When Your Employee Asks for Equity, Do This

Most business owners think that giving their best employees equity is how you keep them. In reality, it's usually how you lose them, or worse, it's how you lose them while also losing a big chunk of your business that you can never get back. Now, I built multiple 8-figure businesses, so I've had these conversations more times than I can count, whether we're talking partner buy-ins, phantom equity deals, or just telling one of my best people, I'm really sorry, but no, no No, you can't have equity. And I'll tell you, I've done it the right way a few times, and I've definitely done it the wrong way too many times. And what I've discovered is that there are really only 3 rules that decide whether giving somebody equity is a good idea or not. So in this video, I'm gonna give you the 3 rules that I use anytime I need to price in an equity split. We're gonna talk about the one question that tells you whether or not someone actually deserves equity. And no, it almost always has nothing to do with how hard they've worked. We're gonna talk about the structure that you should use so that you're never stuck with dead weight on your cap table, and we'll talk about the single clause that I put in every partnership agreement that makes sure that neither of us can ever trap anyone else into a bad deal. Now, this one video could easily save you millions in unmade mistakes, so let's get into it. Now, real quick, I put together a tool for you called the Partner Equity Checklist. It's pretty much every question that you should answer before you say yes to anybody, whether it's an employee, a new hire, a partner, the same questions that I Use plus a few that are gonna save you a very expensive phone call with an attorney later on. It's totally free. I'll drop the link in the description. If you're even thinking about sharing equity, go through this checklist first. All right, back to it. Now here's the biggest lesson that I've learned. When someone asks for equity, it feels like a math question, like a math negotiation. We're wondering like, what should the percentage? Should they get 2% or 5% or 10% or more? But that's kind of a trap because before you even think about the number, there are 3 really important what I call equity rules that you need to understand. If you get these rules right, almost any number can work. If you get them wrong, the deal is almost certainly going to blow up in your faces no matter how great a job you did negotiating on the front end. So, here they are starting with rule number 1. Rule number 1, equity is a function of risk, not effort. Alright, so the conversation 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, really long time. Goes like that, right? Like, hey boss, I want to have a talk. I just I feel like you know I've been here for a while, and I've done a lot of work, and like a lot of this stuff wouldn't happen if it weren't for me. The business is really doing really well, so I kind of feel like you know I should get some equity, and I get it right. Unfortunately, when this conversation comes up, that's usually when I have to tell a really good team member something that they really, really, really don't want to hear. Usually it goes something like this. Alright, look Bob, I appreciate everything that you've done. I really, really do. But the reality is you've been paid along the way. So, your paycheck was compensation for your hard work, not equity, because equity is a function of risk, not effort. Think about it like this. Nobody gets equity in your house because they mowed your lawn, right? I don't care if they mowed it every single week for 10 years and they did an incredible job. The reality is you paid them to mow the lawn. The point is Ownership doesn't go to the people who just worked on the house. It goes to the people who signed the mortgage. The people who are on the hook if the whole thing went underwater. Your company works exactly the same way. When someone asks me for a piece of the company, here's the follow-up question that I like to ask word for word just to see if they really understand what they're asking because most people don't quite understand what they're asking. So, let's go back to Bob. Bob asked me for equity. And I'm going to follow up with, let me ask you a question. Are you willing to be a partner on the downside? You're asking to become a partner on the upside. So if we make a distribution, you want to get some of that distribution too, just like a partner would. Or we sell this company, you want to get a nice chunk of cash, am I right? But here's my question for you. If the company loses $100,000 next month and you own 10% of the company, are you going to show up with a check for 10 grand? Like, I might have to. Now, most people won't like that follow-up question. What it does is it highlights the primary difference between entrepreneurs and employees, and that is that when entrepreneurs go into a business, they are the ones taking the most risk. That's why if it works out, they get to participate in the most upside. But if you're an employee, you kind of expect to get paid whether the business made money that month or they didn't. Even if they don't like it, the smart ones will at least understand, and the great ones, the really great ones, might even find it motivating. And listen, this applies to even your best people. Let me tell you about my current business partner, Richard. So almost 2 decades ago, Richard, who was working for me at the time, came to me wanting equity. And I wanna be clear, this guy was great at his job, super smart, super hard worker, super valuable, maybe the most valuable person in the company at that time. 