“This guy can help me grow my business by 25-30% next year, but he wants equity in the business. I guess if he can add value, he’s worth it, right?” Henry (not his real name) was almost breathless, he was so excited. He had called me for advice on how to bring in a new employee and make him an equity partner. My patience level wasn’t high that day so I got right to the point. “It is not a good idea, actually it’s a bad idea,” I said, to which Henry replied, “But, he won’t come work here if he doesn’t get some equity, he says he needs to feel like an owner.”
Henry explained that his five-year old business was at a crossroads. Growing at about 12% a year, he was just beginning to make money, but Henry needed a boost to crack into a new vertical that offered a lot of potential. “This could be one of those defining moments, if you know what I mean,” he continued, “I just don’t see how we can take on this next stage of growth without Andy’s expertise.”
Henry was thinking he would create a formula that gave Andy the opportunity to build equity based on the results he delivered. I’ve done that before, it’s fairly simple. You first get a current business valuation to set a baseline, then set a formula to determine how to value the business in the future, and finally set a formula to determine the benchmarks for the employee to earn equity. But, just because it’s not complicated doesn’t mean it’s a smart strategy. I explained, “Bringing in Andy seems to make sense and it’s reasonable that he be fully compensated for the value he creates. But, giving him equity is likely not the best way to motivate him and it will complicate your life down the road. Let’s find a way to do this that doesn’t involve an equity grant.”
So let’s review. Henry knows his business needs help in a certain area and he’s identified the right person to facilitate that. However, granting equity is the wrong way to motivate Andy. If Andy wants current compensation for his work, paying in dividends is tax-wise inefficient. Henry would be better off to pay Andy a bonus for the results he delivers. Moreover, Andy can be paid for the long-term value he creates through a bonus if/when the business is sold.
The bottom line: giving Andy equity is a bad way to grow Henry’s business, in fact it’s likely to hurt his business. An equity grant to an employee dilutes the owner’s equity and it dilutes the owner’s flexibility to manage the company as he/she sees fit. In a well-intentional effort to grow the company, Henry will end up constraining his ability to manage his company. I am a huge believer in paying key employees what they deserve to be paid. Indeed, pay them for the value they create, both on a short-term and long-term basis. But, don’t fall prey to the “I need equity” tactic. You won’t be doing you or the employee any favors.
JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee.