Understanding Equity: What Employees Need to Know Before Asking for Ownership

In the dynamic landscape of boutique professional service firms, the prospect of equity ownership often entices employees to envision themselves as stakeholders in the firm’s success. However, the allure of equity can sometimes cloud the understanding of its implications. Many employees, when faced with the reality of what it truly means to be an equity holder, reconsider their initial desire for ownership. In this blog post, we’ll delve into eight critical aspects of equity that employees should grasp before pursuing ownership in their firms.

8 Things Employees Should Know About Equity:

1. Personal Guarantee of Obligations: As an equity holder, you’re not just an investor; you’re a co-signer. This means personally guaranteeing all obligations of the firm. For instance, banks often require “jointly and severably liable” agreements, holding all equity holders accountable in case of default. When an employee becomes an equity holder in a firm, they risk everything they have with a personal guarantee.
2. Fiduciary Responsibility: Equity ownership involves accepting fiduciary responsibility, particularly in government scrutinized events such as payroll and sales taxes. In case of tax issues, the IRS will pursue all equity holders, emphasizing a shared liability that many employees find discomforting. With equity comes accepting the risk of the tax man coming after you.
3. Salary Cuts During Slow Times: In lean periods, equity holders may need to slash their salaries, sometimes even down to zero, to sustain the firm. This level of financial sacrifice may not be feasible for many employees who rely on consistent income streams. Equity holders ride the wave up, and down.
4. Loan Obligations During Crises: During crises, equity holders may be required to loan the firm money to meet its obligations. However, employees often lack the financial means to provide such loans, let alone the comfort level to do so. Partners in the firm carry another title: banker. If you do not want to loan the firm money, don’t ask for equity in the firm.
5. Stricter Non-compete Clauses: Equity holders are subjected to more stringent and enduring non-compete clauses, often extending up to five years. This contrasts with employees who typically sign shorter, less restrictive agreements, allowing them more flexibility in career choices. For example, an employee can quit, wait 12 months for a non-compete to run out, and start a competing firm. An equity holder can do the same but after ~5 years. The difference is similar to the difference between dating and getting married.
6. Personal Credit Tied to Firm’s Credit: An equity holder’s personal credit becomes intertwined with the firm’s credit. For example, a firm’s bankruptcy can result in personal bankruptcy for the equity holder, a risk many employees are unwilling to accept.
7. Spousal Involvement in Equity: Equity holders will need their significant others to sign documents regarding the valuation and payment terms in the event of a divorce. This intertwining of professional and personal relationships can create discomfort for employees who prefer to keep these spheres separate. An ownership stake in a private company is an asset. In a divorce, the assets get divided up, including the equity stake in the firm. This means when you become an equity holder so does your spouse. To avoid this messy situation, you can ask your spouse to sign a post-nuptial agreement that excludes the equity stake in the firm, or, you can ask the firm to include your spouse in the partnership agreement. A post nuptial agreement and/or a modified partnership agreement is often a deal killer.
8. Financial Obligation to Acquire Shares: Unlike receiving stock options, becoming an equity holder often requires purchasing shares. Many employees may lack the financial resources to afford such acquisitions.

If after reading these 8 items you do not want to become an equity holder, you are probably wondering if there are alternatives. And the good news is there are.

Alternatives to Equity

Here are two alternatives to equity that allow employees to participate in the upside of the firm without the downside.

1. Exit Bonus for Executive Team Members: Executive team members can receive an exit bonus, a percentage of the purchase price in the event of a firm sale. This simplifies reward structures, offering incentives for successful exits without the complexities of equity ownership.
2. Profit Sharing for Top Performers: Non-executive top performers can participate in a profit-sharing pool, earning a percentage of excess profits generated by the firm. This rewards individual contributions to the firm’s success without the legal and financial commitments of equity ownership.

Conclusion:

Understanding the intricacies of equity ownership is crucial for employees considering ownership in boutique professional service firms. While the allure of equity may initially seem appealing, it’s essential to weigh the associated risks and responsibilities. For those seeking further guidance and insights on navigating the complexities of ownership structures, we encourage joining Collective 54’s mastermind community, where industry leaders share invaluable expertise and support in professional growth and development.