Is Your Equity an Endangered Species? Privately Held Companies Edition

Equity, as a compensation tool, is a finite resource with an infinite value. There is only 100% of your company. Only a fraction of that amount can be used to compensate employees. When that approved fraction is gone, it may not be possible to use equity as a compensation tool any longer. This challenge has always existed, but it has worsened over the past several years.

Every company only has 100% of its stock to share. In a generous company², you may be able to allocate as much as 30% of the stock to future employee compensation. For some companies, investors may limit this to as little as 10%.  Anything less than this is not really a program, it’s more like a special treat for a few individuals. For companies in their early stages, additional funding rounds usually result in new shares being issued. New shares expand the potential pool by increasing the number that makes up the 100% while not increasing the number of shares related to equity compensation. Even if you get new allocations approved, poor usage in your early years may result in ineffective grants just as you need them most.

Each round of funding provides a possibility of new equity compensation shares. With each step it becomes increasingly harder to convince investors to part with additional shares, but the requested pool is a smaller percentage than the last request. The pie may increase, but seldom by material amounts. Understanding and planning the use of your equity compensation pool is critical, but every year companies are shocked to learn that they do not have enough shares for future new hires.

Projecting future headcount growth, future stock price growth, and future equity usage is both an art and a science. It’s a lot like guessing which endangered species will become extinct, and when. Case in point: The last male white rhino died in 2018. His daughter and granddaughter survive, but both will be gone before the end of this century. A lack of attention leads to an irreversible end. But there are 160 California condors on the planet. 50 years ago there were less than 20 condors. Awareness and aggressive conservation saved these creatures. Planning your future is a complex calculation, but waiting until you are obviously low on shares is a great way to ensure troubles.

Once you are desperate for - truly out of - equity compensation shares, your negotiation position with investors is tenuous. When this happens, they literally “hold all the cards” and you are left to scratch and claw for just enough shares to keep your program viable. It isn’t fun and it makes the long path to a liquidity event especially difficult.

Equity is amazing because it links your employees to the success of your company. But equity can be a liability when it links employees to your poor planning. Understanding when and how your equity may become extinct is not something to wait on until only a miracle can solve the problem. Successfully navigating your privately-held company through this process is one of the most important human resources or compensation professional tasks. The survival of your equity compensation program and the recruiting, retention, and motivation it supports may be one of the most important and least understood responsibilities of your job.

More on this topic in my next post…

• Publicly traded companies have an entirely different set of issues to handle. These will be covered in a future post.
• There are companies where employees own all 100% of the shares. These companies are usually formed as ESOP (Employee Stock Ownership Plan) companies and face decidedly different challenges.

Dan Walter is a CECP, CEP, and Fellow of Global Equity (FGE). He works as Managing Consultant for FutureSense. Dan is also a leading expert on incentive plans and equity compensation issues. He has written several industry resources including a resource dedicated to Performance-Based Equity Compensation. He has co-authored ”Everything You Do In Compensation is Communication”, “The Decision Makers Guide to Equity Compensation”, “Equity Alternatives” and other books. Connect with Dan on LinkedIn. Or follow him on Twitter at @DanFutureSense.