Exploring the idea of equity for key individuals in the business is today a common topic of discussion. While there are stories of success beyond expectations, there are also stories of epic failure. Equity is not the only option; before you do go down this path you need to be aware of the pitfalls and possibilities. John Knight explains.
When people start talking ‘equity’ they are typically considering the issue of legal equity in a business – usually shares in a company or units in a unit trust.
Once an employee has a legal interest in the business they have a definitive entitlement to the profits and capital value. They share in the lot – whether paid in cash or not. In the case of a company, shareholders have a number of legislated rights, including the ability to request financial statements and an audit if they own more than five per cent of the shares.
A minor shareholder can be a massive nuisance if the relationship does not end positively. It can end up costing a fortune to get rid of the shareholder – not only in dollars to pay them out on exit but also in time and distraction. A solid Shareholders’ Agreement should always be put in place to dictate not only how the business should be operated but what would happen if one of the parties needs or wants to leave the relationship.
However, introducing the right people as shareholders at the right time can have an extremely positive impact on the business. Benefits include:
- Retention – although you should not just issue equity for retention purposes
- Engagement – the individual may feel more ownership in the business decisions
- Reduced reliability on principal – acceptance of new responsibilities from existing principal can free them up for other opportunities
- Succession – could be a big step in a potential succession strategy
- Corporatising the business – encourages a more corporate approach to how the business is run, e.g. board meetings, dividend policies, approval processes
- Unlocking some of the equity – allows the existing principal to be more aggressive with the balance of the value in the business.
Overall, it is a great thing to consider if it would enable you to make the growth opportunities a reality, like opening a new office or division.
Issuing equity straight up is not always the best option, though. Often we advocate a stepped model that involves getting to know each other better before ‘jumping into bed’ together. As an alternative, while you are getting to know each other better consider stepping through some of the following as a way to achieve some of the above benefits before issuing legal equity.
- Skills development: Simply investing some time to develop the individual’s management and leadership skills could identify whether they have the ability and aptitude to be a business owner.
- Title and recognition: Promoting someone to a more senior position (e.g. sales manager) can provide the title and recognition for the individual, but it can also let you see how the individual now deals with the new responsibilities.
- Broader bonus structure: Implementing a bonus structure that rewards the individual’s contribution to the overall team, rather than just their own sales, can give that individual more leverage and also promote a broader view of the team.
- Profit share: Essentially a bonus structure, but a much deeper relationship that will promote discussion of the holistic business considerations and at the same time reward the individual for their contribution.
- Shadow equity: Essentially this is a legal commitment for the individual to be treated as if they have equity, but all amounts paid are still taxed like wages or bonuses. Shadow equity can work very well when the key person is responsible for growing a rent roll or when it is difficult to transfer equity tax effectively.
A new shareholder, and the new energy they can bring, could be just what your business needs to catapult it to the next level. The key message, though, is don’t jump in too quickly without first laying down the foundations for the relationship and testing the individual’s skills and abilities to step up.
