Here’s an insight for fairness: Always separate payment for work from equity ownership. I posted arguing with partners over compensation earlier this week, dealing with a real problem in a real company. I got a follow-up question to that today, offering more detail and asking for more detail in return. It’s messy. It also looks like a good illustration for the rest of us.

So hypothetically, assume four people named A, B, C and D. They each have exactly 25 percent ownership in the new company. They are all working in different ways, but one is semi-retired and doesn’t need compensation, another has been working a lot at night and is keeping their day job, and two others have no other income and want to get paid. The argument is whether getting paid for your work should reduce your equity share. Literally, the question is:

Partnership has not agreed yet on compensation levels for all, only for equity levels for partners. Should those receiving monies have their equity levels reduced and shared among remaining partners?

The right way to solve this problem is to have foreseen it and agreed what to do and gotten it in writing. Point one here, and this is me advising you, reader, so you don’t make the same mistake, is read my three vital rules for early-stage equity ownership from last month. The executive summary of that is: “Get it in writing.” It’s too late for these four because they’re already in operation. But I advise you not to get into similar messes caused by not talking these things out ahead of time. Apparently they divided up the ownership very carefully, but they didn’t specify who gets paid and who doesn’t. That’s really tough to deal with after the fact. It would have been much easier beforehand.

Ah, but in this case it is already too late for what they should have done, and they asked me to offer some advice on what they can do now, not on what they should have done earlier (that should-have component is for you, not them). So here’s what I say they might do now (As a disclaimer, I don’t know the people and I have just a description in e-mail; I’m making recommendations as an entrepreneur, not as an attorney or an accountant. This is hypothetical and sketchy):

  1. Ignore equity ownership for at least enough time to have a good, honest discussion about what salary levels should be for all four jobs. Be fair and honest, and take into account market values for jobs and what it would cost to recruit somebody with no equity ownership to do the job. Set salary levels for all the owners’ jobs. For those who are working hourly or part time or after hours, let them record their hours. You have to separate ownership from compensation for work. In your case, that starts with establishing who’s working how much. You don’t just ignore work.
  2. Don’t let anybody work for free. That’s bad news. Businesses need numbers that reflect reality, and when you have owners working for free you are creating false numbers. It also breeds unfairness and resentment. Ideally you find a capital contribution to give the company working capital to support its expenses. Can all partners contribute equally? If not, then give the partners who contribute more money more ownership. Keep it fair, in writing and agreed upon in the beginning.
  3. If you don’t have the money and can’t raise it to pay people for what they do, which leaves working for free the only option, you still have to record the value and keep track of it as money owed. And you have to be very careful with how you handle the bookkeeping and the tax implications. If it weren’t for tax law, you could book the work value as an expense for one side of the double entry, and as a debt–owed by the company to the person who worked for free–on the other side of that double entry. So if the owner’s work is worth $4,000 per month, you record $4,000 as a debit to payroll expense and $4,000 as a credit to liabilities. Unfortunately, tax law is there, so you have to be very careful about the tax implications. You can’t report unpaid wages to owners as an expense. And the tax man wants payroll taxes, too, from the company and from the employee. This takes some professional help to get you through it.

This, by the way, is why I often cringe at the phrase “sweat equity.” Real sweat equity is what you build in your own company when you work it alone. As soon as other people are involved, working for free causes a lot of problems. It fouls up your numbers, which means you have a distorted view of the business. It can also cause a lot of tax problems. What’s more, investors don’t like it, either.

Tim BerryTim Berry

Tim Berry is the founder and chairman of Palo Alto Software and Follow him on Twitter @Timberry.