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. Now, fast forward a couple years later, and that business, that I was running, that he was working for, it was in trouble, like about to go out of business trouble, and good people were getting poached and leaving left and right. And Richard, like everybody else, had the chance to leave and make a lot more money working for somebody else than he could have made continuing to work for my crappy little business that was basically weeks away from going under. But instead, he chose to stay, and he didn't just stay, he actually took a pay cut because he believed in what we were doing. Now, that is owner-level risk. So, what did we do? We decided to give him a piece. Started out as a 5% profits-only interest, which he later grew to 10%. At this point, he still didn't have actual equity. So, how you structure these deals is really, really important, which is what I'm going to get into in rule 2. The point I want to make here is that it really is about risk. Now, I know what you might be thinking. But they're just doing so much for the business. Don't they deserve something? And the answer is yes. Your best people deserve to be incredibly well compensated, maybe even overcompensated. So bonus them, profit share them, make them really, really, really stupid rich, but don't make them your partner just because they were there. Salaries reward effort and impact. Equity rewards risk. Do not, do not mix the two. So that's for the employee who's already on your team, but what about the other version of this ask? What about a big new role? Somebody comes in and they expect a piece of the pie. Maybe you're bringing in a COO or a CEO. Same rule, just a different mechanism. If someone wants to walk in the door and they want to be treated like an owner from day 1, they need to bring risk in the door with them starting day 1. And the cleanest way to do that is with some kind of a buy-in. That's exactly how my other business partner Roland came in. Roland wanted to be equal partners and he brought a lot to the table. Brought a lot of skills, brought a lot of relationships that we simply didn't have, and I was happy to value all of that. So, we went and did a company valuation. We said, all right, this is what the business is worth, and if you want X% of the company, 30% or whatever, then you have to buy in. Now, we gave him a strategic discount, or what's sometimes called a sweat equity discount, because he was willing to work for a little bit less than what he could make out on the market, and because he was bringing a tremendous amount of strategic value to the company. So yes, if somebody who has a ton of experience and they could go out and work for somebody else and may make $400,000, $500,000 a year, and they're willing to come work for you for less, Yes, there's a case for that being risk and for them perhaps having the ability to earn equity. All right, so let's say that the business is worth, for round numbers, $1 million, and let's say somebody wants to buy in for half. That might be a $500,000 buy-in. If you offer them a 20% discount for their strategic effort or their general awesomeness and what they're bringing to the table, then they would need to bring an additional $400,000 If they wanted equity, that's the 20% discount of the million-dollar offering. Now, that could be paid in a lump sum or it could be paid out of future distributions or maybe it's a combination of all of the above. That's typically how we do it and that's the basic shape of the deal that we worked with Roland. Now, why does that matter? It matters because when you bring money to the table, you're also bringing risk. The discount is what's honoring their talent. But it's the buy-in, in whatever form that comes, that's what's going to price in the risk. Remember, equity isn't a reward for effort. It's not a reward for general awesomeness. It is the price of risk. If someone wants a share of the upside, the only question that matters is whether or not they're going to sign up for the downside. And downside can come in the form of a buy-in, could come in the form of a compensation reduction. It can come in the form of not taking distributions that you're technically owed. Either way, I want to see him make some kind of a buy-in. Now, here's the problem. You can get the who exactly right. You can get this part figured out perfectly in terms of somebody who's actually genuinely earned it like Richard, and you could still blow the whole thing up if the equity arrives the wrong way and at the wrong time, and that is where rule 2 comes in, and that's where the deal that I made with Richard got really, really interesting. Rule number 2, equity is earned Not given. Alright, here is a nightmare scenario that I have personally watched happen way, way, way too many times. You got a great team member. They are awesome, A-player, and business is good. So you're feeling generous. So you decide, you know what, I'm gonna just give this person some equity, 5%, 10%, whatever. Now, to you, this isn't just a reward, but this is a lock-in, right? This is a motivation for the future. You're thinking, okay, they're gonna start thinking about this business like I do, like an owner. They're gonna wanna really stick around and grow. They got a stake in the outcome, a piece of the upside. But then 18 months later, they're gone. They've taken a job somewhere else. There was a bigger, better deal. And while they are gone, their ownership isn't. That is what is known as dead equity. And I have seen it stall out more fast-growing businesses than almost anything else, because depending on how your partnership agreement is structured, you might not be able to even bring on another equity partner without approval from that old employee. And let's say you can get the approval, who's going to want to buy into a company Or a significant chunk of the equity is going to somebody who isn't doing anything and they didn't provide all that much. It kills future capital raise opportunities because one of the first questions that any investor is going to ask is, who else is on