’s talk about the good, the bad and the ugly of bringing employees into ownership in a business.
The Good
The best reason for selling or giving away part of a company to key employees is retention. You’re putting ‘golden handcuffs’ on them. As an owner, they are much less likely to leave. The other common use of providing equity is to attract top talent. As the main owner, you may also be trying to create a buyer for your share by creating your successor owners. This is especially true in professional service companies. Think of doctors, lawyers or accountants. The new partners buy in and the retiring partners get bought out.
The other hope of making an employee an owner is to change behavior. The plan is that an employee starts to think and act like an owner. Hopefully, they take a long-term view, help in business development and set an example for others in the company. But this change from an employee mindset to an owner mindset isn’t an easy one.
The other good thing, of course, is that the new owner’s compensation is now tied to and contingent on the company’s performance. This alignment will provide more compensation when the company does well and less when the company struggles. Nice.
The Bad
The bad things about providing equity are several. First, the person may want ownership when times are good but they are poorly suited to more challenging situations. Being a business owner is like getting married—for better or worse. In small businesses, owners are usually going to be personally responsible on bank debt and often other borrowings. New owners are often shocked to find that their entire net worth, including the home they live in, must be put at risk to secure company debt.
As a business owner, a person should help in business development and will likely be faced with difficult decisions at times. For example, valued staff members may have to be laid off in a recession. An owner needs to have the fortitude to make tough decisions and then execute those decisions. An owner often must also take a pay cut, sometimes a substantial one, to help the company in a rough patch. Often, the pay cut is working for nothing for a period.
And even in the best of times, providing ownership to key employees dilutes the ownership interest of others. This is particularly true for a company with one shareholder who then brings others into ownership. Not only is ownership diluted but eventually the founder can find themselves losing control of ‘their’ company.
For closely-held businesses, there typically is no market for the stock. That means that stock transactions are with the company or other shareholders. A good valuation means little when there are few buyers for the stock.
The Ugly
I mentioned above that bringing others into ownership is like getting married. By the same token, when a mistake has been made and the equity interest provided needs to be taken back, it isn’t easy. In fact, unwinding the provision of equity to others is like getting a divorce. It is often expensive, painful and time consuming. It is better to have a buyout formula built in from the beginning than to have to negotiate everything when the arrangement hasn’t worked out. Even with a buy back provision in place, buy backs are usually unpleasant when the situation hasn’t worked out as originally hoped.
Conclusion
So what is the answer here? I’d suggest that sharing ownership is worthwhile under the right circumstances but it is not something to be taken lightly. Think through the potential downsides before rushing in and hope for the best while being prepared for the worst.
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