Sharing the Wealth in a Technology Startup: How Much Stock is Enough?

3/2/09

When I founded Science Applications International Corporation (SAIC) in 1969, I owned 100 percent of the company’s stock. However, I soon realized that to attract talented employees—and keep them—I would need to offer them real ownership in the business by allocating some of the stock I held. So, within a year after I founded the company, I had reduced my ownership stake to roughly 10 percent. The company continued to issue new stock every year (as well as recycling stock repurchased from departing employees) and by the time I retired in 2004, I owned less than 2 percent of SAIC’s stock.

There is no doubt that this approach to structuring SAIC’s ownership was an unqualified success. The prospect of owning and running a piece of the business attracted many extremely talented men and women to the company, and we were able to grow SAIC from nothing in 1969 to about $6 billion of annual revenues by 2004. Today SAIC’s annual revenues top $8.9 billion a year.

But for entrepreneurs and company owners, there is another question that I am sometimes asked: How much stock does the founder need to maintain control of the company?

I can only answer this question using my own example, as each situation is unique.

By 1970, as I mentioned above, my ownership stake of SAIC was diluted to 10 percent of the company’s stock—so trying to maintain majority ownership and control of the voting stock became a moot issue for me. Even so, the benefits of our employee ownership were tremendous, and nobody really questioned who was in charge.

Company management issued stock to employees who brought new business into the company, and to attract highly talented new employees while rewarding high-performing current employees. By 1990, I owned approximately 2 percent of SAIC’s total shares outstanding and that continued until I retired as chairman in 2004.

Lacking majority voting control, I was fully accountable to the SAIC employee-shareholders during the entire time I served as CEO. That fact, coupled with our broad-based employee ownership structure meant that in many respects SAIC operated as a publicly traded company (including registering our shares with the SEC). But that didn’t inhibit my ability to control the company from the perspective of setting the strategic direction and overseeing key decisions typically handled by any CEO. If you know anything about SAIC’s history, you are probably aware that the pressure to take the company public grew considerably in the several years immediately preceding my retirement. Unfortunately, as my own ownership stake declined below 2 percent, so too did my ability to control efforts—both inside and outside the company—to pursue an IPO and change our unique approach to employee ownership.

I personally believe my position within the organization would have been strengthened if I had held onto 8 percent or so of the company stock to the end. This would have helped to keep those pressing for the IPO at bay—at least until I retired.

So my advice to founders is to hold on to 8 to 10 percent of their company’s stock for as long as they possibly can. This will allow them to use a large portion of the remaining stock to incentivize their employees while at the same time retaining a sufficient balance for themselves to maintain firm control over the company’s direction. This will also make their negotiating position at retirement stronger than what I personally experienced.

Dr. J. Robert Beyster is the founder of Science Applications International Corporation (SAIC), the largest employee-owned research and engineering company in the United States. Follow @

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  • b_e

    Dr. Beyster,

    Thank you for your article. I have a friend right now who works for another large company which is implementing the same type of private employee-ownership program that SAIC had for so many years. It sounds like a good incentive, but I have always been confused about a couple of points:

    * My understanding of the program was that SAIC employees were only allowed to sell company shares among themselves or back to the company. How was the value of an employee’s shares determined before the IPO? Did employees have to wait for a quarterly report to find out how much their assets had changed in value?

    * What happened to an employee’s shares in instances of divorce or bankruptcy? If the communal assets in a divorce included $30,000 worth of SAIC shares (held by the spouse who was an employee) and $70,000 in cash, would a 50/50 division of assets imply that the non-employee party gets $50k in cash because the other party has to hold on to the stock? Could pre-IPO SAIC stock be offered as collateral on a loan or bequeathed after the death of an employee?

  • b_e

    A clarification of my earier post, which I can’t edit for some reason:

    A better phrasing of the “collections agency” question would be: Could SAIC stock be used by the employee as collateral for a loan, given that the bank could not access those assets directly in case of a default?

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  • http://www.nceo.org Corey Rosen

    As the director of the National Center for Employee Ownership (www.nceo.org), it’s been my privilege to get to know Dr. Beyster. He is an extraordinary man. If his leadership principles were the norm, rather than the exception, we’d all be a lot better off.

