After reading this title, you might be wondering if I'm not the same guy who just wrote an article about giving employee's equity. You're right, I did. But there's a right way to do and a wrong way to do it. The key message is that you should avoid giving your employees actual equity in your business. Here are four reasons why.
1. When you give anyone, including your employees, equity in your business, you are granting them ownership over a certain percentage of your company. Handing out equity means you now have a new minority partner in your business who you have some accountability to. Most likely you have been running your business as the sole shareholder, which gives you the ability to make critical decisions in the business without answering to anyone else. Once you hand out equity, that dynamic changes. Of course, most entrepreneurs rely on the input from key members of their team when making a decision. But now, their vote counts as well. You also now need to share your financials with your partners, which, depending on how many expenses you have been running through your company, might open some eyes anc cause uncomfortable conversations among your partners.
2. Another downside of handing out equity to your employees is that they now have rights to the distribution of the company's profits. That factor can come into play when you might be considering a growth strategy for the business - say expanding into a new market or hiring on new employees - which could cause profits to plummet in the short run with an eye on a long-term gain. If you are the sole shareholder, you can make those kinds of decisions. You can also decide to take on additional expenses to help drive down profits for tax purposes, like taking a spouse along on a business trip. But if you have minority partners, you need to convince them that not collecting any profits this year will be worth it to them next year or beyond - which can sometimes be a tough sell depending on the financial situation of your employees.
3. A third reason you shouldn't give equity to employees is that if you do, you create a taxable event for them. Let's say, for example, that you give an employee equity worth $100,000. That amount is now taxable at somewhere between 30% and 40% - or $30,000 to $40,000. Most people don't have that kind of money laying around to send off to the IRS. I have seen situations where owners have also given cash to employees to help pay their tax bills - but any cash gift is taxable as well (as well as an expense to the business). So you'll need to solve for some circular logic if you don't actually want to create a significant short-term financial burden for your employees if you decide to give them equity.
4. If you give employees equity, and make them your minority partner, you now have an obligation to buy them out should they decide to leave the company - or vice versa. In some cases, equity deals include a valuation model in the agreement that establishes how the company will be valued in the event of a buy out. But this step is often overlooked. That can result in you having to pay an inflated value to your partners if you choose to buy them out.
Oftentimes you may also have to borrow money to buy out a partner - that creates debt the company needs to work off, which makes the company's future riskier. I know of one CEO who took on a log of debt to buy out his partners right before the market crashed. The result was that he was left with a ton of debt and a smaller company to try and pay it off. All in, it took this CEO more than 10 years to pay off that debt load and finally get back to profitability - all because he granted actual equity.
That's why, when you add up these four reasons - shared decisions, shared distributions, taxable events, and partner buy-outs - the smartest CEOs avoid handing out equity to their employees.
The good news is that there are alternatives to awarding your employees the equivalent of equity that don't put your company at risk, and I'll cover that in my next article.
Jim Schleckser is an in-demand speaker for keynotes and conferences on business growth and CEO effectiveness.