Entrepreneurs: Have You Thought About How to Grant Ownership Interests and Incentives in Your New Venture?
When I was developing a reading list for the entrepreneurial-finance class I teach to business majors, I came across an interesting article titled “The Founder’s Dilemma.” In it, author Noam Wasserman asks entrepreneurs to consider whether they’d prefer to be rich or a king. “Entrepreneurs face a choice, at every step, between making money and managing their ventures,” he writes, “Those who don’t figure out which is more important to them often end up neither wealthy nor powerful.”
But are wealth and power mutually exclusive notions when it comes to entrepreneurial ventures? Or is it more a matter of degree: the extent to which the entrepreneur chooses to be in control and the level at which enough wealth is, well, enough?
No matter your area of commercial interest, sharing ownership with those who help you realize your goals is not only the right thing to do, it also makes good strategic sense.
When I bought my last company, I also made the decision to significantly dilute my ownership in favor of my senior management team and staff. Although I thought about retaining control by maintaining a majority stake, that wasn’t going to be possible because of the amount of stock we also had to grant to our external investors in exchange for the capital we needed.
But what if my senior management team — a strong and confident group — were to wage a proxy fight for control of the company by banding together with some or all of the external investors?
I turned to my trusted advisors — in this case, attorneys in the law firm that guided me through the leveraged-buyout process and a new-company formation. The senior partner proposed the perfect solution: two classes of stock. My diluted ownership interest would consist exclusively of shares that had attendant voting rights, while those that I granted (and optioned) to my managers and employees — which fully entitled them to a pro rata economic stake in the new company — did not. (Google did the same thing some years ago.)
Although my associates were initially skeptical, the fact that I was freely granting ownership positions that had real and immediate value outweighed their concerns.
Entrepreneurs use equity stakes and other stock-based incentives to attract and retain talent. They also used these to tip the balance when salaries are competitive or to bridge the gap when they’re not. Either way, as the enterprise grows and prospers, so does the value of the employee’s ownership interest. That will create a pretty powerful disincentive to making a change, as long as you also take the following things into consideration when you map out your ownership-sharing plan:
The Size of the Pool
What percentage of ownership are you willing to give your current employees? And how much will you give to those who might join the company at a later date? I made the decision to set aside 40% of my personal stake for the benefit of present and future employees. Roughly three-quarters of those shares were allocated at the time of the buyout — in the form of grants and options — while I kept the rest on the shelf in anticipation of new hires. And even though I could have diluted the amount allocated to current employees for the benefit of future hires, I felt that reserving a distinct and separate block of shares sent a better message: You can count on what you’ve been given.
How the Shares Will Be Allocated
Do you intend to grant ownership rights up front or over time, or both? I granted 20% of the stock up front and the remaining 80% over a five-year vesting period. That way, each of my partners knew he or she had a meaningful equity interest at the start, and I protected myself against an early departure — voluntary or otherwise — that would have forced me to buy it back.
Triggers and Transferability
Life happens: People don’t work out, change their minds, have financial problems and need money, get sick, die. What if they also happened to own shares of stock at that time? What if they wanted to sell those shares to a colleague or to a competitor, for that matter? This is why it’s important to retain a first right of refusal for the repurchase of previously granted shares that have also vested over time, along with a methodology you can live with for their valuation and redemption.
Note that this is especially important for ventures that are intended to be passed down to future generations because there’s no way to predict the number of descendants who will ask to have their interests cashed out.
In my case, I developed a straightforward process that subtracted the company’s liabilities from a then-current appraised value of its assets, and determined my share of that by multiplying my diluted ownership percentage by the difference. I also arranged for the payment to take place over an extended period, so the company wouldn’t be unduly burdened, and provided for an immediate vesting of everyone else’s holdings and options, which is typically what happens when a majority interest in the company is sold to another party.
Excerpted from Practical Finance: A Straightforward Guide to Personal and Entrepreneurial Finance
Mitchell D. Weiss is an experienced financial services industry executive and entrepreneur. He is an Executive-in-Residence at the University of Hartford, co-founder of the university’s Center for Personal Financial Responsibility and adjunct faculty at Rutgers University as well. His books include Life Happens: A Practical Course on Personal Finance from College to Career, Business Happens: A Practical Guide to Entrepreneurial Finance for Small Businesses and Professional Practices and Practical Finance: A Straightforward Guide to Personal and Entrepreneurial Finance, all of which are undergraduate courses that he teaches at the aforementioned schools and elsewhere.
