Thursday, March 7, 2019
Delray Beach, FL- I knew that William was a potential superstar the moment we started talking. He was smart and funny and confident – real confidence, not bluster.
He wasted no time establishing himself as a valuable employee. He then worked in overdrive till he was put in charge of his own product line. He hired and trained a crew that grew that product line into one that was contributing nicely to the company’s overall profits.
As CEO of his division, William made a six-figure salary plus a bonus of 10% of the profits. As his business grew, the bonus was increased to 20%. And as part of his contract when he made CEO, he was also promised 20% of the purchase price if his division were ever sold.
Some years later, the division stopped growing. And because I had an interest in the business, I was called in by my partners to speak to William about it. He was gracious and appreciative of my concerns, but he ignored my suggestions. He was comfortable with the division running at that level of profitability.
I’m not comfortable with an idling business. Unless you are seeking to grow profits, entropy takes over and sales gradually recede (along with everything else). But when William’s sales began to recede, he didn’t seem bothered.
I was bothered. And my partners were bothered. So when an offer was made to buy William’s division, they thought: good timing. To be fair to William, I recommended that we allow him to have a voice in the negotiating process. That proved to be problematic, as he had an unrealistically high idea of what the division was worth.
Eventually, it was sold at the right price. And William received, as promised in his contract, 20% of the purchase price.
Instead of feeling good about it, he shocked us by asking for 40%. His rationale was that he deserved an additional 20% of the profits because, in his role as CEO, he had somehow “earned” an extra 20% in “sweat equity.”
“Sweat equity” is a term that is sometimes used with start-up companies. To persuade a CEO (or other key executive) to work for a salary much below market rates, they are offered the chance to receive equity as a trade-off. For example, instead of paying Sally the $150,000 she would normally make, she is paid $50,000 and receives (after the year ends) $100,000 worth of equity.
That is how sweat equity works. It is a deal the two parties make beforehand. And it is not merited simply because someone works hard or successfully. It is essentially bought with the compensation that the executive willingly gives up.
When both parties agree to it, it’s fair. What William was asking for was, in our view, completely unfair.
I’ve always said that what is fair in a business relationship is relative. It’s relative to the people involved and to the situation, which is always changing.
If, as things change, your view of fair is in a range that doesn’t overlap with mine, we have a problem. Sooner or later (in William’s case, later), we will be at odds. And because our views of fairness are so different, there is a good chance the relationship will be ruined.
If you are entering into a long-term business relationship – whether it be a partnership, a joint venture agreement, or an employment contract – it’s not enough to agree on terms and to put those terms on paper. You have to spend some time talking about how the terms might change in the future.
My partners and I never did this with William. We just assumed, since he shared our views on so many other things, that he shared our sense of what fairness would look like as his role in the business became more important.
Had we done so, we might have realized that, for one thing, he had a very peculiar idea about meriting sweat equity based on his own assessment of his work.
Equity is a term that means ownership.
If you invest in a public company, you are an equity owner. And as such, you are legally entitled to a certain share of the company’s distributed profits. It doesn’t matter that you have nothing to do with how those profits are made. Once they are made, equity holders are entitled to them.
In a business relationship, it refers to ownership of the business. In a normal business relationship, there are owners and employees. Employees get compensation based on terms set down by their employers – the equity holders. The employees negotiate to get the best compensation they can demand. And their employers give them the compensation they believe will have the best result for the business. That idea of “best result” includes profits. For the equity holders, this is key because they make their money from the distribution of some portion of the profits.
This is a fundamental aspect of free enterprise within a capitalistic economy. In fact, it could be said that the essential difference between Capitalism and Socialism is that the former respects this distinction and the latter doesn’t. The idea that the employee without equity is automatically entitled to a share of profits is the essence of the Socialist argument.
William’s idea that, as CEO, he deserved the equivalent of equity in the business was impossible for us to understand or to accept.
Had he asked for a goodbye bonus for doing good work, it would have been a different thing. Although he technically didn’t deserve it, we might have given him something to make him happy.
In fact, that is more or less what we ended up doing. Not wanting to end the relationship in a fight, we awarded him a goodbye bonus that was equal to about half of what he had been pushing for.
But the compromise left both parties unhappy. William felt he didn’t get as much as he deserved. And we had discovered something about him that would make it difficult, if not impossible, for us to do any potentially profitable business with him in the future.
The lesson learned: Whether you’re the employer or the employee, make sure you have ongoing discussions about what fair compensation means. Make sure those discussions address future possibilities, including how the relationship itself might change in terms of who is contributing what, and how you would adjust the deal to compensate for such changes.