Harvard Business School Working Knowledg e Archive

Is Equity-Based Compensation a Good Thing?

2/16/2004
It can be. But it's not the best motivation tool in all situations.

QuestionDo you think an equity-based compensation plan is a good way to motivate employees?

AnswerMy first instinct was to write, "Yes, of course." Halfway through my third rewrite, however, I discovered it's a wickedly complex question. Yes, equity motivates, but the question is what does it motivate? It has to motivate the right behavior for the right reason to be effective. And even when equity does what you want, its hidden gotchas can still cause a train wreck.

What do you hope equity will motivate people to do? You might find easier ways to get the same results.

One popular reason for giving equity is "We want people thinking like owners." But think again. Most employees don't want to think like owners; otherwise, they'd be out there starting companies. Besides, one thing owner's think is, "I will get a huge percentage of the company's value when it's worth something." I have yet to meet an owner who wants their employees thinking that.

We say, "think like an owner" when we mean, "be cost-conscious." And equity is supposed to do that? I've watched company owners take a salary of $200,000 and spend a week and $10,000 worth of management time deciding whether to buy a $500 laser printer for their product development group. When even owners don't think like owners when it comes to cutting costs, it's foolish to ask it of employees.

Besides, owning stock doesn't necessarily lead to frugality. Even in startups, the small expenditures are peanuts. Employees reason (often correctly) that the big expenses—rent, executive salaries, property, plant, and equipment—will make or break a company. And those decisions are big enough that cost is considered as a matter of course.

If the real goal is frugality, skip the stock. Offer people a budget and give them a percentage of any money left in their budget at year's end. I guarantee you'll have cost consciousness oozing from the company's collective pores.

Yes, equity motivates—but the question is, what does it motivate?

Perhaps "think like owners" means we want employees to get the big picture, use good judgment, and keep the company's best interest foremost. A laudable goal, but again unrelated to stock. Lack of big-picture thinking is often a leadership void. If you want holistic thinking, share the big picture with people about ten thousand times, coach them to live it every waking minute, and add "gets the big picture and acts on it" to the yearly performance evaluation on which their bonus is based.

Of course, stock is also used to make up for being woefully underpaid and overworked. It motivates until burnout occurs, at which point nothing can rekindle motivation. Given overseas job migration and record joblessness, unemployment fears probably keep people working 100-hour weeks as well as equity could. And if you don't like to rely on economic bad times to retain people, spark commitment by aligning the culture and work with the people's values. Equity is optional.

When equity is justified
A closely related goal may justify equity: retaining employees and creating long-term commitment to the company's success. Stock does this well, especially if they think it will be worth a lot of money someday. Of course, providing meaningful jobs well matched to individual strengths also keeps people around.

You might also give stock to employees so they share in the long-term value they create. If this is your motive, more power to you! You're a rare breed. Stock is a great way to do this, and I've even known private companies to spread the wealth with simulated "phantom stock" granted to employees.

You want people owning stock for the right reasons—but stock motivates different people for different reasons. If someone wants stock in order to get rich in three years, will they make good long-term decisions for your company? Coming from the start-up world, high-six-figure executive motivation puzzles me. Many of these folks jump companies for higher salaries. In start-up land, executives join because they're passionate about the opportunity and idea. They get $70,000 for thousand-hour weeks, and bend over backwards to make the company successful. It's beyond me why a big company would pay upper execs ten times that for employment based on money and not a passionate commitment to the company.

You want people emotionally invested in the company's success. You can get that investment by giving them meaningful work in service of a worthwhile goal. Hire people who believe in what you're doing and match them to jobs. If you want to reward their commitment, then give them stock, but make it crystal clear you're rewarding their innate involvement, not trying to buy it.

Although you can't expect stock to give people an owner's attitude, some people really do think like owners once they own stock. They take pride in the company and commit 100 percent. They save money, talk up the company, bring in great employees, and sacrifice to help it succeed. If stock motivates someone to do the Right Thing because they identify with the business, give them that stock today!

