Thursday, March 10, 2011

Lesson #9: Spreading Equity to Key Employees and Partners

Posted By: George Deeb - 3/10/2011


& Comment

As a rule, entrepreneurs are very protective of their equity, and try to keep 100% ownership for themselves.  Usually this is fine, provided that important key parties (e.g., employees, partners) are appropriately motivated to help you succeed.  Sometimes that motivation comes in the form of cash compensation (e.g., lucrative sales commission plan, profit share plan), and sometimes that comes in the form of equity or equity linked incentives (e.g., stock, options, warrants).

For employees, my rule of thumb is to set aside 10%-20% of the company's equity for the key members of the team.  You can spread that as far as you like, from as few as your senior executives (e.g., 2-4% per senior exec), to as many as the entire organization (e.g., 1-2% per senior exec, 0.1-0.2% for junior staff).  I typically reserve equity for the key individuals that are going to help my business the most, regardless of title.  For example, if your key developer has been critical to building and maintaining the code of your site, and you require his long term commitment for R&D improvements, make sure he is motivated to stick around.  And, it is important the employee thinks they are properly being motivated.  Each employee beats to a different drum, some prefer a smaller cash based package and others prefer a bigger equity based package.  So, design a package that works for both parties.  I typically give the a matrix of options (e.g., big cash/low equity, medium cash/medium equity, low cash/high equity), and let them pick what works best for them.  And, worth mentioning, equity should only be given to employees you deem are full-time, long term partners of the business (not part time contractors that may come and go over time).

And, when we talk about giving equity, there are many structural considerations.  Unless they are a co-founder at the time the company is formed, giving an employee stock outright has two problems: (i) the recipient and the company will both have immediate tax implications, as stock grant would be treated like immediate compensation; and (ii) if that employee quits tomorrow, you don't want them to walk away with the equity.  So, to address these issues, you would set up a stock option plan, or something similar, where the employee: (i) has the right to purchase equity at today's fair market value; and (ii) the options have a vesting schedule with the employee's purchase rights being earned over time (e.g., over four years, 25% of the grant is earned in each year).  That keeps the employee more committed for the long term, which is what you want, and only rewards them for actual time invested with the business.  Also, be sure that the stock option plan provides the company with a mechanism to easily repurchase any exercised shares from the employee at any time, so you can easily recapture ownership down the road (if things go awry with the employee, or if there is an impending change of control that requires recapturing 100% of the outstanding shares).

If you don't want to spread actual equity or options, you can easily accomplish the same goal with a "phantom equity" plan, that basically mimics equity ownership via a profit share plan or otherwise.  For example, employee could own 5% of all net income created each year, instead of 5% of equity.  Or, employee could own 5% of the company's valuation at a mutually acceptable revenue, EBITDA or net income multiple.  These plans typically are paid in cash, or accrue as interest bearing debt until paid out, so make sure you anticipate having the cash resources to relieve these claims before going down this road.

In Lesson #6 we talked about the important of strategic partners to help you grow your business.  And, as we mentioned before, it is important to spread the equity/upside with such partners, as well, so they are motivated to see you succeed.  Typically with strategic partnerships, you are simply granting them stand alone, 3-5 year warrants with a strike price of today's current fair market value, with similar repurchase options for the company.  Strategic partners could get 5%-20% of the equity, depending on how important they are for your business.

Now, you might be saying, you just gave away 10-20% for key employees and 5%-20% for the key strategic partner, that totals 15%-40% of the company.  First of all, you didn't "give" it away, the employees and the partner have to earn their upside before they exercise their options or warrants (e.g., grow the company's business and valuation, bound by vesting rights that accrue over time).  But, more importantly, I would rather own 60-85% of a wildly successful business, than 100% of a business where the staff and partners are not invested in our mutual success.

Also, worth mentioning, if the business requires outside capital, all parties would share pro-rata in the dilution from that equity financing.  So, an an example, post a financing, your ending ownership table could look like:  founder 50.1%; investor 30%; partner 10% and employees 9.9%.  So, forecast your desired ending ownership well ahead of time, to protect yourself from losing majority control of your business down the road (unless you are OK doing so).

It is hard to do this topic justice with one simple post, given all the variations to a theme for motivating your team and partners, but hopefully it gave you a good sense to the importance of this topic and a few mechanics you can use to implement such.  I am happy to help you think through any specific issues you may have, if there are any questions.

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