By Atta Tarki
Cash is king in the current economic climate. Given this, managers of privately held companies trying to attract and retain top-tier talent are fighting with one hand tied behind their backs. Most of these companies aren’t offsetting the amount of cash they spend on compensation by creating meaningful equity programs — this is how they can change that.
Tech startups have for long known that paying equity is crucial to attracting top-tier talent. Startup owners typically give up about 7 percent equity to initial employees before any large rounds of financing and 54 percent equity to investors and employees by the time they reach Series A funding, according to an analysis of over 10,000 cap tables of VC-backed companies by Morgan Stanley’s Shareworks.
Analysis from Institutional Shareholder Services shows that equity is also important in how a public company compensates its top-tier employees. Public company CEOs, for example, earn 68 percent of their compensation in equity and options. Only 10 percent of their compensation is in the form of salary and bonuses.
But just rolling out an equity program does not solve the problem for privately held companies. Candidates receive most of the value from company equity when they sell their shares. And since privately held companies don’t trade on public markets, candidates can often only sell their shares if the company owner sells the business. When I started thinking about rolling out an employee equity program last year, that meant I had to ask myself a tough question: When do I anticipate exiting my business? After a lot of soul searching, I realized the honest answer was I don’t know.
Most candidates will not place any value in the equity received if they anticipate the company remaining private over the long haul. This made me look into how privately held companies with no intention of going public create equity programs that can attract and retain top-tier talent. The first piece of advice I received was to follow the example of consulting and law firms. A number of them have set up a model where newly elected partners at the firm receive or buy equity even if the firms never go public.
However, I discovered that “equity” meant very different things to these firms. In some firms, the partners don’t receive any actual ownership in the company. Instead, they get to invest money in a bank account and receive 20-plus percent interest rates on that money. In other firms, the partners receive so-called phantom stocks, which are designed to act like equity by increasing in value as the company does and paying dividends but don’t provide the same legal rights as co-owning a company. Many of these partnerships also only allow partners to sell their shares back to the company when they exit the firm, and at pre-determined valuations that are not connected with the true value of the company.
To me, these restrictions would have defeated the purpose of offering equity in the first place. After all, I wanted my star performers to feel like owners in the company. By its name alone phantom equity indicates it’s not a real equity program. And modern employees want equity because they not only want to be part of growing something but also getting a piece of the value they’ve created. An extra bonus check once a year and then selling back their shares for pretty much the same price as they received them doesn’t cut it.
Luckily, my firm places executives with public, VC-backed, private equity owned and privately held companies. I had observed more than 100 equity plans over the years and had seen a number of creative equity structures.
After all my research, I decided to model my program after one used by a family investment office focused on acquiring small- and medium-sized businesses. It competes with privaty equity firms for talent, which is where the candidate I placed used to work. Unlike private equity firms, however, many family investment offices buy companies with a long investment horizon, sometimes holding the companies over multiple generations. And most family offices don’t have any intentions of selling their own investment office or going public. This family office was no different, and it created a problem for the talent it wanted to attract. Because there was no clear exit from the firms it owned, there would be no clear payout events either. The candidate I placed wanted to know they had liquidity in the equity they owned even if they didn’t plan to leave.
Despite these restrictions, this family office offers candidates real restricted stock units (RSUs) – not phantom stocks. And it also gives employees the right, but not obligation, to sell back their equity to the firm every two or so years. This gives the candidates even better liquidity than many VC-backed companies where employees are locked in to holding their equity until the company goes public. The value of the RSUs can either be determined by an external valuation firm, set by the management team or tied to a pre-determined formula based on the company’s revenues, profits or other metrics.
keptics of this model often ask if this creates incentives for the company to hold future valuations artificially low so they don’t have to buy back the equity at a high price. However, this is not quite true. If the company wants to keep attracting future talent and retain the talent that has received equity, it’s incentivized to make the price for every equity buyback fair and attractive.
The more I researched the topic, the more I discovered that there are endless ways for privately held companies to design equity plans. Many of the designs offer the owners of the company strong protection, leaving the employees with the short end of the stick if something goes wrong. As nervous as I was to give up real ownership in my firm for the first time, I realized that if I truly wanted to attract and retain candidates who would be excited by the value of the equity they received, it was in my best interest to make the program fair for both parties.
Cash is king during tumultuous times. Privately held companies can level the playing field by compensating top-tier talent with structures that require less up-front cash.
This article was originally published on Entrepreneur.
Atta Tarki is the founder and CEO of ECA and the author of Evidence-Based Recruiting (McGraw Hill, February 2020).