When Your Employee Asks for Equity, Do This

Before we get started…

If you're working harder than ever but your business still can't run (much less grow) without you, that's not a "you" problem…it's a systems problem.

We work with founders to build a custom "operating system" inside their business (the same process we've used to scale our own $200M portfolio) so the business can scale without the founder doing all the scaling.

If you want to see how it works, check it out here.

Ok, back to this week's issue…

It could be the loyal employee who's been with you from the start.

Or the big new hire who expects a “piece of the pie.”

If you run a business long enough, the equity question is going to eventually come up, and if you get it wrong, it can cost you:

I've had these conversations more times than I can count: partner buy-ins, phantom equity deals, and telling some of my best people, “Sorry, you can’t have equity.”

Here's the biggest lesson I've learned: When somebody asks for equity, it feels like a math question.

What should the percentage be?

2%? 5% 10% More!?

But that’s a trap. Before you can even think about the “number,” there are three “Equity Rules” you need to understand.

Get these rules right and almost any number can work.

Get them wrong, and the deal will blow up in both your faces.

Here are the rules…

It usually starts like this: a valuable team member wants equity because they've worked really, really hard…and they've been here a really, really long time.

And that’s when I have to tell them something they don't want to hear:

In other words…

Effort does NOT earn equity.
Tenure does NOT earn equity.
RISK earns equity.

So when someone asks me for a piece of the company, here's the follow-up question I ask, word for word, to see if they even understand what they’re asking:

Some people won't like that question, and some will leave.

It sucks, but that's the question doing its job. The ones who only wanted upside would've been dead weight on your cap table in three years anyway.

And I’ll never take on a partner who's only a partner on the upside.

"But they're doing SO much for the business…don't they deserve something?"

Yes. They deserve to be well-compensated…

…maybe even OVER-compensated.

So bonus them, profit-share them, make them really stupid-rich. But don’t make them your partner just because they were “there.”

Salaries reward EFFORT.
Equity rewards RISK.

Don't mix the two.

Here's a nightmare scenario I've watched over and over: you're feeling generous, so you just GIVE a great team member equity.

Eighteen months later, they take a job somewhere else. They're gone…but their ownership isn't.

That's called dead equity, and I've seen it kill more businesses than almost anything else, because:

The fix is a profits-only interest (if you're an LLC or partnership) or phantom equity (if you're a corporation): a contract that treats someone like a partner with respect to distributions (meaning they get paid the same way you get paid), but they hold no actual equity and they have no voting rights.

And if they leave, the agreement leaves too. No dead equity.

And if the business sells one day, you can build in a trigger where their “phantom” interest turns into real equity.

That's exactly how my business partner, Richard, became my partner.

Almost two decades ago, Richard came to me wanting equity.

He was a hard worker…SUPER valuable. But I had to tell him no, because he was being paid market rate and he wasn’t being asked to take on any extra risk or sacrifice.

Fast forward a couple of years, and the business was in about-to-go-under trouble.

It was ugly…

Good people were getting poached left and right, and Richard had the chance to leave and make A LOT more money than he could working for my crappy little business (that was weeks away from going under).

Instead, he chose to stay. He even took a PAY CUT, because he believed in what we were building.

THAT is real risk.

So we valued it: a 5% profits-only interest, which he later grew to 10%, with a trigger…if the business ever sold for $10 million or more, it converted into actual equity.

That's exactly what happened...

The equity showed up when the cash showed up, and we’re still partners to this day.

And that structure protected HIM, too.

I’m not a CPA, but I do know enough about taxes to know that if you give someone 10% of a $10 million company, the IRS is going to view that as them getting PAID an extra $1M…and they’re going to expect a few hundred thousand in taxes (even though the employee technically never received the cash).

This is why you can’t just hand out equity.

If you don’t do it right, you aren’t giving someone a gift… you’re giving them a giant tax bill without the cash to pay it.

But because Richard's equity converted at the sale, the equity distribution and tax bill arrived at the same time as the actual cash.

And had he decided to leave before then, we were still covered because actual equity was never issued.

Phantom equity and profits-only interest isn’t stingy. It's typically the safest and most generous option for all involved.

This one's personal…

I've walked away from good, profitable, GROWING companies because of a bad partnership. It sucked, but life is too short to be “business-married” to the wrong person.

That’s why it’s critical that you decide AHEAD OF TIME how the partnership ENDS before it begins. When things are good, nobody wants to talk about it. When things are bad, nobody CAN.

At a bare minimum, your partnership agreement needs to answer three questions:

"We'll figure out the value when the time comes" is NOT a plan, because when the time comes, it’s too late.

The best partnerships aren't the ones that never end. The best partnerships are the ones that planned the ending so well that they never needed it.

Everybody obsesses over the number. How much do they get? How much do I keep?

In my experience, the percentage of equity matters way less than person who’s getting the equity.

With the right person, a deal that's slightly wrong gets fixed. With the wrong person, even a "perfect" deal is miserable.

So before you say yes, vet the person. Watch how they treat their friends, their spouse…even their waiter.

Because if somebody will lie, cheat, and steal in one area of their life, they'll eventually do it with YOU.

Price the risk going in, earn the equity over time, and agree on the exit before the entrance.

Do that (and do a little research on what percentage is fair and typically for the role and industry), and you’ll motivate your people without putting your hard-earned equity at risk.

⚡️ Action Step: The next time somebody asks for a piece of your company, don't answer with a number. Sit down together and answer these four questions out loud:

If any answer surprises either of you…congratulations. You just had the cheap version of a very expensive conversation.

Give it a shot and let me know how it goes…

-Ryan

Ryan Deiss
Co-Founder and CEO, The Scalable Company

P.S. We help our clients navigate issues like this all the time: equity asks, partner buy-ins (and breakups), comp structures, all of it.

But here's the truth: if your business doesn't have the right systems in place, none of it matters.

That's why the first thing we do with every client is install a custom "operating system" inside their business…so it runs (and grows, and becomes worth owning) without depending on you.

Click here to see how it works.