There are considerable benefits to rewarding your employees with equity. In a survey that we conducted earlier this year, we found that employees who are given shares are more loyal, more aligned to their company’s vision, less likely to leave, and more motivated than those without equity.
But a question that is frequently on founders’ minds, and that we are often asked, is ‘when is the best time to give you employees equity?’.
As with many questions surrounding equity, the answer isn’t as straightforward as you might have hoped. The truth is, the best time to share ownership varies depending on which stakeholders you ask.
In this article, we will consider the perspectives of founders, employees, and investors to help you to decide when to share equity. We will also explain some of the best ways to share ownership with your team.
Why would you give your equity away?
There are a host of reasons why you might decide to share ownership. In the early stages of your business cash may be scarce. When hiring key employees you can use equity to get them on board.
Attracting the right talent at all levels is another reason why you might choose to part ways with some equity in your business. Employees who are bought into the idea of ownership are more likely to hang around, which is great news for startups and scaleups as hiring is a difficult and often expensive business.
In other cases, the reasons for employee equity might be more philosophical. Some founders simply want to share the rewards of the business with the people who have helped them to build it.
There are also considerable tax benefits in sharing ownership with your team - at both the corporate and individual levels. This is especially true for some employee ownership schemes, such as Enterprise Management Incentive (EMI) Schemes, where there is liberal tax treatment for employees as well as a write-off against Corporation Tax for employers. Everyone’s a winner.
Regardless of your reasons for giving your team a piece of the action, the question of timing is key. For the different people involved, when you choose to share ownership will have very different implications.
The best time to share equity for employees, founders, and investors
In deciding when to give your employees equity, it is important to consider the subject from different perspectives. A founder will have a very different view to an investor, and an employee will have a different opinion once again.
Let’s consider the best time to give equity away from the perspective of each:
For founders, the idea of giving equity away can be scary. It is a company’s most valuable asset after all. Many entrepreneurs are concerned with the idea of dilution or a loss of control - especially in the early stages.
Giving away equity does mean that a founders’ percentage share decreases but it’s better to have a smaller piece of a much larger pie - and that really is the ultimate goal of employee ownership.
Therefore, with respect to founders, the best time to begin rewarding your employees with equity is early on.
These early employees should be motivated by the potential size of the prize, loyal to your company, and will be more engaged in helping the business to grow when they have some skin in the game.
For employees, the answer is simple: the sooner, the better. The earlier that a person is awarded equity, the greater the potential upside will be later down the line.
With most conditional share or option schemes (e.g. Growth Shares or EMI options), the employees vesting will take place over a number of years. Therefore, they will earn the right to a greater share of the equity when key milestones or performance-related goals are reached.
Employees will also feel a greater sense of achievement if they are rewarded with equity early on, as they will be able to watch the value of their shares grow in-step with the company.
Depending on the nature of their investment, the terms agreed, and the time at which they invested, some investors prefer for option pools to be in place before their money is on the table.
This is usually the case with VCs. Many larger investors stipulate that an employee share scheme is in place before they invest.
There are two main reasons for this. Firstly, they don’t want their share to be diluted. Secondly, they understand the benefits of employee ownership and the positive impact it has on company performance.
Many VCs insist portfolio companies have EMI option schemes because sharing ownership in the right way increases the chances of success. In this sense ‘the right way’ means a vesting schedule, tax efficiency and the ability to entirely offset the costs of the scheme.
However, early stage investors, such as friends and family or angel investors, may not share this view. For them, any equity that is shared will dilute their holdings, but as with the founders, the goal is to increase the overall value of the business. As such early investors may need to be educated about the business case for sharing ownership.
But what about dilution?
Generally speaking, founders fall into two categories: those who understand the value of sharing equity, and those who don’t. Many who fall into the latter camp are fearful of diluting their share and ending up with less in the long-run. This is a fallacy.
According to a piece entitled ‘The Founders’ Dilemma’ in the Harvard Business Review:
“A founder who gives up more equity to attract investors builds a more valuable company than one who parts with less - and ends up with a more valuable slice, too.”
So, founders who distribute their equity end up with more? That is the bet you make, whether you are handing over equity to team members or investors.
Founders who realise the benefits of incentivising people with equity, or using it to attract investment, are more likely to end up with a smaller piece of a much bigger pie.
While on paper their equity share has reduced, by having an engaged, motivated, and aligned workforce, founders benefit from business growth that is unlikely to be achieved with teams working on a 9-to-5 mindset.
What is the best way to share equity with your employees?
There are lots of ways to give your equity away. In the past Ordinary Shares would be granted and that was that. This can be risky. If you give someone their slice at day one, what stops them from taking the money and running? In short: nothing.
You will be pleased to learn that things have evolved. There are now a number of employee share schemes that build a level of conditionality into the process. With these schemes, certain criteria or milestones must be met before employees can receive their shares.
Three of the most popular ways of doing this in the UK are Unapproved Options, EMI Schemes, and Growth Shares. All three have their merits depending on the circumstances.
Let’s briefly consider each of these:
1. EMI Schemes
An EMI scheme is a government-backed, tax-advantageous share options scheme. An EMI scheme offers flexibility in terms of the conditionality and the time frames that can be set as a part of their terms. These can be used by UK SMEs that meet the right eligibility requirements.
2. Growth Shares
By contrast to EMI schemes, Growth Shares allow employees and other recipients to become shareholders immediately, but at a ‘hurdle rate.’ This means that Growth Share holders only benefit from the net proceeds from the point once this hurdle is met.
Growth Shares only dilute the equity of existing shareholders for growth from that point onwards. As such they can be an excellent choice for founders who have built up some value in their business.
3. Unapproved Options
Unapproved Options are incredibly flexible and can be awarded to employees, advisors, contractors, and consultants alike. These can include conditionality, but do not benefit from the tax advantages of other types of employee ownership scheme.
4. Agile Partnerships
Agile Partnerships is Vestd’s proprietary framework for providing equity rewards. Setting up an Agile Partnership allows companies to determine equity rewards based on agreed performance-based milestones.
Equity is distributed in a way that is proportionate to what people contribute, making it fair for all shareholders.
The early bird catches the worm
In the immortal words of Benjamin Franklin: “Don’t put off until tomorrow what can be done today”. Whether you are a founder, an investor, or an employee, it is a sensible idea to establish your employee share scheme in the early stages of your business.
For those who might have invested to help you get started, this might be met with some resistance. It is vital that you communicate the benefits of sharing ownership and educate them on the upside of doing so.
Dilution may be a real concern but is par for the course and can be pacified by your plans for growth, which will be more readily achieved once your team is deeply aligned with your mission.
Equity can be complicated and it is easy to walk down the wrong path. If you need any help in understanding your options - no pun intended - then book a free discovery call with one of our specialists.