The Power of Equity

The power of equity is the most undervalued asset in a business. Not undervalued in terms of its price on the open market, but undervalued in the minds of employees. For those who aren't familiar, equity is essentially an ownership piece of a company, divided up into shares. For example, a company may be broken up into 10 million shares outstanding, which means if you owned all 10 million shares, you would own 100% of the company. If you owned 1 million of a company's 10 million outstanding shares, you would own 10% of the company, and so on and so forth.

The number of shares a company is broken up into, as well as the value of each share, is determined by underwriters and unique articles of incorporation, and we won't get into it here. What we will get into, however, is the power of owning equity - the power of ownership.

In today's working world, the main focus of employees is salary and benefits. Offer a job to a potential employee and the first thing out of their mouth will be "what's the salary?" This question in of itself isn't the wrong question to ask, we should all be focused on our livelihood. Thinking that a salary is the only way to increase our livelihood, however, is where we go wrong.

Don't misunderstand me, earning a high salary is great; most of us aspire to earn big paychecks and then spend those paychecks on expensive toys. But when you work for a salary you are falling into the trap of trading your time for money. You are essentially a contract employee whose investment - your time - cannot increase in returns.

Lets assume that your salary is 100k a year (if we were all so lucky). No matter how much time you invest in your work, you will not see an increased return on your salary. Salary increases are possible of course, but at any one point in time, whether you work 40 hours a week or 80 hours a week you are still being paid the same.

The definition of a good investment is seeing increasing returns on the original amount you invested. Buying one thousand dollars worth of stock on the open market and then watching your money increase by 2%, then 5%, then 10%, is a much better investment than investing your time - your most precious resource - for a fixed amount of dollars with no potential for increasing returns. By working for a salary you are essentially capping your earnings, or capping the returns on the investment of your time.

Here is where the idea of equity comes into play. Pretend for a second that you are the partial owner of a company, say a 1% ownership. If there are 10 million shares of the company outstanding, that means you own 100,000 shares. As you work on your business more and more you start to see its revenue and profit increase, so you invest more of your time. In one month your company makes $5,000 in profit, the next month it makes $10,000 in profit, and then the next month it makes  $18,000 in profit. You start to realize that the more time you invest into your business the more money it makes, which means nothing to someone being paid a salary (they are helping make the owners rich), but as a part owner it means everything to you.

Each month you invest more and more of your time in your business, and each month the profits increase. This, my friends, is the definition of increased returns on your investment. Say now that the company has gained good traction and is ready to pay out a dividend. A dividend, for those of us who don't know, is a percentage of a company's profit that is paid out to shareholders, and is usually paid out on a quarterly basis. Profits for the quarter were $50,000, and the company decides to pay half of that out in dividends. Since you own 1% of the company - or 100,000 shares - you get 1% of the $25,000 dollars, or $250 dollars.

I know that everyone reading this is ambitious and motivated, and you may be scoffing at $250. Might as well work for a salary, right? Wrong. As your business begins to gain more and more traction, its profits are going to increase. Maybe next quarter you get a dividend of $500, and then maybe a dividend of $1,000 the quarter after that. The point is that when you own equity in a company there is no cap to your potential earnings or your potential return on investment.

Going one step beyond dividends, owning equity in a company gives you the possible opportunity of a huge payout. I'm speaking, of course, of an acquisition or an IPO (initial public offering), the holy grail of entrepreneurship. If you own 1% of a company that sells for 100 million dollars, then boom, you're a millionaire (pre-tax of course, those damn taxes). Talk about a great return on your investment.

I can feel everyone beginning to roll their eyes; there are risks involved, sure. It's accepted that 9 out of every 10 startups fail, and it's normally a startup that would offer you an equity stake. Indulge me for a minute, however, while I break down the risk and prove to you that it's still a smarter investment to work for more equity rather than a higher salary.

Lets assume - as we have been doing this entire post - that you are a diligent worker and if you earn a salary you are probably going to get a raise every year for five years. Lets also assume that there is a 90% likelihood that this will actually happen. your future earnings - your future return on your investment of time - will look like this:

Total earnings over a 5 year period = (60k + 70k + 90k + 100k + 120k) * 90% = $396,000

Not bad for five years of labor. But now let's look at your future earnings if you had a 1% equity stake in a company that sold for $300,000,000 five years from today. Given the going rates of tech companies nowadays, I think that amount, although it looks mind-boggling, is totally believable. Lets now assume that your company has a slight competitive advantage in your industry, which adds 5% to the 10% chance of survival (9/10 startups fail). Let's also assume that you had been making a small salary of 36k to cover living expenses for the five years leading up to the sale of your company (measly compared to the salaries above):

Total earnings over a 5 year period = [(36k*5)+($300,000,000*1%)] * 15% = $477,000...and that doesn't even take into account possible dividends.

So even when accounting for the risk of taking more equity over more money, owning an equity stake in a company will pay off greater than taking the safety of a salary.

On top of all this quantitative analysis is what I believe to be the most valuable aspect of owning equity, and that is the feeling that you are in control of your professional destiny, that you are an owner of your future. Instead of working for a salary and making someone else's dreams come true, owning an equity stake in a company - even half a percent - means that you are making your own dreams come true.

And if you happen to own half a percent of the next Whatsapp, those dreams can be lucrative.