Equity Plans Part I – The Sooner the Better

“The time has come, the time is now . . . ” quote from the book “Marvin K. Mooney Will You Please Go Now!” by Dr. Seuss

Hopefully many of you remember this fabled line and for me, it is what comes to mind when I think of the right time to finalize most equity plans. (I am using equity plans to cover anything which resembles ownership – from stockholder agreements to shadow equity plans.) Sooner is almost always better as delays always seem to have unwanted complications. To confuse matters further, my next blog is Equity Plans Part II – Are We There Yet? So before you conclude I have probably gone off the deep end (a concept constantly reinforced by my family) let me begin with a true story.

In the early 90s, leveraged buyouts (or LBOs as they were known) were the rage and I participated in my fair share. I was called in to help one group of four very qualified managers who were buying a half dozen plants from their parent company. The four covered different disciplines and were great at what they did – – they were just lacking in the skill set needed to buy and set up a separate company / operation. So we focused on the deal for about three straight weeks; long days with hard tasks and two days before closing, the five of us went to lunch. I brought up the subject of equity plans and shareholder agreements among the four. The CEO let me know that considering what was pending, bringing this up at that time was the “dumbest thing he ever heard.” I backed off but shortly after the close, I persisted and we finalized the equity plans. Six months later the CEO called with the heartbreaking news that one of the four had passed unexpectedly. While distraught over the loss, he came to appreciate the fact that all settlements related to ownership had been concluded during a less emotional time and he came to appreciate that fact.

Here is another situation which highlights why it is best to conclude on any equity plans as early as possible. Going through a transaction is stressful, and I have had a handful of situations where trying to finalize an equity type bonus when a sale was pending almost cratered a deal. Owners see the chance at monetizing their lives’ work becoming a reality while key employees believe they were responsible for creating that value and should be rewarded. Incentive and reward plans go from a thank you with benefits to a hard fought negotiated settlement and at times, transactions suffer. All of this stress can be avoided by addressing this issue earlier in the process when a sale is hypothetical and parties are more prone to have a logical view of how an equity plan should work.

So the punchline is that when you have concluded on the sharing portion of any equity plan, be it shares in the company, options, stock appreciation rights, etc., then the time is right to finalize the plan and complete the documents to avoid the hardships and risks that delay can bring. If you are an owner thinking of this issue, the time is now to address it.

It Does Not Say That; Does It?

It Does Not Say That; Does It?

“The devil is in the details.” – quote with various attributions

As I reflect on what has been keeping me so busy these last few weeks, I realize that there are three problem situations that have their roots in owners not fully understanding (or reading) certain underlying documents. Now I know everyone is busy and all of us have been guilty of asking a more knowledgeable advisor, “What does the document say?” Fortunately, in most cases, we get a complete picture but in many cases, there are some final changes added that the owner may not see (there is something called “deal fatigue”) so they do not do a final read. So let me highlight my three recent situations.

In the first, I was asked to review an equity option plan and stockholder’s agreement for a prospect that was a growing company. As one of my hot buttons is any provision which requires the Company to provide liquidity to the option holder, I asked if there was such a provision and the CEO was adamant that he would never provide for it but there it was in the agreement. It clearly stated- – if an option holder exercises and leaves for any reason, the Company has to buy back the underlying shares at the then fair market value in cash within 90 days.

In the second, a buyout agreement between two shareholders of a very profitable and growing prospect required the surviving shareholder to buy out the deceased shareholder’s interest at full fair market value. What made this standard provision very unusual was that it stated any shortfall between fair value and any life insurance proceeds would be covered by a full recourse note with short payment terms. In a call with one owner and the current corporate attorney regarding this agreement, that current attorney was incredulous and used some choice “legal terms” to describe his reaction.

Finally, using a combination of informal legal advice and documents obtained off the internet, two shareholders in a startup filed incorrect 83B elections in addition to creating some major tax problems with the timing and incorrect data on various formation documents. The situation as described to us was fine; unfortunately, the underlying documents bore no resemblance to what was intended.

We were able to find solutions to each of these situations, but that is not always the case. So some simple advice to all entrepreneurs. Documents, especially those related to ownership, should never be signed without a reading and thorough understanding of what they say. There are no stupid questions in this area; and ignorance can really cost you. And if legal counsel tells you when to sign something; sign it then and not later. Many documents are time sensitive and while it might seem like a small issue, if it is ever challenged, you will find that what is documented is what is considered done and the devil will be in those details. Please do not let them come back to haunt you.

Change of Control – Revisited

Cardinal Ximinez: “Nobody expects the Spanish Inquisition! Our chief weapon is surprise, surprise and fear, fear and surprise. Our *two* weapons are fear and surprise, and ruthless efficiency. Our *three* weapons are fear and surprise and ruthless efficiency and an almost fanatical dedication to the pope.” – Monty Python “The Spanish Inquisition”

I have seen my fair share of situations where change in control provisions in agreements resulted in unintended consequences. Until recently, I thought their sole purpose was as the name implies and as Curly said in “City Slickers,” “One thing; just one thing.” But maybe as the Cardinal suggests, there is more than one thing. Let’s look a bit more closely.

Every smart business owner knows his most valuable assets walk out the door at the end of each day. Most owners like to retain key employees and enter into employment agreements that among other things, provide for incentives (many of which vest over a period of time) that are protected, should the owner or owners no longer be around. This standard solution is known in plain English as a “change in control” provision. What this normally provides for is the acceleration of any vesting or even liquidity provisions of any incentive provisions for the key employee in the event the current owner no longer has more than 50% (usually) of voting control in the company. Everything seems fair so far; what is the problem?

