Equity Doesn’t Make Employees Owners

Here's my rant about some of the false ideas around equity and ownership.

Equity doesn’t make employees owners

Most entrepreneurs have the common misconception that giving equity to employees makes them feel like owners and thus treat the business as if it were their own. Much of this ideology comes from people like Jeff Bezos, who compare the differences between renters and owners and how renters only optimize for the short term at the expense of the long term.?

This argument for ownership makes sense at the surface level until you break it down into the reality that companies face: shared ownership. What if 10 people owned a house and had to share the kitchen? Would everyone feel like they’re owners of the kitchen and take care of it since they own 1/10th of it, or would some people abuse the shared ownership and not wash their dishes, leaving others to do it for them, and then others would give up on washing their own dishes too since why should they bear the consequences of cleaning up for everyone when the gains of a clean kitchen are shared among everyone? Imagine if the number of shared owners of the house grew to 1,000 people or 100,000 people.?

True ownership is more than just getting a piece of the upside. It’s having control over the outcome.?

Ownership means control

Equity is a shared resource in a company, and for the vast majority of employees, the outcomes of the equity are completely out of their control. Why would someone work harder if their hard work doesn’t lead to increasing the value of their equity and they can’t make the decisions to change that? Also, why should someone bear the consequences of working harder than their peers if they must share the gains of their hard work equally with everyone else who might not be working as hard??

This is a perfect example of the highly studied topic in economics called the Tragedy of the Commons. It’s when a shared resource is owned by multiple people, leading to it being exploited by individuals acting in their own self-interest.?

The company's interest is to maximize long-term profit by balancing downside risk with upside potential. With an equity compensation model, this is not in alignment with employees' interests since they personally receive all the downside of risk-taking but only receive a small portion of the upside since they share it with everyone else in the company who’s also an equity holder.?

This inherently leaves the scale out of balance for someone acting as a rational human being in their own self-interest.?

Companies then have to increase complexity to try to balance this misalignment by implementing performance management systems to encourage people to maximize profit by giving them additional personal upside such as cash/equity bonuses or giving them additional downside if they don’t maximize profits, usually in the form of being let go and often done through stack-ranking which has it’s own perverse incentivizes that don’t drive maximizing profit.?

Equity is a poor motivator?

Equity is also a poor motivator of work performance because there’s no extra benefit of being a top performer versus a bottom performer outside of someone keeping their job. This would be similar to living in a communist community where there’s no incentive to work hard to become a doctor if you get paid the same as a janitor.?

The other reason it’s a poor motivator is because value is subjective, and in most cases, employees place less value on equity than they do on immediate cash compensation. It’s human nature to value the short-term greater than the long-term and the additional complexity of trying to understand how to value equity only lessons their perception of it.?

This is especially true for private companies in today’s economy, where it’s become general knowledge that companies might have complex vesting schedules and purchasing stock options comes with the risk of losing money.?

A mental model for thinking through paying someone in cash versus equity is supposing you want to hire an employee for a total comp of $200,000 and pay half of it, $100,000 in stock options, but they discount the value of equity by 80%, so they see the total comp as being $120,000 when compared to other offers.?

Suppose there is an investor who wants to buy the equity at the valuation the $100,000 would be given to the employee. Why wouldn’t you sell the equity to the investor since they more highly value it, then give the cash to the employee since they more highly value that? This creates a more efficient trade of value.?

The argument against this would be that a higher all-cash salary doesn’t have any upside, so there truly is no reason to work harder. That’s what the section below will address.?

How to create motivated owners within a company

How can you create owners across your company who are motivated to balance downside risk with upside potential to maximize profit over the long term??

The answer is by replicating the system as closely as possible, which has already been proven to do this: Free markets and entrepreneurship. We’ll break down the solution to implementing a free market economy inside of a company into three parts

1. Creating ownership?

We know that shared ownership without a sense of control leads to people feeling like they’re not owners since control over outcomes is truly what creates the sense of ownership.?

Luckily, the solution to the Tragedy of the Commons has been well documented. The way farmers, among many others, have solved this tragedy is by taking a shared resource and subdividing it to create owners of each piece, thus creating property rights and true owners who can control the outcomes of their property and are incentivized to balance the downside risk with upside potential to maximize profits over the long term.??

In a company, property rights can be replicated by taking a piece of shared ownership and subdividing it to create owners of each piece and giving them decision rights to control the outcomes of their piece. This means a single person will own a portion of the business where they are accountable for maximizing profits over the long term and can make all of the necessary decisions to make that happen, leading to a sense of ownership.?

2. Incentivizing ownership?

In a free market economy, the reason people become entrepreneurs and take bold risks is because the upside potential outweighs the downside risk. How could a business hold someone accountable for maximizing profits if they are only punished for taking risks and failing, yet don’t receive any of the upside if successful??

