Jan 5, 2024 | Financial Acceleration

Should I agree to be paid with equity?

Q. Dear Zenagos,
I get thrown off track in business meetings because people offer me things I haven’t thought about. For example, someone offered to pay me with equity. I don’t know how that works. Should I just say no, or should I try to figure out what they mean?
–Munyaz

“Equity” is an exciting word because it means that you are a part-owner of the company. If the company does very well, you may benefit from growth in equity. However, it’s not easy to calculate the monetary value of equity because there are quite a few variables to consider. Before you accept equity instead of cash payment, take your time to evaluate the offer and discuss it with trusted advisors who can give you a sense for its value and the risks you are taking.

Equity only turns into cash if there is an “exit”
A typical equity offer is made in the form of stock options, which provide an opportunity to buy the company’s stock in the future at a fixed price. If the company is publicly traded (on a stock exchange like NYSE or NASDAQ), then you may purchase the stock and sell it at market rate, turning it into cash. However, most companies are private, which means the stock will not be issued until there is a triggering transaction, which is called a “liquidity event” or “exit.” (Click here learn about company exit strategies.) Typically, the equity holders in a private company can only sell their stock if the company is bought (by investors or by another company) or if the company makes an Initial Public Offering (IPO), making the stock available to be publicly traded on a stock exchange (JP Morgan, 2023).

The probability of a liquidity event is fairly low
The current trend is negative for private company exit transactions. Morgan Stanley (2023) reported that 37% of private companies are “choosing to stay private longer than originally planned.” If the company stays private, then the employees have no way to convert their equity into cash. A handful of private companies create occasional opportunities for employees to cash in their equity, but these arrangements are rare. Sarin, Das, and Jagannathan (2002) examined 52,000 rounds of equity financing by professional investors (venture capital and private equity) and determined that 19% of the companies failed and were liquidated, paying nothing to equity holders and 21% were still privately held after 10 years, providing no cash opportunity for equity holders (P. 9). About half of the companies provided an exit via acquisition or IPO (P. 4). If the probability of success for a venture-backed company is only 50/50, the odds are presumably even lower for companies with less well connected and trained financiers. And, even if the company does have a liquidity event, that does not mean that employee shareholders acquired meaningful wealth. The exit price needs to be high for common stock shareholders to receive meaningful benefit.

Employees are attracted to the dream
Despite the low probability of exit, employees are drawn to the dream of acquiring wealth through equity ownership in a company. According to research conducted by Hallock and Olson (2006), employees consistently place higher value on stock options than the estimate that would come from a rigorous financial analysis. This is not surprising, since even well-trained financiers find it difficult to agree on an accurate valuation for a private company’s stock. This is a good reason to talk with a financial advisor about the potential value of the equity to you, considering your specific situation.

Look carefully at the terms in the equity agreement
When it comes to private-company equity, the details matter. Many offers come in the form of stock options. It is typical for these options to “vest” over a number of years. Until the options “vest,” the employee does not really own them and cannot exercise them. Also, even if your options have vested, many companies include terms that enable the firm to buy back the options at a company-favorable price if the employee leaves. For this reason, it is important to have the equity agreement reviewed by an attorney who can explain the risks to you.

If you are most comfortable with cash compensation, then you do not need to evaluate the equity offer. However, in some situations, equity grows quickly and can become very valuable. So, rather than dismissing the idea out of hand, it is probably worth it to consult some experts to evaluate the opportunity, so you can make a fully informed decision.

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References

Frank, A. (2023, December 18). Managing stock-based compensation in private companies. JP Morgan [website] Retrieved on January 4, 2024, from https://www.jpmorgan.com/insights/business/business-planning/managing-stock-based-compensation-in-private-companies

Hallock, K. F., & Olson, C. A. (2006). The value of stock options to non-executive employees. National Bureau of Economic Research. https://www.nber.org/system/files/working_papers/w11950/w11950.pdf

Liquidity trends: Perspectives from private company leaders. (2023, June 25). Morgan Stanley at Work [blog]. Retrieved on January 4, 2024, from https://www.morganstanley.com/atwork/articles/liquidity-trends-report-2023
Sarin, A., Das, S. R., & Jagannathan, M. (2022, January 22). The private equity discount: An empirical examination of the exit of venture backed companies. http://dx.doi.org/10.2139/ssrn.298083. Retrieved on January 4, 2024, from https://ssrn.com/abstract=298083

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