When A Key Employee Wants Equity

I’m going to talk about a scenario that doesn’t happen very often—maybe a half dozen times over your entire life—but which has short- and long-term implications if you handle it poorly.

The Scenario

Picture a dedicated, key employee on your team. They lead, think like an owner, take (the right sorts of) chances, grow accounts, smooth the waters when a client’s feathers are ruffled, take new employees under their wings and train them up right, etc. In every way they make your life easier.

This person is also ambitious, though, and this just can’t be ignored when they come right out and press you for ownership. Not in a passive aggressive way, and not with any sort of improper leverage, but just through expressing a desire to take that next step of commitment to the firm. It’s a signal, a reaffirmation, a deeper commitment to the cause.

Your Reaction

First, this is never a surprise because you’ve either seen hints that it might happen or you just figured it would, because this team member stands above the rest. It’s the first person you consult with after some big change occurs to you the night before at home. It’s the person you check in with about the vibe and how the larger team is reacting to something.

Second, you’re relieved that you won’t apparently lose this person, which would be a blow to you, personally, because this employee has made your life easier by sharing the burden and making it possible for “ownership” to be in two places at once. You trust them and you’ve realized, in fleeting moments, that they have become a linchpin and this request signals their continued commitment.

Third, after you sit with your thoughts for a bit, you wonder if this might complicate things down the road. Will you now be required to get their sign-off before all the big decisions? What will this mean for their pay? Or even your pay?

What if something goes wrong down the road? You may have even had a partner that resulted in a bad break-up, and this brings all that pain and frustration to the surface.

The Best Path Forward

I’ll start by saying this: you absolutely must deal with this in a respectful manner, and part of handling it respectfully is to not delay and just hope it dies. It won’t. It’s actually taken them quite a while to even bring this up, and all that time has anchored this request as something they want.

So if they are asking for equity (partial ownership), then that’s what you must explore.

But the Downsides

Part of being respectful to someone that’s important to you is to be honest with them. So you have to push back just a little to make sure that equity is the right answer. And newsbreak: it’s usually not. But let’s play this out with the “cons” of ownership. This is what you’d convey to them:

1. You might be required to add your name to a personal guarantee for a LOC or loan.
2. You’ll have a fiduciary responsibility around tax and other issues, even if you weren’t aware of the problem.
3. We might need to lower your pay in a business slowdown.
4. Even worse, you may be asked to make a proportional cash infusion.
5. We’ll need a tighter non-compete, which is legal because you’ll be an owner.
6. Your personal credit might be exposed.
7. We’ll need your non-participating “significant other” (spouse or not) to sign an agreement that acknowledges how your shares will be valued and what purchase terms will apply.
8. Equity is normally purchased and not given.

These things are all true, and when you explain them…kindly…it may insert a bit of doubt into the whole process. If it doesn’t, then you might need to proceed with real equity, in which case you should probably engage Punctuation to confirm that it’s a good idea and to let an experienced guide shape the process.

A Better Alternative

But if those eight “cons” above have scared them off, but they still like the idea of ownership, you don’t want to leave them hanging. In other words, you may very well want to reward their genuine interest with something that sets them apart and rewards their commitment.

That option is an ownership warrant, otherwise known as contract equity. This is similar to a tracking stock, but for the whole company, though it can’t be traded (i.e., sold to someone else). It gives them a vested interest in the company without all the entanglements of actual ownership.

Say you give (yes, it can be a gift) someone 5% contract equity in your firm. This means that they:

• Get 5% of the transaction value if the firm is sold while they are employed. You could also add a provision that grants them this payout if they were employed within the last X amount of time (say one year).
• Get 5% of the distributions (as ordinary income, of course).

(Contract equity always includes the first; the second can also be included, but isn’t core to contract equity.)

What it doesn’t do is give them:

• Any voting rights.
• The right to sell their position to anyone else. In fact, it disappears when they quit or are terminated.

There are at least a dozen minor provisions that can be included with contract equity, and it’s actually a marvelous tool that benefits both sides if done right.

Finally

That’s it. When someone wants to be your minority partner, you should treat it as a compliment. Which means treating it seriously. But then you have to decide what’s in your best long-term interest, as well as theirs. Partnerships can be the best…or the worst…thing that’s ever happened to you. Enter them cautiously.