Private Company Concerns: Expanding the Equity Pool

This is the first article in a series about transitions and transactions for midsized companies authored jointly by Karen Albritton and Deana Labriola. Transitions & Transactions Logo

To Share, or Not To Share?  That is the question...

Creating ownership options for your leadership team can align interests, motivate performance and improve retention, but there can also be a downside. In this article, we address frequently asked questions about potential pitfalls when privately-held companies decide to expand ownership to a broader group of stakeholders.

What factors should be considered when deciding to expand ownership to a broader group of stakeholders?


First and foremost, an owner or group of owners should be clear on the reasons they find it necessary to give equity to other stakeholders (usually other internal employees of a closely-held business).  Our experience has taught us that most owners feel that giving equity is a natural way to retain employees and incentivize them to grow the business.  While that may be true, owners and employees receiving equity often don’t understand the financial and legal rights and obligations of that decision.  

Experience has also shown that owners tend to focus on this choice without fully considering other options. There are other ways to incentivize employees to stay without giving equity.  Because giving equity sounds like an easy and practical choice to keep employees engaged and committed to growing the business, owners often overlook several other good options.  Before making this vital choice, it is important to understand your other options, some of which can align the economic rights of the employee and the company nicely. 

Finally, we've seen owners underestimate the employee's inevitable change in circumstance. At some point, this employee, or the employee's family member or beneficiary, will want to monetize ownership. At this point, you will want to have options so the company can buy back the equity. Having well-documented and judicious agreements for equity holders within the company is key to a successful partner relationship.  But keep in mind, you as the owner should also be subject to these agreements.    

What happens if a once-critical leader becomes a less-than-stellar performer after they’ve gotten equity?


We've seen this happen time and time again. We have found that addressing the equity piece cannot happen without addressing performance.  This can be the most difficult part for many business owners.  Often, owners focus on the mechanisms by which to retain or recapture equity, but never address performance.  It’s actually best to reverse that order of conversation.   

The owner/President/CEO of any company has an obligation to provide rigorous performance management throughout the company. That starts with clear expectations about performance at every level, and then consistent follow-through on those expectations.  We are surprised by how many companies don’t have regular performance discussions, especially at the leadership level. So, the first step should be to establish clear expectations for this leader and have a schedule of check-ins to monitor progress. A strong performance management program will enable a company's leadership team to better analyze when it’s time to adjust roles and responsibilities, or perhaps take more serious action to address a serious performance issue.  We have seen it work best when there’s a discussion about what’s needed for the business along with a path forward that can be reasonable for the individual.

If the performance metrics can be improved, then keeping equity may be warranted.  If performance remains lacking, and there is no agreement that dictates how a buy-out happens, the best solution is a reasoned and thoughtful transition (and perhaps buy-out) of the leader.  This remains an “art,” and can be the most difficult situation for a company's leadership team. We have seen this happen multiple times in privately-held and family-owned businesses. Depending on the person’s age and experience, helping that performer transition into retirement or another, more suitable, position is ideal.  

As a leader, you also need to determine whether it’s warranted for that less-than-stellar performer to keep the equity even if he or she no longer works in the company.  There are plenty of situations when a former leader of a company is allowed to keep equity even after exiting the business.  Determine whether this is right for your business.  

Equity adds another level of complexity to performance management for leaders, certainly, but it doesn’t excuse poor performance. Ideally, the company would have the agreement in place to be able to buy equity from an individual if and when necessary. Owners will want to have both a good understanding of the value of the business and the right legal documents to support these situations.  

Should you establish and communicate different equity options for different roles?


This is where we have to give a "lawyer" answer to the question: perhaps.

With equity, we've found it is relatively easy to give on the front end, in comparison to the difficulty of re-acquiring it on the back end. As such, when contemplating the choice to give equity to anyone (in equal or differing percentages), an owner should understand how equity gets returned to the company, and create a mechanism for doing so. Further, there are tax consequences related to the receipt of equity by an employee, and it is important for the employee to understand these tax consequences and be prepared for them.  Understanding the impact on the employee of this event should weigh in the decision.

If an owner decides to give differing equity positions to differing roles, the business reason for giving those differing equity positions should be communicated in advance to all employees receiving equity (and perhaps some who are not).  The value of equity given, if different, places a natural value on that role relative to the business as a whole.  A Controller receiving 5% may believe he or she is (and may actually be) invaluable to the business at a certain point in time. However, the COO may receive more equity because that role will bring the business into the future, or allow the CEO to grow the business, and may warrant a 10% equity grant. Whatever the reason may be for differing roles receiving different equity positions, those reasons should be communicated clearly and in advance to all potential owners.

An owner should also consider whether there are non-equity options that can be available for the next level leadership, at least for some period of time.  Non-equity incentive compensation options include milestone-based bonus plans, phantom stock plans, and profit sharing plans.  All of these mechanisms economically incentivize key employees to grow the business, without giving equity, and the attendant complications that grants of equity may bring.  

How will a potential acquirer view a broader group of owners?


When the owners are engaged in the business and are part of a thoughtful succession strategy, a potential acquirer should view multiple owners as a positive. If there is an earn-out period tied to specific business milestones, having multiple members of the executive team with equity means everyone is aligned in pursuit of the same goals.  

In our experience, a potential acquirer usually views a broader group of owners as either neutral or a positive, so long as that broader group of owners is aligned on the mechanics, details and post-closing logistics of the acquisition.  In other words, if the broader group helps the acquirer steer the ship in the same direction after the acquisition, a broader group works.

However, if the group of owners is not aligned on the sale itself, or disagree on the details of such sale, an acquirer may not want to “buy” into a problem. Those dynamics can significantly impact the sale price. Additionally, the broader group can be difficult to manage if some of the owners will stay and other owners will transition out of the business immediately following the acquisition.  Clear and effective communication on the front end, before the sales process begins, is the only way to improve the chances that these situations won’t sink the sale.

Other article(s) in this series:

 

About the authors:

Karen AlbrittonKaren Albritton is a partner with the Newport Board Group, and consults with midsize businesses on marketing and corporate reputation management, strategic planning, driving growth, strengthening brand reputation, and driving business outcomes. Karen.albritton@newportboardgroup.com 

 

Deana Labriola is a business attorney with Ward and Smith. She regularly advises midsize companies in merger, acquisition, shareholder, and ownership matters. dl@wardandsmith.com

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© 2018 Ward and Smith, P.A. For further information regarding the issues described above, please contact Deana A. Labriola.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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