Q & A section:
Q: I’m the 100% owner and CEO of a privately held business. I’m planning to add some senior managers to my company, and several of the best candidates have asked me if I would consider granting them equity incentives as part of their pay package. What factors should I consider as I weigh this request? If I do decide to add equity incentives, what issues should be included in the negotiations?
A: The question of whether to grant equity incentives in a privately held company is a complex one, and you are right to take it seriously. I’ll use the term “equity incentive” to include both options to purchase shares in your company (a feature found in most publicly and privately held corporations) and incentive units (the typical equity incentive in limited liability companies, or LLCs).
Regarding the question of whether to offer equity incentives, consider these issues:
1. Liquidity. Will there eventually be an external event, such as a sale or an initial public offering, that will crystallize the value of equity incentives in your company? If you don’t plan to sell your business or go public, executives may not be able to receive the benefits of the incentive. Therefore, it probably doesn’t make sense to offer equity incentives if you are likely to retain individual or family ownership of your private company for the next few decades.
2. Relative value. Although executives might like the idea of earning the equity-like returns they associate with options, upon reflection they might realize that they would prefer a higher salary or annual performance bonuses to the long-term value of an options payout. Some companies offer long-term bonus plans that include cash payouts with multiyear targets and vesting provisions that can provide benefits similar to those of equity plans without some of the disadvantages.
3. Unfettered control issues. As an owner, you may not want the potential headaches associated with option holders who could become minority shareholders in your company. Although most option holders exercise their right to purchase shares only when a company is sold or goes public, they could do so as soon as they have vested and can demand the rights of a shareholder. (Most plans entail four- to five-year vesting provisions to ensure that executives stay long enough to “earn” their options.)
4. Drawing the line. Some company founders have started equity incentive plans for a hired-gun CEO or top executives and then slowly been forced to provide similar benefits for a longer list of executives or even the entire workforce. Some owners have found it easier to say, “We provide generous base pay and bonus plans but do not offer equity incentives for anyone” rather than make a somewhat arbitrary list of executives who would be included in such plans.
If you can work around these issues (and perhaps others specific to your company), you might decide to consider offering equity incentives to attract that special executive who won’t join you without a feature in the compensation package that looks like equity. You also might decide that the ability to align the incentives of key executives with shareholder interests makes the administration of an equity incentive plan worth the effort.
If you do want to consider an equity incentive plan, talk over the following issues with your lawyer and accountant: vesting provisions (such as one-sixteenth of the award earned each quarter for four years, one-fifth of the award earned each year for five years, etc.), the strike or hurdle price (the price at which an executive can exercise his option and buy stock in the company), the percentage of stock in the company that you are willing to grant, and the structuring of buyback features to handle such cases as a departing executive who holds vested equity incentives.
Senior Lecturer, Harvard Business School
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