Carrot Equity

What Is Carrot Equity?

Carrot equity is a financial incentive in the form of company shares granted to a manager (or key employees) of a firm who meets specified financial targets or operational goals. Carrot equity is dangled in front of managers to encourage them to work harder to attain sales objectives or any number of financial metrics, such as earnings per share (EPS), EBIT margins, free cash flows, leverage ratios, etc., depending on the type of firm.

A manager could also receive carrot equity by achieving business milestones, such as completing the integration of a tuck-in acquisition, closing a divestiture of a non-core asset, or establishing factory operations in a new market.

Understanding Carrot Equity

Carrot equity is generalized to mean a non-cash incentive for managers of a company. This type of equity is offered at companies large and small, but it may be more important as a compensation tool at smaller firms or startups because the cash necessary to pay leading employees could be in short supply.

These managers are normally attracted to the financial upside potential that equity presents. The payoff of equity can be much greater in the future than a routine salary. When properly structured, a compensation plan that includes carrot equity can create powerful incentives for managers to work hard, make wise decisions, balance short-term imperatives with a long-term strategy, and act as responsible corporate citizens.

The overall goal is to tie the success of the manager to that of the company. If the company does well, then so does the manager. If the company fares poorly, then the manager will not realize many benefits monetarily, regardless of how hard they worked.

Carrot Equity and Ownership

An area of concern for smaller companies is providing too much equity to a manager or managers that would give up a significant portion of control of the company. For example, the founder of a startup might bring in a CEO after a few months, relying on the CEO's experience and knowledge to take the company to the next level. The founder may have had the idea but not the know-how to run a company.

As a form of payment, the founder gives the CEO a percentage of equity in the firm. As long as the percentage is small, the founder is still able to keep control of the company, have the final say on decisions, and steer the company in the direction that they had initially envisioned.

If a founder gives up too much equity, usually over 50%, or even less, they may run into difficulty in keeping entire control of their company, as now other managers have a majority or hold a significant share of equity, where they may seek control and a direction that is different to that of the founder. The amount of equity that should be given up is a fine balancing act.

Special Considerations

Stock options and performance-oriented restricted shares are two common types of carrot equity. Such awards to "named executive officers" (NEO) are tied to key financial targets or specific near-term business objectives.

A firm's proxy filing (SEC Form DEF 14A) contains, or should contain, a description of the objectives that would lead to the granting of the equity to the NEOs. An investor studying a carrot equity plan should be mindful of whether it is too generous to the executives.

Excessive equity grants for meeting low hurdles, for instance, is suboptimal from a performance standpoint; moreover, it tends to cause unacceptable shareholder dilution. Appropriate amounts of carrot equity for reasonable financial or operational targets are part of good corporate governance practices.