the cap table and what the heck do they do? And when they see that 5%, 10%, 20% of the equity is gobbled up by some former employees who left back in 2022, probably just going to pass. This is why any equity needs to be earned over time. And not just simply handed over, given out on day 1. Think about it like this. Back in the 1800s when the US government was just giving homesteaders land and stuff like that, people didn't just get to show up, you know, plant a flag and say, this is it, I own this now, nobody else can have it. They got to stake a claim, but what the government said is that you've got to live on the land and you've got to work the land for 5 years, then it's yours. Claiming it Was never the point. Proving you would stay was the point, and that's exactly how equity should work in your business. Nobody owns the land just for showing up and just dibs. I got it. Now there are two fixes for this. Fix number one is vesting. I'll talk about that in just a second. Fix number two is to have a phantom equity or a profits-only interest agreement instead of actual equity. First, let's talk about phantom equity and profits-only interest agreements. In terms of what makes them different is somewhat nuanced. I'm going to let the attorneys argue over the fine print. The basic idea is that if you're an LLC or a partnership, you're probably going to go with a profits-only interest agreement. If you're a corporation, then it's going to be phantom equity instead of profits only, but the idea is the same. A phantom equity or profits-only agreement, it is a contract that treats someone like a partner without actually granting them equity, and there are lots of ways to structure these, but the basic idea is that when a distribution is made, They're going to receive a percentage of that distribution just like if they were a partner. You can even structure it, and I'll get into how we do this, so that if the company sells, their phantom equity or profits-only interest can convert into actual equity, and they can then receive proceeds from the sale of a company or an asset, again, just like if they were a partner. But it's still just a contract. They hold no actual equity, they have no voting rights, and if they leave, The agreement gets left too, it gets torn up, that's it, it's gone. But if they stay, they not only get treated like a partner day 1, they've got a good chance of becoming an actual partner in the event of a sale or other liquidity event, and this is exactly how my business partner Richard became my business partner. We rewarded that risk by giving him a 5% profits-only interest in the company. We also gave him a path to increase that to 10% through a combination of just goals being hit and him deferring some of his profit sharing and distributions and things like that, uh, that he would've ordinarily been eligible for. In other words, he effectively bought another 5% interest opportunity in the company. Now, while he was there, Richard received distributions just like a partner, first on his 5%, eventually on his 10%. But we also wrote a trigger into the agreement that if the business ever sold for $10 million or more, His profits-only interest converted into actual equity. And that's exactly what wound up happening. The equity showed up when the cash showed up, and we are still partners to this day. It's been great. Now, here's the part that almost nobody understands, and it's why this structure that I'm talking about isn't just good for you, it's good for your employee too. It was definitely good for Richard. I am not a CPA. This is not tax advice, and this is not legal advice. But what I do know, in terms of knowing just enough about taxes is that if you just give someone 10% of a $10 million company, the IRS is going to view that basically the same as you just giving them a million dollars in cash, right? So, if you figure if you got a $10 million company, you give them 10%, that's worth a million bucks. The IRS is going to go, where's our taxes? And they're going to expect to receive a few hundred thousand dollars in taxes even though your employee never actually received the cash. This is what's known as an in-kind transfer, and it's why you can't just hand out equity. Not only is it really, really risky for you because once you hand it out, as we're going to talk about, you can't necessarily get it back. It's also just really, really hateful to the person that you're giving it to because what you're actually giving them is a giant tax bill without the cash to pay for it. But because Richard's equity converted at the time of sale, his actual equity arrived at the same time as the cash that arrived, which means the tax bill arrived when the cash was there to pay it. And had he decided to leave before then, we were still covered because again, any actual equity was never issued. Phantom equity and profits-only interest agreements aren't stingy, they're not miserly. They're typically the safest and most generous option for all involved. Now, one more quick thing before we move on. Even with brand new ventures where the risk is the same and the buy-in is the same, I still believe that equity should be earned over time. This is what's known as vesting. So for example, let's say I was going to launch a brand new business venture with a new partner. It could be a new partner, old partner, it doesn't really matter. What I would require is that everyone who's involved in this deal agree to a 4-year vesting with a 1-year cliff, and I'll explain what that is in just a second, but here's what you want to avoid. This happened before. We actually had a client who they had their core business and they decided to start another business on the side. And they had a partner in that business who was the primary operator of that business. And they had it to where, you know, I think they had like a 60/40 partnership where, you know, my client, the