Should I Offer Equity, Stock Options, or Profit Sharing?

Bootstrapped founders face a big question: How do I incentivize employees beyond the agreed-upon salary? —Bonuses? Profit sharing? Stock? Equity? First, let’s talk about why this might be a good idea.

Hopefully your employees love working for you because of the interesting things they’re working on. Extra incentives—when properly aligned with the company’s goals—can provide motivation and retain employees. And in a competitive talent market, smart incentives can help you land top candidates.

It’s not a requirement to offer bonuses or profit sharing, but if your team is cohesive and working hard toward the same end goal, you’re creating profit, value, and wealth together. It feels right to share that with your team.

(Note: Nothing in this book should be considered legal or tax advice. Speak with a lawyer and accountant before starting an employee incentive plan.)

Bonuses sound great because of their flexibility, but they are tricky, given their arbitrary nature. They are a decision to give people an extra few thousand dollars at the end of a year.

Bonuses can make people feel left out or that you’re playing favorites. They might feel like you’re giving more money to someone who doesn’t deserve it.

If you don’t have a profitable year and don’t give out bonuses, people can get angry and blame you. They’ll point out how much money you spent on things they don’t like. Not to mention in California, a lawsuit ruled in favor of employees over nonpayment of bonuses those employees had come to depend on.

Usually, it’s better to incentivize employees with something more aligned with the business goals you’re trying to achieve.

Equity gives employees ownership—and not just literal ownership. It gives them emotional ownership of the business and motivates them to grow it.

Equity is tricky, though. An equity holder only makes money if you sell the business or pull out dividends.

With a venture-backed startup, selling is often the goal, and equity comes with the promise of large liquidity in the relatively near future. Because bootstrapped startups tend to grow more slowly and deliberately, equity isn’t always as much of an incentive.

Another challenge of equity grants is that they’re different from stock options. You’re literally giving a portion of the company to someone, which is taxable on the current value of the company. You might create a brutal taxable event for an employee if you give them a substantial amount of equity (or even an insubstantial amount if the company is large enough).

In addition, if you’re a pass-through entity (such as an LLC in the US), capital gains will pass through to any equity holder.

Let’s say your LLC makes $500,000 in profit this year, and you’ve given 1% equity to a key employee. Even if you haven’t pulled money out, they will receive a K-1 for 1% of that $500,000, or $5,000. Essentially, they’re getting taxed on $5,000 even though they didn’t receive that money.

In most cases, equity is best for founding employees (cofounders) who receive it when it’s virtually worthless and they know the ramifications.

Stock options are the standard startup approach to getting deeper buy-in from employees. An option just means an employee has the option to purchase a share of stock in the company.

If you grant someone 10,000 options, they can purchase 10,000 shares at a fixed price (called the strike price) set each year by a company’s IRS filing. That strike price is usually quite a bit less than the share valuation during the last funding round, which means it’s a good deal, at least on paper.

Those 10,000 options vest over time, the standard is four years, creating an incentive for the person to stick around so they don’t lose their unvested options.

From the company’s side, you would set up an options pool of 10% or 15% of outstanding shares that are given out in small chunks to new hires, the amount varying based on seniority.

Stock options have simpler tax implications than equity because they are a promise to the employee that they can buy shares at a future time rather than actual shares.

Stock options are a reasonable choice for employee incentives, especially if your goal is growth and an exit rather than running the company for the long term.

The nice thing about profit sharing is that it doesn’t require you to sell your business for your employees to make money. If your goal is to make your company profitable and run it for the long term, profit sharing may be your best option.

Consider structuring profit sharing as a pool rather than a committed percentage to an individual. For example, instead of telling early employees that they’ll get 1%, 2%, or 3% of profits, have all key employees share in a 10% or 15% profit-sharing pool.

As you add more people to the pool, those first employees’ percentage of the pool will go down. But ideally, profits should be growing, and every team member should be contributing to that.

Peldi Guilizzoni, founder and CEO of Balsamiq, wrote perhaps the best explanation of profit sharing I’ve seen. To read it fully, go to bit.ly/balsamiq-profit-sharing. Essentially, the company started with a pool of 10% of the profits, which was distributed each quarter. At some point, years into the company, he increased that pool to 15%. I believe he’s now up to 20%.

That profit pool is allocated to full-time employees. Twenty-five percent is split equally, and 75% is based on seniority, then it’s weighed by the cost of living for each employee.

Guilizzoni notes that they do quarterly distributions because monthly was too much paperwork and yearly kept some unhappy people around longer than they should have stayed.

Some companies have folks vest into profit sharing for their first few months, much like some companies have a waiting period to get health insurance or to access a 401(k). This is a way to make sure the person’s a fit for the team and that the team is a fit for the person.

Of course, if your plan is to grow and exit rather than run profitably, profit sharing is likely not your best option.