Equity As Compensation?
Can equity be used as compensation? There are at least a couple of ideas I have seen at work in this direction.
Stock grants. We have worked with a couple of firms that use stock as compensation through stock grants. The idea is very simple. Instead of paying cash bonuses, the firm pays the bonuses in stock. The employees can choose to convert the entire bonus into stock and pay the taxes out of their own pocket or take two-thirds of the bonus as stock and use the remaining one-third for taxes.
The idea is quite powerful and promises perfect alignment of contribution and equity. In fact, many industries routinely use this. For example, technology firms use a lot of stock option compensation, which is a very similar idea.
There are two drawbacks, however.
One is that the amounts at play are relatively small, and the process is too slow. A typical bonus for an advisor is $30,000 to $50,000, and if two-thirds of that is converted into stock, at most larger firms the result is ownership measured in basis points rather than percentages. Given that there are significant administrative complications when you issue or sell stock, the result may not be worth it.
The second issue is that when employees get stock through bonuses, they seem to be a bit more reluctant to buy stock. For some reason, if you can earn it, you don’t want to buy it.
Intentional dilution. The second idea is very interesting to me but unfortunately is quite complicated. What if a firm were to issue new stock every two years and to grant or sell that stock based on contribution? If you are a 30% contributor, you get 30% of the new stock. If you fall behind in your contribution relative to your ownership, you get diluted. If you contribute ahead of your ownership, your ownership increases.
If you want to aim for better alignment of equity and contribution, you can speed up the process by issuing more stock, more often. If you want to respect equity more, you can slow down the process by issuing less or less often.
The issue with this interesting idea is, again, the administrative complications (I cannot even begin to think through the tax consequences) and the fact that it can hurt passive owners.
Ordering the line. Rather than doing something proactive, such as issuing or granting shares, a firm may choose to “order the line” based on merit whenever equity becomes available. For example, when one of our clients has a partner retiring and selling their shares, the firm will make the equity available to other owners based on their average performance scores from the firm’s balanced scorecard. This is a potentially simple and effective idea.
Ownership Philosophy
Ultimately, all of these approaches come down to a clear and well-thought-out approach to equity within a firm. Ideally, every firm can clearly define who are the owners, what is expected of the owners and how they can continue to contribute. A good philosophy will answer the fundamental question, “Do we allow passive owners?” It will also define the allocation of value between contributors and investors. Unfortunately, if we don’t explicitly define who built a firm and who owns it, we may find that both builders and owners lose interest in the whole thing.
Philip Palaveev is the CEO of the Ensemble Practice LLC. He’s an industry consultant, author of the books G2: Building the Next Generation and The Ensemble Practice and the lead faculty member for the G2 Institute.