Outside the Box: Why giving equity shares to top executives and employees is a costly mistake

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One e-mail, six figures, and six months is what it took for me to learn my lesson. Managing ownership, especially in an early-stage company or small business, is one of the messiest, most-confusing things you’ll ever have to do as an entrepreneur. Yet somehow, potential hires in the U.S. have come to expect an offer that includes equity anytime they’re an early employee.

Startups began using equity as a form of compensation decades ago, but nowadays it seems anyone and everyone thinks they deserve a piece of the pie. And in many cases, they are getting a share. It’s not a question anymore of whether or not you should give equity — it’s how much.

To me, that’s shocking. Maybe that’s because I’ve seen the ugly side of how sharing ownership without thinking it through can cost you. I had a business partner until a few years ago, and one day he decided he was done. But unwinding that partnership wasn’t so simple. 

Unfortunately, I had failed to take the right steps to protect myself. Things got ugly. By the time he finally left the office I had spent a significant amount of money on legal fees, the entire business had experienced lost production, and I was in need of several stiff drinks just to recover from the ordeal. 

Giving away equity doesn’t have to be the norm. Here’s what to consider and how to protect yourself if decide to offer employees a stake in the business:

1. Minority owners have unintended rights and responsibilities: Whether you’re granting straight equity, a vesting stock plan, or some other form of ownership, you’re giving your employees unintended access and rights that some should never have.

In most cases, minority owners can request and have access to all of your financials, whether you like it or not. And they can take part in voting for board seats and in some cases hold even more sway over the overall governance and direction of the company. 

When you give away equity, you’re not just incentivizing employees, you’re giving them real power and leverage.

When everyone’s getting along, this might not be a concern, but what happens if you need to fire someone? An employee with access to your financials, the ability to vote or block certain board members, and possibly even more leverage, can do serious damage before they’re shown the door.

When you give away equity, you’re not just incentivizing employees, you’re giving them real power and leverage. That includes employee stock-ownership plans, or ESOPs, where everyone has to be included in the stock plan. If an ESOP borrows to pay for stock it can put incredible financial and cash-flow pressure on the company. It also has no investment diversity and, if the company has a downturn, must pay laid-off employees, putting even more pressure on cash flow.

That’s why it’s imperative, if you decide to grant any kind of ownership, in any form, that you cover all of your paperwork bases up front, while everyone is still getting along.

The most critical part of this puzzle — the one I screwed up — is ensuring you have a buy and sell agreement. It’s a legally binding agreement that stipulates what happens to ownership units in the event that the employee leaves the company, for whatever reason. 

A buy and sell agreement certainly won’t block all possible disputes, but it’s a tool that gives you a clear picture of how things will end — namely, with the ownership units coming back to the company, and you avoiding the nightmare I endured.

2. The tax conundrum:You can’t grant equity or ownership without incurring a tax event. The moment you do, you create a cascade effect that will end up where you, the employee, or both of you are paying the IRS for the transaction to take place.

Before you take that step, ensure you’ve reviewed all of your options. You don’t want to saddle a key team member or your business with a high tax bill. 

One option is to use an 83(b) election when granting equity, giving the employee the option to pay taxes on the current value of the company — which in theory could be quite low or even zero in the early stages — rather than on the company’s valuation later on.

Offer performance bonuses instead

Equity or a vested-stock plan are often dangled as carrots that keep employees engaged and give them a stake in the long-term health of the company. But I’m going to tell you exactly what I tell my clients: there are other ways to do the same thing.

If it’s a matter of compensation, offer a bonus program that doesn’t dilute ownership. Only hand out the cash when you’ve achieved a benchmark and your incentives still align. Entrepreneurs and small business owners put in hundreds of thousands or even millions of their own dollars into their ventures, not to mention their time and effort.

You are not obligated to give that up. You don’t owe anything to someone who wasn’t there when you had to drain your savings to get the company started, or when you stayed up nights to meet a deadline before you had any employees. 

Maybe you feel like equity is the only way to lure someone or retain a key member of your team. If you’re hiring engineers in Silicon Valley, that might be true. Anywhere else, though, and you should ask yourself if that’s really the case. 

Before giving away equity, consider the risks it creates for your company, both financially and legally. Lock yourself in a room with your most trusted advisers and go through every possible scenario. Keep in mind that just because everyone’s getting along well now doesn’t mean that will always be so.

I realize there may be times where equity is a necessary part of a compensation package, but there are also many, many instances where it doesn’t have to be. Granting ownership comes with a price, and sooner or later you’ll have to pay it. Just make sure it’s worth it when you do.

Bruce Willey has advised small- to midsize businesses for more than a decade, helping them navigate business and tax law, as well as asset protection, exit planning, and estate planning.

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