I remember all so well the first time I was faced with the “E” question.

It was 1974, and my two partners and I had ourselves a “tiger-by-the-tail” company by the name of Information and Systems Research (ISR --- a terrific name for a start-up trying to get its prospect phone calls returned --- I doubt I need explain).

ISR was formed to provide on-line database searching - a novel concept at that time. Our first big project was the Carnegie Library for the Blind and Physically Handicapped here in Pittsburgh --- for this project we actually created our own text retrieval software. The library patrons loved this software as it significantly reduced the time and effort required to acquire and “read” any one of the library’s tens of thousands of “books on tape”. Later on, we would also implement the Philadelphia Free Library. Finally, we also began, but never fully installed (due to budgetary reasons), the Blind and Handicapped library in New York City.

Great fun. Great company.

That company morphed a bit, as all start-ups do, and after a while we were employing a couple dozen people installing business-oriented custom inventory management and financial control systems using the Digital Equipment Corporation’s (DEC) PDP 1134 mini-computers. I was all of 27 years old when this was happening. I was running a three million dollar company that would ultimately grow to the point where profits exceeded seven figures. Who’d a thunk it?

Did I know what I was doing as a manager? No. At least I doubt it. I believe that great managers are made, not born --- and that it takes at least a decade, and probably longer, to rightfully earn this mantle.

And so it wasn’t at all surprising to me that I was completely flummoxed when I had to deal with my first equity-seekers --- in my case two employees --- both of whom approached me towards the end of our third fiscal year.

Equity.

Scratch any entrepreneur/business owner and you’ll meet someone who treasures the stock in his or her company almost as much as he treasures his family.

Because, and in a number of ways, each one of those shares of stock is “family”. And just as few people would “give” a family member to another, so too are owners of equity shares very reluctant to part with them.

Consider:

• Once equity is transferred to another, a partner is legally created. And all that this means. So that, and for the most part, great consideration now has to be given to each and every significant move made by the original Founder(s). So let’s say that you now wish to add an expensive machine? Well, now you must “check with the partner”. You want to start paying yourself more money? Again, you must see the partner.

  Get the picture?



• Once equity is transferred to another, it is unlikely to come back. So, you not only have a partner --- you have a partner for life.


• And, once equity is transferred to a partner, you just may well (and unless you plan carefully --- see our friends at Henderson Brothers Insurance for advice ---) have a second partner as well. This of course being the equity holder’s spouse. And I’ll bet you probably never even considered going into business with your partner’s wife (or husband, for that matter).

There’s more, A LOT more, to taking on an equity partner. And believe me; I’ve dealt with most of those issues in my forty years in business.

So I guess the only admonition I can make here is, tread lightly and get great advice before entering into equity arrangements. You’ve got a lot to lose.

So why even offer equity? Why have any partners other than those few daring individuals who risked it all with you when you first started out?

Why?

Here are the three reasons why most business owners “equitize”:

• To reward outstanding performance
• To retain (or recruit) outstanding personnel
• To reduce ongoing salary costs

In a “pure” start-up, these reasons are reversed. That is, and to a brand-new start-up, stock is almost universally employed to enable a cash-poor business to compete, talent-wise, with the big boys. This is done by, and in essence, giving the business owner a fungible asset that can and will be deployed to “make-up-the-difference”, providing equity that (hopefully) might be worth something at some future point in lieu of salary.

Reductions in salary are almost always related to the original team. These are the Founders, if you will. These people generally split up the equity on day one with distributions of ownership weighing more heavily towards: a.) he who puts up the idea; and/or, b.) he who puts up the money (always an interesting argument --- which is “worth” more --- the money that makes the company exist, or the idea that gives the company its “raison d’être”?).

A typical three or four person start-up team can and will have some very talented (read, “expensive”) people on it. Thus, 50% reductions in salary (against proportionate equity distributions) can be a very significant game changer in terms of making future payrolls!

I personally believe in equity. But only for the right people!

Let’s now look at bringing equity players on board after company formation. Like I said, this is tricky.

First, let’s look at the “recruit/reward” proposition. Equitize the wrong individual here and you have a headache of major proportions. Equitize a “player”, and you have just strengthened your business ten-fold.

