In a recent video, I shared some examples of what I have found to be the biggest wastes of money in life. One of these areas was equity, or ownership percentage, in your business, specifically when given away to friends or relatives without meaningful value added in exchange. Now this is not to say that I think friends or relatives are not worthy of an equity stake in your business, but rather that I have had lots of experience as a young man of starting businesses with friends or family as partners, only to have those individuals become distracted, lazy, or totally incompetent. Sometimes people surprise you in the worst way, and you need to have a strategy to protect yourself from these types of situations.
Terrible performance is bad in itself, but even worse is having to deal with bad performers when their performance is hurting your business and reputation by making you look foolish in front of other employees or customers. There is no easy solution to this mess. The situation sucks for you, your co-workers, and your customers, and worst of all, it can make the excitement about your business fizzle for everyone involved.
As someone who has dealt with these challenges firsthand, I want to offer some advice on how to prepare yourself for dealing with these problems when the time comes.
I propose you ask these three simple questions when devising equity compensation offers to partners in your business:
1. Are they risking as much money and effort as you are?
2. Are they focused on the long-term and willing and able to sacrifice immediate cash draws for greater future growth and sustainability?
3. Are you able now or can you foresee the ability to have honest communication with them about poor performance?
If you answered “No” to any of these questions, then do not offer equity to them. Remember the rule, “Share profits liberally, but equity stays in the family”.
If you are forced to share equity in the business and do not see any other viable option, then consider this alternative structure which I have personally found to be incredibly successful:
Offer equity that vests over a 5-year period with a 2-year cliff.
This is easiest to understand with an example:
Say you have started a business, and as means to attract top talent, you want to offer equity as part of the compensation package for your new hire. You decide to allocate 20% of your business to this new hire, along with a salary, benefits, etc. But instead of giving this individual 20% of your business on their first day of employment, you instead incorporate cliff vesting to help protect yourself and your business. The advantage here is that if at any time prior to the end of the cliff they decide to run off and do something different, they forfeit their equity entirely. If they decide to leave after 2 years, they walk away with only 2/5ths (8%) of the equity instead of all 20% of it. The forfeited equity all goes back to you to use for replacing that individual or for other means.
This is just one example of many strategies that can be used to protect you and your business from partners who turn out to be uncommitted or incompetent.
Require your partners to earn their equity by putting in the work over time.
Treat them well and treat them like an owner, but hold on to control. And remember, this cliff vesting clause must be included in their employment agreement in order to protect you if things go bad.
Good luck with this strategy. It is the very best way to test employees who are not easy to attract or to get rid of. NEVER rely on luck to be your guide. Be strategic and purposeful to protect yourself and everyone will be the better for your efforts.