    I admire the idea that entrepreneurs would be willing to go down to 8% or so of a company, but, in my experience, most companies that share equity, including start-ups, look at a much more modest program. Most of the companies I talk to say that they plan to share about 10% of the equity. When I ask how they came up with that number, they say it’s what they hear ofter people do. I point out that 10% of their company is hardly the same as 10% of some other company, and we are off on a different track.

    Rather than use a static number, a better approach is to set a target each year based on whatever your financial critical number is (or numbers are). If you meet that, share a significant percentage of the incremental stock value it creates with employees; if you beat the pants off it, share an even higher percentage.

    This gives employee something to shoot for each year. It gives shareholders the peace of mind that they will only share gain, not pain. It tells employees how much they can own is not limited.

    At the other end, if ownership by employees and investors starts to shrink the entrepreneur’s share, then I agree with Bob that retaining a significant percentage you or people you absolutely trust to agree with your core vision hold, is essential. How much that is probably depends on the governance agreements you have with investors and the voting rights of employees. One solution is what Google did — to dilute the equity in terms of economic ownership, but retain a special class of shares that provides ongoing control. That may make some investors blanch, and some employees may not like the idea of not having full voting rights, but if you have a very specific vision for your company, this may be the only way to protect it long term.

    Finally, beware of what buyers say they will do with your vision (ask Ben and Jerry about that). They will always say you’re just wonderful, and so is what made your company unique, but the honeymoon rarely lasts. And doing an IPO, unless you do it the way Google did it, almost assures your original vision will vanish, no matter what you incoming board or new CEO says.

  • J

    Dr. Beyster – I very much appreciate your article on how much stock is enough in Xconomy.com. I think your observations are relevant to our economic troubles today, and they are correct. I also agree that the virtues and competitive advantage of being a large private (employee owned) company far outweigh those of a public company, especially in this distressed market.

    Having said that, should I add that it takes more than just a large CEO equity share in a private company to ensure that good governance stays consistent with the core values and mission of the company, which I think is the problem you really meant to address here.

    To ensure that good governance remains true to the companies core values and mission, I would add a few important structural requirements to your basic suggestion of a material (8-10%) ownership position by the CEO.

    a. Class of preferred stock – if the CEO owns a class of stock with preferential voting or other governance rights, that goes a long way to ensuring that the voice of the CEO is heard loudly in all governance matters.

    b. By-laws – this establishes the rules of order by which the board must discharge their basic responsibilities of governance. Therefore getting the by-laws right goes a long way to mitigating board mischief down the road. Of course it is a lot easier to get this right at formation of the company than it is to amend the by-laws once a company has grown large and successful. All too many small companies ignore the importance of creating good solid by-laws at inception.

    c. Mission and Goals of the Company – beyond the by-laws, establishing a clear and articulate set of goals and mission statement for the company help channel the actions of the board and management. The mission and goals of the company should transcend the presence of the CEO and the board thereby protecting the company from going in the wrong direction in the event that any of the CEO, key board members or key managers are lost, removed or otherwise marginalized.

    d. Selection of Board Members – the selection and maintenance of a board of directors who buy-into the mission and goals of the company and are like-minded is critical to the consistent governance of the company. Most senior management dysfunction in a company usually starts with the board. This is not easy and a lot of damage can be done by just one rogue member with divisive intentions.

  • http://www.beyster.com J. Robert Beyster

    Thank you b_e for your questions. I will do my best to answer them. Please understand that these answers reflect the way SAIC operated up until I retired in 2004. My understanding is that things have changed, particularly after the IPO. Regarding your first question, any SAIC employee could buy or sell shares in the quarterly trades – amounts above a level set by the Operating Committee required advance approval. The company was the net purchaser (in the case of more sellers than buyers) or the net seller (in the case of more buyers than sellers). In the event that the dollar amount required by the company to purchase shares in the trade was higher than the company wanted to use to support the trade, the company could pro-rate the shares sold by sellers. SAIC’s Board of Directors set the stock price quarterly before the trade based on fair market value. The company used a formula based on its published financials (10-Q; 10-K). It also used publicly traded comparable companies and an appraiser to make sure it was fair market value. Regarding your second question, if an employee left SAIC, the company typically purchased the shares from that employee at then-current market value. Current employees could transfer shares to their immediate family, but if that employee left SAIC, the shares would be repurchased from the employee and any transferred shares to their family. Shares could also be transferred to charities, but these shares would be repurchased as soon as possible from the charity. SAIC shares could be transferred to a spouse in a divorce, according to the terms of the settlement, and SAIC shares were used by collateral by banks to make loans. The terms and conditions for such loans were set by each individual bank. Finally, SAIC shares could be bequeathed. The shares were then repurchased from the individual or charity over the next year.

