How much equity should I give a new hire?
This question greys the hair of every business owner and entrepreneur. After all owners bear the burden of risk regardless of how they answer that question and the more that they choose to let go of equity, the less they feel like an owner and the more they feel like any other executive -except that they incurred a risk others didn’t.
While holding equity is fundamental to being a business owner, the distribution of equity from owners to employees is not fundamental and happens for a wide variety of reasons – some justified and others misguided. And while few employees would ever shun being given equity, their rationale for and level of interest in equity varies for many reasons.
Even reasonable candidate/employees and well-intentioned owner may view equity differently. While the potential for participating in the rare but particularly lucrative business sale of IPO is perhaps the most well understood (yet unlikely) reason for wanting equity, there are many other reasons to be valuable to owner or employee, most of which are not unique to actually holding equity.
Make equity distribution the tool of last resort
In most situations, an employee with equity in the company makes decisions that more naturally align with the interests of other owners because of the inherent alignment between business and personal success. Yet the ownership mentality that leads to better decision making for sustainable growth and business success can be incentivized by other instruments than equity.
However, these alternatives come with a price which may be too high for cash-strapped organizations. Practical necessity (or at least a fiscal prudence) may drive a company to opt to issue equity in exchange for the behavioral incentives sought and a reduced cash cost. This can be quite sensible and beneficial. Distributing equity is NOT something to be avoided at all costs. It should just not be the first option explored.
Understand the appeal to employees of equity before giving it to them
Holding equity has only a few direct benefits: voting rights, access to upside during sale or IPO of the company, and distribution of earnings. Yet, not all equity creates these benefits in the same way. High growth companies frequently re-invest a large share of earnings causing the distribution of earnings to be small or zero even when the company is profitable. Companies with no ambitions to have an IPO or be sold, eliminate the value of equity from the standpoint of having a large monetization event. For people with small equity positions, voting rights may seem useless when the size of influence has little potential to move a contrarian agenda forward.
Thus, it is important to understand what employee hopes to achieve through holding equity to avoid relinquishing equity without getting a favorable return. For example, many employees care little about the voting rights associated with share ownership but want access to the potentially significant upside in the event of IPO or sale.
In a different example, employees commonly want to see their contributions to the company’s success rewarded in proportion to the impact to the company’s bottom line. Voting rights and the access to upside in a sale/IPO are not as important as sharing in the success of the company.
You expect things to get better without being able to change things
It is difficult to know if your most recent hire was “successful” until they have had ample time acclimate and then demonstrate their skills in the role. Usually this takes a minimum of 6-12 months at which time nearly all has been forgotten about the interview process.
When you have a “failed” hire, you typically end up seeking a replacement for this person because either they failed to perform, and you had to manage an exit, or they failed to integrate, and you lost them as unplanned attrition. Either way, you’re back to seeking candidates and you would prefer not to make the same mistake again. However, what was the mistake? All the following could have been at issue:
- Sub-optimal skill profile sought
- Wrong prioritization of qualifications
- Inaccurate evaluation of candidate
- Deception by the candidate
- Biased decision making
The narcissistic hiring manager will assume the candidate misled him/her in the process, not willing to take responsibility for any other root cause. Even if this was the case, there is potential to improve the process to reduce the ability to be deceived through optimization of the evaluation process, but only if there is clarity on where the business was deceived.
However, by not having invested time early in the process to define clear explicit criteria for the job and the process for evaluating, the ability to run a post-mortem review of the hiring mistake to improve the process disappears.
Had the company been able to review the scoring rubrics for the employee from when he or she was a candidate and compare against actual performance, it would likely become quickly clear where the weakness was in the process and the potential to improve in the future would become equally clear and actionable.
Ultimately, as seemingly time-consuming and even painful as it may be, taking the time to rigorously define and execute a well-designed recruiting approach manages risks better and captures value more thoroughly than even the most capable hiring manager could do alone.
Focus on alignment of agendas, not alignment with the market
Many companies include equity rather than substitutes because they believe “the market requires” them to offer equity or risk not attracting the right talent. Yet many of the same employees only request equity because they think at a certain level of seniority, they need to have equity else they are being under-valued. However, in many situations if employer and employee are honest with themselves and eachother, a solution can be hatched to address the needs of the employee without relinquishing equity, often creating a more attractive solution to all involved.
While it can feel awkward to have such an open, transparent conversation with a candidate, it can also send a powerful message to the candidate that the company seeks to do the right thing for all involved parties. Being able to explain how a profit-sharing program not only enables the employee to share in the success of the company but also removes uncertainty and potential discord related to the level of reinvestment is a powerful starting point for a negotiation. That conversation could still ultimately still land on the distribution of equity but may also land on a scenario that is better for everybody involved that what the “market says should be done”.