Rewarding key staff with shares is a good idea, but it can go horribly wrong.
Entrepreneurs usually dread dealing with the allocation of equity in their venture. Most will freely acknowledge that sharing the equity around is the right thing to do and makes good business sense. They know that key staff who are also shareholders are motivated to put more effort into making the venture successful. So why is sharing equity a problem?
In a nutshell, once the shares are allocated they are almost impossible to get back and, if you find out that you have given them to the wrong person, you are not able to correct the mistake. The dynamics of the business change over time and what was right for the business at one point in time may be wrong several years on.
In allocating equity, the decisions the entrepreneur has to make are:
- Who should get the shares initially?
- How do you provide equity for new staff?
- What happens when someone fails to perform?
- How do you cope with people leaving the business?
- How do you reward the people who made it successful?
When two or three people get together to start a business they often share the equity equally. But the people who start the business may not be the best people to manage the business as it gets larger or may not be willing to make the sacrifices later on to expand it.
If the business owners later cannot agree on how new shares should be allocated, the venture can stall and will probably never achieve its potential. The next phase of the business often requires the firm to hire some key staff, who may need to be attracted with some shares or options. When the business is young, new executives often demand a substantial stake in the business.
This can be resented by those who started the business and they may refuse to agree to any serious dilution of their shares to people who did not share the start-up risks.
As an entrepreneur, you will inevitably have the problem of shareholder employees who fail to perform when their equity share is needed to motivate the people who are performing. Then there is the problem of staff who leave, taking their shares with them when you believe that the shares should be reserved for the people who have to stay and make the business successful.
Share allocation needs to reflect many contributions including the investment of time and money, contributions of knowledge, reduced salaries, networks, years of employment and leadership. Not all contributions are equal and there is no magic formula for weighting them. So how can you best protect yourself against the most obvious problems and inequalities?
One technique is to build multiple scenarios of what the shareholding could look like in several years or at a possible exit point. How should people be adequately rewarded at that point for their role in achieving the venture's success? You can then show new employees and investors what they would gain through their participation.
Build an allocation model that shows how new staff and investors receive shares. If you set the expectations correctly, current shareholders will normally accept the logic regarding new allocations.
Another technique is to use options priced at different price points to change the allocation at the time of exit. This way, staff that perform well can be allocated more shares as the value of the venture increases. You can use voting and non-voting shares to determine how key decisions are made.
Convertible and redeemable preference shares can also be used to effect the manner in which the exit value is allocated. You should consider non-share compensation to reward outstanding performance. Bonuses, commission and profit sharing can take the pressure off you to allocate shares.
Make sure you set up a shareholder agreement that allows you to buy back the shares from staff who leave, and to deal with a situation where a small shareholder can hold you to ransom. Ensure you get good legal and tax advice on the structure you put in place so that it is both tax efficient and supports the business decisions you will need to make in the future, especially the option of a trade sale or an initial public offering.
Most allocation problems can be dealt with if you set the right expectations and provide a fair mechanism for allocating shares and options as the business develops. If shareholders expect their share will be diluted with external investment or when key staff are recruited, they will more willingly accept the change.
You can normally gain agreement for an exceptional situation such as a venture capital investment, but anything else will be difficult unless it has been planned and agreed in advance. Sharing the equity is the right thing to do, but plan for the worst-case scenario.
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