Employees have a cost of capital too (don’t they?)

This article builds on some of the themes explored in a piece co-authored for the publication Corporate Financier, which you can read here.

Boards understand cost of capital instinctively: higher risk demands a higher required return. Reduce risk through structure, protections and credible information flows and capital becomes cheaper.

What boards rarely quantify is that employees apply the same kind of pricing logic to equity pay.

Not in a textbook “WACC” sense. Employees aren’t setting the company’s market cost of capital. But when you ask an employee to take illiquid, employment-linked deferred pay instead of cash, they apply a required return to compensate for risk, time and uncertainty.

That required return - the risk premium employees demand to hold equity-like pay - is what I mean by Employee Cost of Capital (ECC).

A simple example (and the problem in plain sight)

A senior hire is asked to trade £100k of cash today for equity pitched as being “worth £200k at exit.” From the board’s perspective, this looks generous - a 2x headline multiple.

From the employee’s perspective, it looks very different:

• Uncertain timing
• No guaranteed liquidity
• Limited disclosure
• Leaver risk
• Concentration risk (job and wealth tied to one issuer).

The employee does not price a single number. They price a probability-weighted outcome over time:

• Best case: materially more than £200k.
• Base case: around £200k.
• Downside: close to £0 if performance disappoints, the exit slips, or they don’t reach liquidity.
• Plus the realistic scenario that “four years” becomes five or six.

Once you price time + probability + leaver + dilution, the “£200k at exit” headline rarely feels like £200k to the employee.

You can describe ECC in two equivalent ways:

• as a haircut to headline expected value (“I don’t believe £200k is really £200k”); or
• as a higher required return / hurdle that produces that haircut.

Different language, same pricing behaviour.

Even if the employer says “this is the base case”, many employees assume they are being shown the optimistic case, because they cannot independently validate it. They then discount for that trust gap.

Nothing has malfunctioned. The equity has simply been priced as risk capital by the employee.

So what is ECC measuring?

ECC is not one number and it is not universal. It varies by cohort.

Some employees (particularly earlier-stage cohorts) can overvalue equity as a “lottery ticket”. But experienced executives and high-calibre lateral hires discount aggressively because they have seen:

• exits delayed, repriced or abandoned;
• heavy capital stacks eating the employee equity outcome;
• discretion used unpredictably on leavers and valuation;

ECC shows up in observable market behaviour:

• higher fixed pay demands;
• sign-on inflation and make-whole requests;
• reluctance to accept headline equity values at face value;
• retention cliffs around vesting;
• persistent scepticism unless disclosure and liquidity opportunities are genuine.

You don’t avoid ECC by ignoring it. You pay it elsewhere - in cash, dilution, churn or hiring friction.

When employees believe equity (and when they don't)

Equity is valued more highly when there is an external proof point. In later-stage / secondary settings - where there is already a good story about a previous exit or secondary - belief is higher. In earlier-stage situations, it is often only the senior team (closest to the numbers, with more control) who value equity at the level the board hopes.

Why employees price equity more harshly than investors

Employees are typically:

• liquidity constrained;
• information poor relative to insiders;
• exposed to employment termination risk and governance discretion.

They therefore price additional risk premia and the capital structure reality really matters.

In leveraged or sponsor-backed structures, employee equity is invariably a residual claim behind:

• debt;
• preference instruments and fixed returns;
• leverage-driven return dynamics;
• ratchets, strips and waterfalls that can materially reshape outcomes.

Employees may not model the waterfall, but they still price the uncertainty. 

There is also an optics point: private equity is often associated with “financial engineering”. If participants don’t understand the stack, they become suspicious of it and suspicion is priced brutally.

One of the simplest credibility builders is alignment: employees value equity more highly when they can see they are invested genuinely in line with the CEO (same instrument, same economics, same exit).

What “good share plan design” looks like through the ECC lens?

If employees price equity like risk capital, design is no longer primarily about “more equity”. It becomes a compensation efficiency question: are we buying motivation and retention by increasing expected value, or are we paying too much because employees apply a large risk premium?

Often the cheapest win is not a bigger grant. It is lowering the employee risk premium, so the same equity is valued more highly.

The employee risk discounts and the levers that actually move them

A practical way to use ECC is to break it into components and design deliberately against each one.

The 2026 angle: liquidity and the new governance burden

As private markets develop more structured secondary liquidity, equity plans stop being “set and forget” instruments and start looking like micro-markets.

That can reduce one component of ECC (liquidity risk), while increasing the premium employees place on disclosure and governance, because the moment equity becomes tradeable, fairness becomes a design obligation.

If you open any internal or semi-internal market, you inherit market-like expectations:

• A disclosure framework and internal controls.
• Dealing windows and insider-dealing protocols.
• A valuation narrative that is consistent and explainable.
• Employee education.
• An escalation route for disputes and perceived unfairness.

Liquidity can lower ECC, but only if paired with credible information and governance.

Bottom line

Equity incentives fail less often because of tax or valuation and more often because employees price risk differently to boards.

If you want employees to value equity closer to face value, you should be able to answer the following:

• What do participants know, and when?

• When can they sell, and how does it work in practice?

• What happens if they leave in various foreseeable scenarios?

• What does the capital stack and waterfall really mean for their equity?

• How do we remove funding and withholding friction?

• Where is discretion used, and how is it constrained and documented?

• Are participants genuinely invested in line with the CEO?

Better design does not mean paying more. It means reducing the employee risk premia, so equity has genuine traction as pay. 

At Burges Salmon, we help clients design equity incentives as a complete operating model - legal, tax, governance and liquidity-readiness - so awards are credible in the market, not just “market standard” on paper.