person I knew, had 60, the operator had 40%. We could talk about whether or not that's the right split, probably a little bit too generous, especially when you consider my partner had the idea, had the customer base, was funding the entire operation. This person, his partner, was essentially just running the day-to-day. What wound up happening though is this person basically Ran the business for, you know, about a year, and then they sort of started thinking like, wow, this is hard. You know, I'm not making quite as much as I could if I went back and got my old job. And so that's exactly what they did. They decided to just abandon the business and go back to their old job. Now, the problem is my business partner still had a 40% partner that was now doing exactly nothing. He didn't have to pay him a salary anymore, but that equity was still sitting there. This is why I never do deals Even if it's a brand new startup and everybody's contribution is quote unquote equal without some type of vesting schedule. So the way that a 4-year vest with a 1-year cliff works, until the end of year 1, everyone's actual equity is 0%. So at the end of year 1, 0%. Day 365, boom, there you go. Everyone earns 25% of their available equities. For my business partner, he'd get 25% of his 60. The other person would get 25% of the 40. Then it's another 25% every year through year 4. What that means is that in year 1, nobody owns anything. Not them, not me, nobody. So, if someone decides to bail after 6 months, there's no buyout. There's no lawyers, no drama. The first 25% is gonna vest at the end of that year, and if they don't hang on that long, that's it. Now, if they hang out for a year, they'd still have that 25% they got. You'd have to figure out how to get that back. That's not ideal. But it's a whole lot better than having to get back all of it, and if they frankly have been in it for a solid 4 years, it's probably earned. The key is you didn't get equity just for showing up. You earned it by staying and you earned it by building. So, the profits-only agreement is going to protect you if somebody leaves, but things can still go sideways if you forget about rule number 3. Rule number 3, equity is easy to give and it is hard, like really hard to get back. This one's a little bit personal. For me, I'll tell you, I have walked away one time from a very good, very profitable, very fast-growing company because of a bad partnership, and it sucked. I mean, they weren't necessarily a bad person, they were just a bad partner. But the reality is life is too short to be business married to the wrong person, and it happens. Understand this, the moment you give anybody any real equity, it could be an employee, an amazing employee, it could be a brand new hire who you think this person's essential, it could be your best friend. When you gave them that equity, you didn't just give them a reward, you took on a life partner. Because once equity is given, it is hard to take back, and this is why I'm very, very, very slow to give out actual equity, and why as a general rule, we don't give equity to any team members at all. We'll use the profits-only interest agreement that I talked about from rule number 2. Now, whether you're taking on a true equity partner or a phantom equity partner like I described earlier, It still is critical that you decide ahead of time, how is this partnership going to end before it ever begins? When things are good, nobody wants to talk about it, but when things are bad, you almost can't talk about it. So at a bare minimum, your partnership agreement needs to answer 3 questions. Question number 1, how will we value the business? So if someone wants to leave, if they want out, if you want somebody out, think about my friend. They started this brand new company with this person. Let's say this person, instead of having 40%, they did the vesting thing, so they only had 25% of 40%, which I guess is 10%. So now they've only got about 10% of the total. Still wants to know, I don't want this person to just have 10% forever when they're doing nothing. How are we gonna buy them back and how are we gonna value it? Now typically, the way we do it is we typically have a third-party valuation done, and it's usually gonna be on some multiple of EBITDA. And we're usually gonna apply some kind of a floor because a lot of these businesses, especially if it's in the early stages, the EBITDA, the profit could be zero. So you're not going to say, well, I'm going to buy you out for zero. It's going to be worth something. So we're going to have a minimum floor. The minimum buyout would be X, right? This valuation is done. If one of the partners disagrees, maybe it's too high or maybe it's too low, that's when they can choose to commission their own valuation at their own expense. The first one the company is going to pay for. Somebody doesn't like it, they can get their own done at their expense. Now you got 2 valuations and you can generally negotiate between the 2 and we disagree, that's how we're going to decide what the company is Question number 2, how does the buyout get paid? So, you figure out what the company is worth and that's good, but it's rare that one partner is just sitting on enough cash for a lump sum. So, this is when it can make sense to write in that partners can be bought out over 5 years or 10 years at some predetermined rate. Question number 3, what about the exits that nobody chooses to make? You've got to consider things like death, disability, divorce, bankruptcy. If those triggers aren't in the agreement, you can end up in business with an heir, somebody's obnoxious spoiled nephew or grandson, maybe an ex-spouse who really is unhappy and just wants to kind of blow the business up, or maybe a creditor even. Let's say somebody, you know, you got a business partner, you don't know this, they got tons and tons and tons of debt and they've assigned some