To help defend against “wrongful equity”, I suggest using a two-year safeguard plan. What this means is that no one (besides an original partner) may participate in the ownership of the business until the Founder(s) have had an opportunity to observe his or her work for a minimum of two years.

This isn’t infallible, but in a small business, it’s awfully hard to “hide out” for two years. Eventually, the guy is going to have to step up to the plate.

I have probably only used equity as a recruiting tool two or three times in my life. Why? Well, and for one thing, to equitize a “newbie”, I must start out by breaking my most sacred equity rule (see above).

Of course, and on the other side, there is that performance standard. How can one possibly observe performance by an individual who hasn’t ever been asked to perform that/those task(s)?

Recently, I was presented an interesting candidate for our flagship business, Pittsburgh Business radio. This is the year that we want this business to grow nationally, and I need someone to help us do that.

It is a daunting job, one that requires creativity and skill. But try finding someone who has actually done this. Very difficult.

So, I suggested that we employ a technique that is widely used in industry (in fact, I once built a huge company almost entirely on this method) to determine whether or not the candidate had the requisite skills. The marching orders were, “Go away for a week and think about how you might build out a national customer base for our product. Then, come back and tell us how you might approach the problem.”

You might know the name Tom Donohue. Tom and I grew up together in Dormont, and he ultimately became the head of Personnel/General manager for the Pittsburgh Steelers. When I would ask him how he made sure that the football team got the right people on draft day, he replied, “Ron, if I need a guy to go over the middle to catch a tough pass knowing that he is going to get rocked in the process, I’ll watch film until I actually SEE that guy. Then, I want to see him catch that tough pass and take that tough hit dozens of times.”

“And then, I’ll know that I got my guy.”

When I asked Tommy, “But what if there is no such person available?” He replied, “If that’s the case, you have to replicate that situation. Find something that is very much like what you want to see. Or, create that scenario yourself --- bring the guy into camp and make him take those throws and those hits --- you’ll probably soon find out if he is capable.”

But this can work the other way, too.

For example, advertising agencies are forever “pitching” their wares “on spec”. I spent a year in advertising and probably made a couple dozen presentations that were designed to land new business. Unfortunately, all of that time (and expense) went unrewarded. There were simply better pitches by better pitchmen. We lost.

Such is business. Such is life.

Equity is a tough call. Basically equity is like this: “Look, I can’t afford to pay you but I can give you the opportunity of a lifetime to make whole lotta dough and have a whole lotta fun along the way. So if you have the guts (I cleaned that up!) to come and play, then let’s play! But remember, start-ups are for risk-takers. It’s the highest highs and the lowest lows. KNOW THIS before you enter!”

It’s funny. I once posed the above hypothetical (that is, “go away for a week and then come back and present”) to a guy who was scared to death that he would come back and make a complete fool out of himself. “I just don’t know your business”, he said to me at the time. To which I said, “That’s OK --- I don’t really CARE if you know my business --- what I DO want to know is how you THINK! Show me how you think.”

And so after just two DAYS of prep (the guy was on a sales trip that week --- with his BOSS no less), he came back and gave the presentation of his life.

Not only did we hire him, but we gave him more equity than he had asked for, plus a ten thousand dollar bump in bonus money.

He was THAT good.

I hope this helps. I get a LOT of calls and questions about equity and when to give it and when not to give it. I guess the best thing I can tell anyone is this --- “If the person you wish to equitize gives you the confidence to make him or her a partner, then go ahead and pull the trigger. But he or she had better rock your world --- either with past performance or by presenting some brilliant plan or insight for your future.

And even then, please know that you have just taken on a real and true partner. This is someone with the same rights and privileges as you, and therefore someone who can really make you crazy if you guessed wrong downstream.

And so, if he or she gives you even one small indicator of fear or doubt --- well, in my opinion, the best thing you can do is move on.

For as Richard Branson often likes to say, “Great people are like buses --- there’s always another one coming.”

Have a wonderful Holiday Season everybody --- and keep your eyes peeled for our first annual Christmas Message! It’ll be coming to our web site real soon!