This is where a rational human being would do what’s in their own self-interest by minimizing risk-taking, even if it’s at the expense of maximizing long-term profits.?

The best way to solve this is to balance out the equation by giving people profit motives to work hard and take risks, just as entrepreneurs in a free market economy. I’ve found that the best way to do this is to work backwards from a metric with known business value to identify their inputs so that you can assign a value to how much it’s worth to the company. You can then set the purchase price the company is willing to pay for the metric based on ROI goals inside of a service level agreement detailing exactly what the company is purchasing and the expectations around the services provided. The team will also need to have the necessary decision rights to make all the decisions required to drive the outcome and have true ownership of the results.?

A team will then turn into a business by having a single buyer of their product (the company) to which they’re selling the metric, and expenses based on all of the costs associated with the team, such as salaries, benefits, software, etc. The difference between the purchase price and their expenses is profit for the team leader to share. Individuals can take this profit as cash or use it to purchase equity in the company at a set valuation if they more highly value equity than cash.?

This model incentivizes teams to be entrepreneurs acting in their own self-interests, always trying to maximize profit by balancing costs and risks with upside potential, perfectly aligning their interests with the company's interests.?

An example of this in CourseCareers case would be us knowing that every new student who lands a job from one of our courses is worth $1,000 and the input of course completion generates half of that value. Based on how many people are going through our courses and landing jobs, every 1% increase in course completion is worth $40,000 annually to the business.?

If the company wants to generate a 2X annual ROI at our current scale, then we would purchase the course completion metric at $20,000 per 1%. If the team has annual costs of $500,000, then they would need to increase the completion rate by 25% to break even to stay in business, and every additional 1% after that is a $20k bonus.?

We would then create an SLA with the terms of what we’re purchasing with the team leader. The following components of the SLA are:

Metrics Owned: These are the metrics the team will own and be accountable for.

Metrics Value: This is the value the company is purchasing the metrics for.

Metrics Measured & Audited: This is how the metrics will be measured and audited for accuracy.

Metric Goals: These are the goals the team is accountable to hit and the expected profit generated if hit.

Team Resources: These are the resources the team has to achieve their goals, in which the company is making an investment.

Team Decision Rights: These are the decisions the team can make without approval and the regulations they must abide by.

Contingencies: These are how we should prepare for possible scenarios/risks that could disrupt or degrade the service performance.

Mission Statement: This is a one-line statement about the mission of the team.

Narrative Plan: This is a well-written plan the team writes detailing how they plan to achieve their goals. It’s their job to figure out what they’re going to do to improve the metric and how they’re going to do it.

Any work a team does outside of their SLA should be considered a tax since it inherently reduces how much profit they’ll generate. It’s important to keep taxes and regulations minimal to incentivize entrepreneurship.?

3. Second-order effects of free market management?

There are many second-order effects that are created by turning every team into its own business with a P&L and pursuit of personal profit.?

Creates a data-driven culture. If the company only purchases metrics that can be clearly and accurately measured and audited, then everyone will try to identify and measure the most valuable input metrics in the company to get a purchase order for. This highly incentivizes a data-driven culture.?

Efficiently allocate capital most profitably. By knowing the P&L of every team within the company it allows leaders to very efficiently let unprofitable teams go bankrupt and invest more into the most profitable teams, leading to the highest overall return on capital.?

Human capital naturally allocates to the highest return on capital. The teams that create the most value for the company are also the most profitable, making the people on the team very highly compensated. This will naturally attract the most talented people from both inside and outside the company to want to work on the team even if it’s risky since the upside potential outweighs downside risk, naturally aligning human capital with return on capital similar to a free-market economy where the most profitable opportunities attract the best talent.?

Creates a culture of accountability. Performance management is done by individuals acting in their own self-interests. It’s in the interests of the team leader, aka the entrepreneur, and every person on the team to maximize profit for themselves by minimizing costs and maximizing value creation.?

If anyone on the team isn’t the most profitable person that could be hired, creating the most value at the least cost, it’s in the interests of the team leader and every team member to replace them with the more profitable person. Since team leaders have the decision rights to control the results of their team, they’ll do the hiring and firing. Highly profitable teams driving the most value for the company will be the most competitive to stay on, similar to being a part of a high-performing sports team.?

If a team is on track to be unprofitable, the team leader is incentivized to let people go to reduce costs and stay in business. This structure creates a natural culture of accountability, aligning the interests of every person in the company with the interests of the company.?

The pursuit of profit leads to innovation. Everyone acting in their own self-interest is trying to identify more highly profitable opportunities to work on so they can capture a portion of the profit for themselves. This leads to a culture where everyone is searching for ways to innovate due to it being in their own self-interest.?

The difference between centrally planned innovation and individuals innovating in the pursuit of personal profit would be similar to the difference in innovation between a free-market economy and a communist economy. It’s not even comparable.?