Many new entrepreneurs often tell me that they “need” to give equity to their general manager or a few key employees. The entrepreneur is usually working towards opening his or her first studio or fitness concept, and he or she believes that the only way people will work hard is if they also have an ownership interest in the business. What entrepreneurs sometimes fail to realize is that entrepreneurs are unique individuals – what drives them (equity, building a business, etc.) does not necessarily drive the vast majority of the population. In my experience, most people desire stability (constant paycheck) and/or a company that listens to its employees feedback and strives to become a better place to work. In other words, equity may not excite employees the way it excites an entrepreneur.
However, for some people, being granted equity can be a tipping point in getting a person to leave his or her comfortable job (steady paycheck) in order to grow a business and share in the upside. By the employee having “skin in the game,” he or she may be willing to put in extra hours that non-equity employees will not. From the entrepreneur’s point of view, the instant benefit is that an equity grant to a key employee usually decreases the amount of hourly wages or salary the entrepreneur will need to pay that particular employee in the beginning when cash flow may be non-existent.
Unfortunately, the downside of granting equity to employees is often not carefully considered. A few issues that are often overlooked:
- Duties to Minority Equity Owners. A minority equity owner (whether a 1% or 49% owner) is now your business partner. Most states have laws that generally impose duties of good faith, care and loyalty on the majority equity owner(s). This can prevent an entrepreneur from engaging in certain competitive activities with the business, and could expose the entrepreneur to significant liability from the minority equity owners.
- Lack of Flexibility/Control. Related to the bullet point above, in most circumstances the entrepreneur will also likely have to get the approval of the minority equity holders before making any major decisions on behalf of the business. Major decisions include, but are not limited to, taking outside financing, issuing additional equity or selling the business. Every state has unique statutes and case law that governs the duties of the majority equity owners and the rights of the minority equity owners.
- Equity (Usually) Is Forever. Unless you carefully draft your equity grant documents, the employee will own the equity even after he or she stops working at the company. Sadly, I have lost count as to how many entrepreneurs have found their way to me 1-2 years after opening seeking to remove or buy back equity that was granted to ex-employees (preview: it is not easy or cheap).
- Lack of Clarity on Future Growth. If the new business is successful, the entrepreneur will often want to open new locations. A big question arises: do the minority equity holders also get the same ownership percentage in future locations? If the entrepreneur did not properly document the business deal in its legal documents, then the minority equity holders (even ex-employee equity holders) have a strong argument that they should get the same equity percentage in the new locations.
- Inconsistent Liability Exposure. The entrepreneur may have to sign a personal guaranty in connection with the company obtaining financing or signing a lease for its initial location. More often than not, the minority equity holders are not required to sign personal guaranties, leaving the entrepreneur unfairly holding all of the risk without proper compensation.
The bullet points above cover some, but not all, of the major issues with poorly conceived equity grants. That said, there are many reasons to grant employees equity in the company, and when done correctly, it can be extremely beneficial to the growth and success of the business.