The Problem with Equity as Compensation

When thinking about how to hire a team or acquire resources for your startup, it’s important—very important—to understand the difference between equity and compensation. I often hear people say that they are “paid with equity” or “earn equity” at their company. And, while it is technically possible to pay someone with equity, it is rarely the case and certainly should not be the case in a bootstrapped startup company.

In order to pay someone with equity, the equity must have a marketable value. Early-stage, bootstrapped companies don’t have any value and, therefore, can’t use equity to pay for anything, including salaries.

Let’s say your company has a marketable share price of $10 per share, issuing a contributor 10 shares instead of $100 cash isn’t really a thing. You must get the shares from somewhere, if you issue 10 new shares you will dilute existing shareholders making all shares worth less than the intended $10. So, you would probably have to buy the shares from an existing shareholder for $100 and incur some unnecessary transaction costs. And, of course, the IRS will tax the shares as income even though the receiver did not get any cash to pay the taxes. Never mind the fact that founder’s shares often have a litany of unnecessary restrictions. It’s a whole lot easier just to pay cash!

Paying someone with equity with a marketable price is just not practical. In a startup with a $0 value, it’s not possible. No matter how many $0 shares I give someone the total will still add up to $0. Founders often make up a value which usually has little or no basis in reality, and now we have the same problems as if there is a value (see above).

Equity is not compensation, it’s an investment. To acquire it, a person must invest. If the person gets a share without investing, then you’re just giving equity away willy-nilly. (If you’re doing that, please contact me because as long as you’re giving away free equity, I’d like some too!)

Just Pay People…If You Can.

The way a company compensates a contributor is by paying them a fair market rate. If a person is getting paid a fair market salary that person owes the company their best work in return. This should be true regardless of the person’s ownership in the company.

If the person does not provide his best work in exchange for what he is getting paid, he probably feels that he is underpaid. In this case, the fair market salary is, in fact, not the fair amount and needs to be adjusted. Or, it is the fair amount, but the guy is resentful of his own personal life choices and wishes he was more valuable. Either way, equity ownership shouldn’t matter.

Consider this scenario: A guy goes to work for Apple computer and is paid a fair market salary. He just happens to personally own a few shares of AAPL.

His stock ownership has nothing to do with his compensation. Apple wouldn’t deduct the dividends or capital gains from his stock ownership from his salary. His compensation is totally separate from his investment in the company. When he leaves the company, no matter what the reason, he would still be entitled to dividends and capital gains from his ownership of Apple shares.

His stock ownership has nothing to do with performance and should not affect his work product in any way because Apple is paying him a salary for his best work. Giving him Apple stock (AKA “grant”) is pointless because it would amount to overpayment which is an inefficient use of capital for Apple.

His ownership of Apple stock is, however, a really good indicator of his belief in Apple’s future. This makes giving him shares even more pointless because if the guy believes in Apple, he should be willing to invest in order to acquire shares. The outcome of a grant, therefore, is to simply overpay an employee with stock they don’t care enough about to buy themselves!

Stock ownership, therefore, indicates a participant’s confidence and excitement in the future of the company. It does not cause confidence and excitement in the future. (I’m saying this because it’s logical, I have not personally researched the psychology here and would welcome the opportunity to see a legit study on the subject.)

Only True Believers Buy Equity

Employees who believe in the company tend to bring their A-game to work and offering them the opportunity to invest will help you attract the right kinds of employees. Giving shares to participants is pointless, selling shares to participants is golden.

Selling shares to participants requires the shares to have a knowable price so people can properly assess the investment. In other words, a known number of shares has a known investment. But, what if those things are unknown? This is where Slicing Pie comes in…

Shares in early-stage, bootstrapped companies are worth nothing. We can give them to people but, as outlined above, that is pointless. On the other hand, we can’t sell them either because selling them requires setting a price. Setting a stock price during this stage is just a random guess.

Before a company can be priced or valued, the company must produce something of marketable value, such as revenue, profits, users, intellectual property and other things investors actually care about.

Slicing Pie allows people to “invest” in the future outcome of the company. But, unlike an established company, startups have no value so it’s not a traditional investment, it’s a gamble. Because it’s a gamble, the price and percentage ownership of the shares isn’t absolute, it’s relative based on each person’s bet.

In a traditional investment, the investor invests a known amount of money for a known number of shares. In a Slicing Pie “investment” the bootstrapper investor doesn’t know how much he or she will ultimately invest, what form the investment will take (unpaid time, money, and other resources), nor how much equity he or she will end up with. These amounts are revealed over time and finalized when the bootstrapping stage is over.

The Slicing Pie commitment, however, is the same (or very similar) to the traditional investment in that the participant isn’t getting the shares for free. The key difference is that in an established company investors invest known dollar amounts for a known number of shares and, therefore, end up with a known percentage. In Slicing Pie, bootstrappers commit unknown resources for an unknown number of shares and an unknown percentage. The unknown elements are what makes the deal a gamble and not a traditional investment. In both cases, however, the gambler and the investor believe in a positive outcome.

When a bootstrapped company uses a traditional fixed equity split, the participant gets a known chunk of equity for doing nothing and is then expected to make an unknown investment of time, money, resources, etc. No matter how much he or she invests, the equity doesn’t change. When the investment gets bigger than the individual’s perceived value of the equity, the participant either loses motivation to continue or is forced to dispute the allocation. Equity disputes often involve expensive legal proceedings, emotional turmoil and strained relationships with cofounders. Many decide it’s not worth the trouble, so they quit and demand buyouts from other founders. If your company buys out a quitter, it is rewarding extremely unproductive behavior!

The moral of the story is this: equity isn’t a creator of motivated team members, it’s an indicator of motivated team members. Giving equity to someone who wouldn’t otherwise invest is simply a waste of time and money but giving them the opportunity to buy equity or acquire it through Slicing Pie will tell you who believes in your company vision!