Of course, some people think equity will give them control. They believe it will give them a voice. If that's someone's motivation, think twice. Other than institutional investors and founders, no one will have enough stock to wield power. Besides, if someone wants control and can't get it by presenting a lucid case through normal channels, do you really want them trying to exert control through shareholder meetings?

Avoiding the stock gotchas
So stock is a great motivator if it makes employees act like owners, rewards emotional commitment, or shares the long-term wealth. But even in those happy circumstances, granting stock is fraught with peril. In many cases, stock recipients have no idea how to value it and have expectations far out of line with reality.

Stock can stop motivating when reality sets in. We hear "stock" and think, "this is it, baby—billionaire in three months!" If you're using stock to motivate sacrifice, you better make sure it'll justify that sacrifice. In twelve start-ups over the last twenty-five years, I've seen just how worthless stock can be. If someone waits too long and sees the pot of gold evaporate as the company tanks, equity-based motivation turns to equity-fueled cynicism.

In pre-public companies, stock can be granted, but it is worthless without an IPO or acquisition. I owned stock in a private company for almost twenty years before it was finally worth one-tenth of what I'd originally hoped. Even if a private company gets acquired or reaches the IPO stage, major shareholders may make out OK, but little shareholders can get screwed. It doesn't do wonders for morale. Resumes begin circulating.

Stock has a place in motivating employees, but check out alternatives carefully.

When the money does come through, jealousy can rear its ugly head. For some weird reason, the further people are above the "game over" amount, the more they care about who has what. Those who've stuck it out through thick and thin resent making far less than the founder when a company goes public.

If a company is planning an IPO or acquisition, they'll lose the "you'll get rich from our stock" effect once they're on the other side. In that case, motivation based on something other than stock had better be in place.

Public company gotchas
Gotchas aren't just for private companies. Big public companies have plenty of gotchas, too. There's rarely a link between someone's work and share price. Stock makes a nice bonus for people, but it doesn't affect their performance because no one can figure out how to have an impact. So stock is a nice reward while the share price rises. When the price falls, though, the company has to resort to motivating with good old-fashioned salary.

Warren Buffett doesn't believe in linking market price to performance. He won't give options to top managers. He says a manager can do nothing and stock prices will still rise at a company's return-on-equity, as long as the company can reinvest in its existing business. Executive options become worth millions, even though the recipients are just taking up space. Buffett instead gives managers ample yearly bonuses, contingent upon their producing actual results above ROE.

Even though top managers are given tons of stock, ostensibly to align their interests with the shareholders, the reality is that large and small shareholders don't have aligned interests. The top company executive who holds ten million shares of stock would sure like the stock to be worth $10 per share, but still scores a home run even if the price drops down to $1. The smaller shareholder with 10,000 shares, however, cares a lot more about that price. Will the top manager do what it takes to make the smaller shareholder rich?

Vesting also makes people do crazy things. Companies don't give stock all at once, they "vest" it over time to ensure people will stick around. The gotcha is that it works. They'll grant 5,000 shares over five years, and the employee gets 1,000 shares each year. Disgruntled employees in a successful company end up with the perverse incentive to stick around until their next vesting date. They happily poison morale, radiate misery, and doom projects while waiting for their stock to vest. In this scenario stock has motivated retention too well; a little less retention would be a good thing.

So where does all this leave us? It leaves us realizing that stock is complex. It motivates, but often for bad reasons. Even when the reasons are right, hidden gotchas can turn it into a negative depending on later events. Stock has a place in motivating employees, but check out alternatives carefully. You may find other motivators work just as well and leave everyone happier in the long run.

Stever Robbins is founder and president of LeadershipDecisionworks, Inc., a national consulting firm that helps corporate companies develop far-reaching leadership and organizational strategies to sustain growth and productivity over time. You can find more of his articles at http://LeadershipDecisionworks.com.