As a business evolves, it will encounter the need to build credibility with outside parties, such as investors and lenders, and to make well-informed strategic decisions. In short, financial...Read more »
Entrepreneurs Sharing Ownership
Times have been tough…your employees have gone several years without raises. You are concerned that some of your key people may start looking around as job prospects improve. Even if you’re not worried about them leaving, you may have a paternalistic streak that makes you want to “take care” of your key people. But in this tenuous, tentative recovery you really can’t afford to increase salaries and cash benefits.
A brilliant idea strikes! Give or sell them a piece of the company! That won’t cost you any cash now and it will allow them to share in the growth of the business. Your interests will be aligned and everything will be perfect…
Not so fast. Let’s think about what might not be perfect:
What is it worth, anyway?
If you give away an ownership interest, what you are really saying is that your business isn’t worth anything. If that is not the case (and we hope it isn’t) then your gift (or a sale for less than fair market value) is really taxable compensation to the employee. And they will not receive any cash to pay the taxes on that value…not exactly a motivating transaction.
OK, then you can sell shares for a very conservative estimate of fair market value, and give the employee a loan so that she can pay for the shares over time.
Two problems here: first, the employee needs to come up with cash for the annual interest, and ultimately the loan principal. Second, having a documented low value assigned to your business can work against you if you ever need to obtain outside capital. Why give a potential investor or buyer a low reference point to bargain from?
Congratulations, you now have a partner!
And that partner may have a different view of the world than you do.
That charitable event that you sponsor every year that adds very little benefit to the company; the relative you pay a little more than he really contributes; the vacation that coincides with the annual trade association meeting.
When the cost of these items reduces the company’s profit, and you are the only owner, you impact no one but yourself. With a partner, however, a little piece of each dollar comes from your partner’s pocket…and that might not make him or her happy.
What have you done for me lately?
Yes, Bobby has been with you for 10 years and he has been your right hand person for most of that time. But things change, and today’s superstar can be tomorrow’s second tier performer.
Maybe the business has gotten too big or complex; maybe Bobby has family or health problems that have impacted his performance. In any event, it is time to hire a new right hand person, and let Bobby do the things he did when the business was smaller. If Bobby has a 5% ownership interest, what do you need to give the new employee…10%? Suddenly, you are sharing ownership in a big way.
Of course, there are cases where sharing ownership makes sense, especially in conjunction with a transition of ownership to the next generation of a family. Using ownership as a form of compensation, however, can introduce a lot of issues and unintended consequences.
In our experience, it is always possible to create a combination of short-term incentives and some sort of severance or change of control agreement to provide key employees with “owner-like” benefits without actually sharing ownership.
If you would like to discuss compensating key employees or anything else related to your privately held business, contact Doug Jones, Director, Fahrenheit Finance at firstname.lastname@example.org