of their equity to it because you didn't schedule stuff right. Now, next thing you know, their equity is owned by some bank or by some person who like Figures out how to get paid back with a pipe wrench. The point is, these are not partners that you've necessarily picked, so you need a way to figure out, okay, in the event of death, in the event of divorce, in the event of lawsuit, like, how are we going to handle that? Now, one of the things that a lot of partnership agreements will do is they'll carry life insurance on each other so that, let's say, one partner should reach some untimely demise, the company has a life insurance policy on that person that would trigger— that would provide the funds to then be bought out so their heirs would At least have some cash, which is what they'd rather have than a business anyway. Now, I said 3 questions, really there's 4, and this 4th one is a biggie. What if one person wants to sell and the other just doesn't? They're just like, can't do it. I will not be bought out at any price, or I'm not going to let you go. This is the toughest question of all, but it is one that you have to answer, and it's one that you can't even imagine having to answer in the early days because again, everybody's friends, everything's fine, but stuff changes, people change. Now, there are lots of different legal tricks for settling this, and you know, at the end of the day, this is the reason that Courts exist and lawsuits exist. At some point, if you can't figure stuff out, you got somebody suing somebody else, but that's not good. That is not what you want. If you're filing a lawsuit against somebody, you and everybody else has already lost, and so that is why my favorite way to make sure that there's always a resolution that can be enacted before a lawsuit happens is what's known as a push-pull clause. Now, to understand what a push-pull clause is, I want you to picture 2 kids and a piece of cake. As a parent, If you had these 2 kids and they each wanted a piece of cake and they're arguing like, I want a bigger slice and I want a bigger slice, right? You could try to cut the cake and do your best to make them as equal as possible, but the reality is, is that some kid is going to be upset that their piece of cake was just a little bit smaller than the other kid's piece of cake. So, here's a trick that I think pretty much every parent eventually figures out. If you've got 2 kids that both want cake and you can already tell they're already starting to Quibble over like, I want the bigger piece and I want this. Here's what you do. Have one kid cut the cake and have the other kid choose which slice they want first. If you do this, I guarantee you the kid with the knife will cut the most even slices you've ever seen in your entire life because he doesn't know which half he's getting. I guess he does, he knows he's gonna get a smaller half. This is how a push-pull clause works. The partner that wants out states a price that they're either willing to buy the other partner out for or be bought out for themselves. Once the price is on the table, in other words, once the cake is sliced, the other partner gets to choose which side of the deal they want to take. Are they going to be bought out for that price that was just stated, or are they going to buy the other person out for that price? Either way, a deal is going to get done, and it's probably going to be pretty fair. The clause punishes greed, it punishes unfairness, and it just forces kind of cooler heads to prevail. Over the last like 25+ years in business, I've never actually seen a push-pull clause used in real life, and that's exactly why it works. Because it's so risky for both sides, it forces reasonable minds back to the negotiating table, or in a lot of cases, it just forces them to resolve their differences and get back to freaking work. I can't tell you the number of times that we've had clients or portfolio companies where the partners were just at each other's throat. They couldn't agree on anything, and finally it's like, well, I'm gonna buy you out, I'm gonna buy you out, and then it's like, well, here's what a buyout looks like. We both really hate this idea even more. Maybe we should just figure out how to work together. But I'll tell you, if worse comes to worse and someone wants out, they need to be able to get out. At the end of the day, the push-pull clause doesn't always end partnerships, but it does end the value-destroying games that certain partners will play, and that is good for everyone. It's especially good for the business. The thing to remember at the end of the day is that equity is easy to give. It is very hard and very expensive to get back. And that's why 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 to end. So those are 3 rules, but there is one thing that matters more than every other rule that I just gave you. It even matters more than the percentage equity or the valuation that you wind up negotiating. And that one thing is The person. The right person, a deal that's slightly wrong or even a lot of wrong gets fixed. With the wrong person, even the quote-unquote perfect deal is gonna be freaking miserable. So before you say yes to any deal, no matter how good the deal is, vet the person. Watch how they treat their friends, their spouse, their partner, even the waiter. Because if someone will lie, cheat, steal, and generally be a jerk in one area of their life, you better believe they're eventually gonna lie, cheat, steal, and be a jerk to you too. By the way, before you think about incentivizing employees with equity that you can never get back, I would look at just doing a simpler profit-sharing agreement. I did an entire video on how we do that as well, and I'm gonna link over to that one next because more times than not, you just don't need to give equity away. Alright, hope you found that enjoyable. I'll see you in the next one.