5 Errors in Drafting Equity Compensation Plans

Best practices in calculating how to share equity with your employees

I have had dozens of conversations with closely held business owners who want to share equity with some or all employees over the past several years. I start by asking what they are thinking of doing.

With almost unfailing consistency, they say: “I'm planning to give out 10% of the equity or rights to the equity;” “I'm planning to give most or all of the equity upfront to those eligible;” “Employees will only be able to exercise their awards when the company sells or goes public;” “Only key employees will get equity;” or “I will base the amount people get on a percentage of the company that I have heard or read makes sense.”

In some cases, one or more of these ideas makes sense. But more often than not, they don't.

  1. The 10% solution. When I ask people how they arrived at this number, they usually say “it just seemed reasonable,” or “that's what I have heard other people do.” But 10% of one company is in no way comparable to 10% of another.

    Say Company A is 3 years old, has 50 employees, is already making a profit, has little debt and has an exciting new product already in production. Company B is 1 year old, has 10 employees, some good ideas but no profits and products only in development.

    Is 10% of each of these companies the same? No. It's not even close. Each company's employees will get radically different amounts. A similar error is saying “we'll give out x number of awards” or some other number you heard is about right, even though you have a very different company whose stock has a very different value.

  2. Most of the equity will be given out upfront. Owners often want to reward and motivate the people who have helped them build the business. So whatever they have decided to give out, they either give out now or maybe reserve a small percentage for later.

    This raises some serious difficulties. First, what happens if you need to add new key people or replace existing ones? There is no more equity to give them, which creates a divisive “them” versus “us” problem.

    Second, you've created a lottery. Say you are giving out stock options. After a very good year, you give 2% of the company to Mary, your CFO, at $20 per share. You've wisely reserved some additional equity to give out next year. But your company hits a rough patch so by the time the new sales director, Joe, comes on board a year later, his options for 2% of the company have an exercise price of just $15. Joe just got a much better deal than Mary. Is that fair? Third, you have lost the opportunity to give out more equity in the future without reducing your own ownership.

  3. Unless we sell or go public, no exercise allowed. Put yourself in the employee's shoes for a minute. You have just been told you're getting $50,000 worth of equity, but you have to stay three years for it to vest. When it does vest, you can only exercise it if the company is sold or goes public.

    You think, “Gee, I may not be here in three years, and if I am, there is no guarantee that either of these things will happen at all. This $50,000 you just gave me seems to be worth maybe $20,000 given the uncertainty and the wait.” These numbers are reasonable approximations of what research indicates employees actually do think.

  4. Only “key” employees will get equity. Company leaders like to tell their workers “people are our most important asset.” But then when it comes to equity practices, it turns out only some people really are important.

    Giving out ownership broadly to employees makes sense, resulting in companies that grow faster and yield better returns for their investors than companies that concentrate equity in the hands of a few people.

    Imagine, for instance, a company in which everyone had a reason to care about treating customers well, worked efficiently and, most importantly, came up with lots of new ideas about how to do everything better. Wouldn't that be a more profitable company?

  5. How much each employee gets will be based on some number I read or heard. You might have seen the number in a compensation survey or heard it at a conference. Maybe you heard the CFO should get 1% of the company, for instance. What the employee really wants to know is how much will I get in dollars I can count on. So consider each person individually.

What number given out periodically would be enough to attract, retain and motivate good people? Surveys and what you hear from peers can help in making this judgment, but you know your people best and what else you offer to employees. Only you can ultimately make the right choice.

Building a Dynamic Model

So what to do? Here is what we have learned works best:

Give out equity in smaller chunks more often. This will average out the lottery effects of changes in stock price while retaining flexibility to give equity to new people.

Focus on giving away a percentage of growth targets, not a percentage of the company. Each year, set a goal. It may be sales, profits or something else. If you meet it, then all the eligible employees would get an amount of equity that represents a percentage of the value of meeting that target. If you meet a stretch goal, you can give out more.

Give out ownership more broadly. Most technology companies give ownership to everyone, but so do many of the most admired U.S. companies, like Southwest Airlines, Starbucks and Whole Foods, which have been “game changers” in their industries.

Working with the employees, figure out what amounts are needed to have a real impact on how they think about the company. If the company is small enough, you can do this on an individual basis. You might even ask employees to suggest a number and then work from there. Use surveys, if available, to set some reasonable parameters, but don't just aim to be at or above the median. Create a liquidity alternative other than sale or an IPO if neither of these events is highly likely in the near term. Somehow, a lot of people have the notion that this just can't be done. Of course it can! It's just a matter of finding the cash (easy for me to say). These are just of the few of many considerations that go into crafting a plan that is right for your company and your people. Giving out equity is expensive. It's worth taking the time to create a system that really fits your needs.

The National Center for Employee Ownership publishes The Decision-Maker's Guide to Equity Compensation. For details, go to www.nceo.org/pubs/equity-compensation.html.

TAGS: Management