Should You Offer Employees an Equity Stake?

Back in the roaring late '90s, bootstrapping startups got cheap help by offering their first hires an equity stake in the company instead of a higher paycheck. When money got tight again after the dot-com bust, business owners began taking a harder look at the equity option.

There are drawbacks to granting equity instead of simply paying workers more. Handing out equity stakes means workers will be part owners of the company. They'll have a say in decisions the company makes and will share in the profits.

Owners who grant workers equity need to realize they'll be sharing power to some extent and giving away some of the company's potential profits. Owners must also be careful to make sure they retain a majority ownership in the company, or they can find themselves outvoted, forced out, or marginalized at their own company.

But offering equity can be a good move for several reasons:

• Save cash: A primary reason startups consider granting equity is that they don’t have the money to hire the talented people they need.
• Attract better-quality workers: Highly skilled workers may be lured by the idea of a possible big payoff down the line if the company does well.
• Improve performance: Reports show companies with employees who are paid partly with equity tend to be more successful than companies where all workers are paid a straight salary.
• Share with comrades-in-arms: With multiple owners working at the company, founders have others with whom to share their responsibilities and worries.
• Raise capital: Once you have equity-owning employees, if you need more cash they may be willing to raise their equity stakes by putting cash in to buy more shares. They also may buy their equity shares from the start, generating some quick cash, or the company may grant them at no cost to the worker.

If you decide you'd like to offer equity stakes to some of your key hires, the first step is getting a professional valuation of the company. You can't grant a stake without knowing how much your company is worth.

Depending on your company type, you can give workers an equity stake in several ways. A limited partnership offers equity by expanding the partnership, for instance.

Most employee-ownership companies are either S or C corporations. These companies can issue private shares of stock to their workers. The workers are given a grant of shares, but must work at the company for a specified length of time, say, two to five years for the shares of stock to "vest," or become theirs.

Another option is offering stock options: the right to purchase shares. Usually such an option becomes exercisable at a future date or when company benchmarks are achieved, such as meeting sales targets. Granting stock or stock options that vest over time tends to improve retention because employees want to stay until they acquire the right to sell their shares.

"Phantom," or restricted, stock pays workers a cash bonus that's equal to the value of their shares. Similarly, a stock appreciation right pays employees a bonus if their shares grow in value over a set time period. In other words, if the company grows, the value of their shares grows, triggering the bonus. Restricted stock and stock appreciation rights can be good options for many smaller companies because the programs are easy to set up.

One of the big issues to decide if you're granting workers equity is how much equity each employee should receive. Often equity stakes are given to just a few key employees, with the size of their stake determined by their value to the company.

Business reporter Carol Tice contributes to several national and regional business publications.