Caution! The 4 Questions You Should Ask Before You Part With Equity
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In working with clients, we're often asked about giving equity to current or potential employees as a retention or recruitment tool. Equity, of course, can be a fantastic incentive. A client of ours has used it to successfully recruit employees he otherwise wouldn't have been able to attract.
Likewise, we know of a long-term and essential contract employee who, when asked to join a different company, countered its salary offer with a request for equity. When the owner of that company declined, the contractor also declined -- to join the organization.
That being said, owners need to be strategic about giving away equity -- even for the most valuable talent. We have seen several small business owners give up equity in their company only to regret it later.
The reason for giving it up, after all, is to keep an employee engaged and motivated. However, before you agree to give up a portion of your company, first ask yourself the following four questions.
Q. Would less than 100 percent of my business with this key employee be worth more than 100 percent of your business without him/her?
If the answer to this question is clearly no, then don't give up your equity. However, if you think your business could grow tremendously with this key person, but would likely be worth much less without him/her, consider giving up the equity.
Q. Can I keep this employee engaged and motivated at a lower cost?
If there are less expensive ways to keep your employee engaged and motivated, you might consider several alternatives to giving away equity.
Perhaps he or she would be happy to settle for a very small percentage of equity. We have a client who gave three of his key employees 2 percent each. A second option would be a generous incentive compensation plan, giving the employee a share of the current year's profits, but not a piece of the long-term value of the company.
If there are still other options that are less expensive than sacrificing equity, consider them.
Q. Can I find elsewhere the skills he or she brings to the table, and at a lower cost?
The candidate you want is likely not the only one in the world with this skill set. If you could replace him/her easily at a lower cost, this may be a good option.
Just be sure you are considering all of the value this employee brings to the table -- his her specific skill set, work ethic, fit with you and your business, plus this person's experience and judgment, knowledge of your industry, etc. If you are reasonably certain that all of these things can be replaced at a lower cost, don't part with your equity.
Q. Is there a cost to having this employee compete with me?
If you have current employees who have created significant value in your organization, is there a chance any of them might splinter off and become your competition? If you aren't willing to include that choice employee in the upside you will generate together, don't be surprised to find him or her working with a competitor who will. In some cases, this employee might even set up his or her own shop.
If you think you can create tremendous value without this person, the employee may just conclude the same. At the end of the day, you should do what is in your own best interest. However, expect that your employee will also do what is in his or her best interest.
Remember this when you are thinking through the pros and cons. We know of a business that lost a key employee after she asked for a small piece of the business that the owners didn't want to give. Three months later, this former employee had set up her own shop.
So, create obstacles to this scenario: Make sure you have non-compete, non-solicitation agreements with employees when that's appropriate.
In sum, parting with equity in your business is a big decision. Owners should consider the situation carefully before giving up part of their company, but there are times when it is the right decision. Many businesses have been hugely successful, at least in part, because the owners were willing to share the upside with employees who helped create their value.
Think about all of the large corporations that attract, retain and motivate their people using stock option plans. By all means, owners must do what is right for their particular situation. But, don't be "penny-wise and pound foolish." Depending on your answers to the four questions above, you may want to incentivize your key employees with equity.