Many startup entrepreneurs are tempted to offer employees stock in lieu of paying them a fair salary. Making your employees owners by sharing equity can be appealing, but unless you’re planning an initial public offering (IPO), it’s almost always a mistake.
Here are five reasons for not sharing equity in your startup:
1. It dilutes the pot.
When you start a business, you take all of the risk. You need to be paid in full for the risk you took and not have your equity diluted by employees who want a steady paycheck and the big win.
2. Employees with a minority share in a closely held business gain no advantage.
As the majority shareholder, you can manipulate your financials so that your minority partners see no annual dividends, and if you never decide to sell, those minority shares are next to worthless.
3. Shareholders are entitled to a reasonable level of disclosure about your financial statements.
Do you really want to show your employees all of the expenses you run through the business?
4. Acquirers like to buy businesses in which the ownership structure is tidy.
If and when you decide to sell your business, having lots of shareholders, holding companies and complicated legal engineering will scare off some potential buyers.
5. LTIP is a better choice.
There’s a simpler alternative to sharing equity that is better for you and your employees. In each of my businesses, I’ve used a Long-Term Incentive Plan (LTIP) instead of sharing equity. Here’s an example of how an LTIP is worded in an employee agreement:
Each year, you will be given an annual cash bonus based on goals the company sets out for you. This annual cash bonus will be paid within 60 days of the calendar year-end. In addition, an amount equal to your cash bonus will be earmarked for you in a long-term incentive plan (LTIP). Upon the third anniversary of the creation of the long-term incentive plan, and every year thereafter, you will be entitled to withdraw one-third of the plan’s total balance.
The chart below provides an example intended for illustrative purposes only:
An LTIP can make your employees feel aligned with your goals and loyal to the company without your having to share your precious equity.