“I would rather own 60 percent to 85 percent of a wildly successful business than 100 percent of a business where the staff and partners are not invested in our mutual success.” – George Deeb
Equity sharing can be an attractive option, especially for startups that don’t have a lot of capital or cash on hand. It can get the ball rolling, secure necessary financing, and get great employees on your side for the long haul… if you do it right.
In fact, equity sharing can act as a team builder and help to create a more cohesive and goal-oriented operation within your business. But there are downsides as well. Understanding the legal issues, the financial red tape, and the personal issues involved with equity sharing can be much more complicated than simply handing over a paycheck.
Unlike hiring potential candidates off the street, you’re now dealing with investor employees. It’s just not as simple overall. The following are a few of the things you should consider before agreeing to any sort of equity sharing arrangement:
You Cannot Trust a Formula
While many business owners have used equity sharing formulas to determine compensation in the past, it’s not smart to rely on one.
Equity sharing formulas are designed to make doling out the proper amount of equity to each individual easier. They often take into account the estimated sweat equity an individual will put into the company versus time, as well as a plethora of other factors depending on the formula you use. You can use one of these formulas to calculate an individual’s equity rates, but you shouldn’t apply the same formula to every person you’re offering equity to.
Different individuals are going to bring different skills and resources into your company’s fold, making an “apples to apples” comparison nearly impossible. That’s why it’s essential to find the right formula for each equity arrangement. While your cofounder may bring in tons of capital reserves, you first few employees may be responsible for actually building the complete infrastructure of the company from the ground up.
But if you’re truly dead set on using a formula, Tim Karrer has aggregated a few interesting sources on the subject.
How Much is Too Much?
As a general rule, you should only carve out 10-20% of your business’s equity to share with anyone—though in extreme cases that number can balloon to as high as 40%. At that point, the question becomes how much each individual should receive in turn for his or her contribution.
New hires picked up at the birth of your company should get the lion’s share (perhaps even more so than silent moneyed partners). That comes out to maybe three, five, or at most ten percent equity—but no more. It’s okay to “water down” your hold on your new business to a certain extent, but you certainly don’t want another individual holding the majority of the remaining equity.
Sweat Equity Versus Investment Dollars
It may sound counterintuitive, but we really believe that some employees should be valued above monetary investors. That may come as a shock to some, but when you examine what you’re getting in return, it’s not really all that revolutionary.
When an investor asks for equity, all you’re getting in return is money. Sure, it’s money you need, money that will help your business get off the ground, and maybe even the money that literally saves your business—but it’s only money.
When you secure an employee through an equity arrangement (especially one with a vesting clause), you’re getting an ally—a buddy in the trenches beside you for the long haul. He or she will have an active interest in building the company to its fullest potential and will help you to actually do it, making this employee a more valuable long term asset than a single capital injection.
Of course, you don’t have to offer the same deal to all employees. George Deeb, managing partner at Red Rocket Ventures, writes on Crain’s Chicago Business Blog that he “typically give[s] employees a matrix of options (big cash/low equity, medium cash/medium equity, low cash/high equity) and let[s] them pick what works best for them.” By doing this, you make the offer more attractive and secure a greater loyalty – an undoubtedly beneficial business move.
Keep an Eye on Your Equity
Keith Liles of KillerStartups reminds business owners not to give away equity without properly ensuring they’re getting something of equal value in return. If it’s employees, make sure they are pulling their weight through milestones, clearly communicated expectations, and regular performance reviews.
You may also want to build-in vesting requirements to ensure you’re not giving away the goods before they’ve ponied up the sweat.
Put It On Paper
Every equity exchange should be well documented through legally binding contracts. Be mindful that you will be bound by them as much as the equity recipient, so you may want to make sure they are written in your favor. Giving away equity without a solid, binding agreement is like trying to borrow from or lend money to family—it’s a recipe for a future disaster.
Keep Your Legal Requirements In Mind
When offering equity arrangements, there are certain legal obligations that you must keep in mind. First, employees of the company cannot be classified as independent contractors simply because it suits your needs. That means that even if they receive equity, they must still be treated as traditional employees—you still have to pay Social Security, payroll taxes and so on to the government. You also need to classify them correctly (hourly, salaried exempt, salaried non-exempt, etc.) in order to avoid complications with overtime pay.
Your specific employment obligations can vary depending on the situation, so consider hiring a lawyer through UpCounsel to get the support you need to go through them.
Is It Right for You and Your Company?
Equity sharing is an attractive option, and many business gurus tout it as the perfect way for startups to get off the ground, but only you know your company (or future company) intimately enough to understand whether or not equity sharing is right.
Make sure you’ve exhausted the myriad of options available: even if it seems to make sense on paper, you need to consider whether you’re okay with potentially handing off huge chunks of your company—the company you built from a dream—to other people just because you can’t immediately find the capital backing you need. Can the extra time you take securing financing actually be a better investment in the long run?
These are the questions that you’ll have to answer before you even consider going down the equity sharing road. Don’t get discouraged by the process. What’s most important is that you understand the ramifications of the decision before you’re knee deep in a bad deal.