  • b_e

    Thank you very much for answering my questions, Dr. Beyster. The program makes much more sense to me now, and I imagine the current employee ownership program at SAIC is very similar to the one my own publicly-traded employer implements.

  • William Kneeland

    Dr. Beyster, your business blueprint for success is in fact tried and proven by others including yourself. As a graduate civil engineer having over 30 years of project development, design and specializing in the control of project design budgets through construction I know for a fact that employee owned AEC companies attract the highest degree of motivated professional employees. Having worked for Bechtel upon graduating from college I learned early in my career that private ownership and/or employee ownership was the business model for success. I agree that your 8% (or more) retained ownership to the end of being the CEO would have made a difference.
    As SAIC moves into the future consideration to market more private sector work while still maintaining its GOV presence would be wise for many reasons………..
    Best Regards,
    William Kneeland, Oklahoma City

  • http://www.beyster.com J. Robert Beyster

    Corey: Thanks for contributing to my Xconomy.com blog. I wanted to make a couple of comments. You pointed out that companies you talked to think that about 10% of the equity should be shared directly with employees. I presume the other 90% is in an ESOP or some other vehicle. That’s a different approach than what we used at SAIC. I’m not sure how the system you’re suggesting works. It might be enlightening for me and for other Xconomy.com readers to hear more detail about what you have in mind. In the fifth paragraph you refer to a special class of stock. I think that’s a good idea. I would suggest 90% preferred and 10% other, unless there’s an ESOP, in which case that must be factored in. Good to hear from you Corey. Let’s stay in contact. – Bob

  • http://www.beyster.com J. Robert Beyster

    J: I agree with you that good governance is the key to preserving the ownership structure and philosophy that a company wants to maintain. I agree that the CEO should own preferred stock with possibly something like 10% ownership. This is not what I did, but it’s what I wish I had done. On bylaws, I think that this has to done by somebody who knows — in the case of employee-owned companies — how to build a bulletproof approach. Having the board approve the mission of the company of course is standard procedure. You must be absolutely sure, however, that each of the board members really believes in the company’s mission and values — for example, preserving employee ownership — so that when times get tough, the company does not sacrifice them. Regarding the selection of board members, I think that in my case I did not spend enough time trying to understand all the beliefs of the board members I selected — whether supportive or not towards our ownership culture. I found to my surprise and disappointment that many of them were not on board with me about this fundamental value and so the company was taken public after I left. – Bob

  • http://www.nceo.org Corey Rosen

    Bob –

    I should clarify in my comment about our experience with new companies giving out 10% of the ownership as a target that these are not ESOP companies. They are younger companies, and 10% is all the equity they plan to give out to employees at any point. The rest is held by investors and founders.

    There are a lot more details about the model we propose as an alternative for this approach in our book The Decision Makers Guide to Equity Compensation. In short, though, decisions on how much equity to give out are based on what percentage of compensation must be provided in the form of equity in order to attract, retain, and motivate people. These decisions need to be based on a sense of what people can get elsewhere, as well as on discussions with employees to get a sense of how much they expect.
    Rather than thinking about “how much” in terms of a total percentage of company shares or total compensation, it might make sense to use a more dynamic model based on performance. In this approach, the issue for existing owners is not “what percentage of the company do we own,” but “how much is what we own worth?” Owners in this model would rather own 10% of a $10 million company than 90% of a $1 million company ( notion, by the way, I learned largely from you). This notion can be made into an explicit plan by telling employees that if the company meets or exceeds certain targets, they will get a percentage of the incremental value created by that performance in the form of equity or something equivalent to equity, such as phantom stock. If the company exceeds its goals, then, by definition, sharing part of the surplus value leaves both the employees and the existing owners better off than they would have been. The targets can be anything—sales, profits, market penetration, or whatever else is critical to the company’s future.

  • http://www.beyster.com J. Robert Beyster

    William: This looks like the SAIC plan which I believe is to continue to emphasize the government business while avoiding risky commercial contracts. — Bob

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