In case one, I was asked to consult with a company that had a key employee that was promised an incentive payment in the event of a change in control. That provision was triggered when the Company was sold to a “strategic” but the Company took the position that they had accepted a lower sales price in return for the key employee being offered a position with the acquirer, thus they did not owe the incentive. While both sides believed their case had merit, the ambiguity created years of turmoil until we helped to resolve it.

In the second situation, an acquirer had issued an LOI for the purchase of one of my clients. During due diligence, they realized that the resulting change of control provisions would substantially “enrich the lives” of all the key management members, and they were sufficiently concerned with their motivation after the deal that they almost walked away. Fortunately, a solution was crafted which all found acceptable.

So just when I thought the key provision in an employment agreement with an incentive was a change in control, I have come to realize that it should be accompanied by a well-defined “continued employment” provision so both the team member and the company do not suffer unintended consequences when there is a change in control. Negotiating them at the start when both sides are not under the pressure of an impending transaction is also very helpful. I am starting to see these provisions in some recent transactions and strongly encourage their use. As the Cardinal said, the two key provisions are…

Kids in the business- Can it work?

“Kids suck” quote from James Beaudette – my very close friend

Jim and I have been friends for over 30 years. We first got to know each other when we began coaching our sons in soccer and our relationship has grown since then. We each had three children and many conversations would inevitably turn to something one of our children had done, which we would both find hard to fathom. The conversation would usually end with Jim stating his conclusion which we both share.

After 40+ years of consulting with family businesses, I could tell you stories about children in my clients’ businesses that would make your head spin. Some had unbelievable success; some abject failure; some were responsible young adults and others entitled brats, I have seen it all. I would almost be embarrassed to tell you how many times I had to lean in to a parent or parents and confide what Jim had taught me long ago.

But out of these experiences came some valuable advice on how to handle kids in the business. Now some of this will sound like motherhood and apple pie, but I have found that it does work. So here are three pointers.

The first is, family is family and business is business. I watched a young son take a $20 million business to over $1 billion in 20 years. Two young brothers who had worked part time in a business stepped up when their father passed away and turned it into one of the leaders in their industry. I also watched two brothers who were in dispute over leadership resolve their differences by craftily splitting the business resulting in two household name consumer products companies. The common theme here is while they shared that important bond of family, they never let family issues blur what they had to do for the business. It was appropriately striking this balance that resulted in each of their successes.

The next is when kids are in the business, be honest with yourself and your children. This is most important when you face major milestones and one that comes to mind is succession planning. I have done more than one succession plan where the end result of my work was that the oldest sibling did not become the heir apparent. They all ended with both successful transitions and with all talking to one another at Thanksgiving. I would love to take credit but it was the direct result of honest dialogue about the objectivity of the process and the importance of keeping the business sustainable. I have also walked away from assignments where the parents wanted me to “anoint” a family member as the next leader. To quote “In Living Color“, “Homey don’t play that.”

Finally, know the difference between being a mentor and being a parent. This is perhaps the toughest task of all. Too many parents make decisions as a supervisor (in one case to support the project a daughter was proposing that had little merit) with their parent hat on versus their mentor cap. This can enable bad behavior, lead to the ill-fated “bosses kid” syndrome and doom your child to failure. So while I am sure that on occasion you will reach Jim’s conclusion about your kids, try to be disciplined and follow some simple rules and you will find kids in the business can work and your family business will beat the odds of next generation success.

Your Business Plan; Are You Making a Living or a Killing?

“Go ahead. Make my day.” Harry Callahan (Dirty Harry) – from the movie Sudden Impact

I get the opportunity to see a good number of business plans / pitch decks each week and I focus on the section of the plan I believe is most critical. While some may believe it is the management team or barriers to entry; to me it is the financial projections. So at this point, you have to be saying, “Of course; he is a CPA. What is so surprising about that?” The truth is, there is no other place in a pitch where one can get a better picture of the “directional indicators” of a plan. Please allow me to explain.

Years ago, a colleague of mind was tired of working the long hours at our firm and wanted to become his own boss. He bought a Basking Robbins franchise. He accomplished his objective; he still worked long hours but now he was working for himself. However, at the end of the day, all he did was replace salary with small business income; from a financial perspective he was still just making a living.

If you are doing a pitch before investors, remember they are focused on high rates of return; getting their money back in multiples of what they invest. They are looking at what we euphemistically call “making a killing” and they are looking for you to “make their day” by showing them how. So where does the projection fit in to all of this?

First, what is the size of the opportunity in your eyes? If your projections show that in five years, your revenues will be $5 – 10 million, you cannot make enough money to attract most investors. Please do not get me wrong; growing a business to this size is a real accomplishment and can be financially rewarding. It is just not a killing.

Next, does the financial model follow the plan? If the plan is a SaaS model with monthly subscription payments, revenue is simple; multiply the expected users by the planned fee and that should be revenue. So now I can see how many users you expect to have (market share) as well as the monthly payment (market price). I can also look at how you plan to get to that level of users.

Finally, are the projections logical? If your margin or operating costs are substantially different from competitors, do you explain why or are you just plugging numbers to provide a financial result some online advice indicated was what investors want to see? It is a simple logic test that many fail on a daily basis.

Shakespeare said, “The eyes are the window to your soul,” and I think your financial projections serve the same purpose as it relates to your plan. So after you get done “crunching the numbers” please step back to see what they really say. There is nothing wrong with creating a nice profitable business model that might allow you to make a very good living for a long period of time. I have had hundreds of successful clients who have followed that path. Just keep in mind how this approach has to “step up” if you are looking for that investor who wants you to make their day.

Ownership Style Options for Key Employees

“I don’t like your cuffs, I don’t like your cuffs, I don’t like your cuffs . . . .” Line by Béarnaise from Mel Brook’s History of the World Part I.

When I begin a conversation on ownership type incentives with owners of early stage companies (and mature ones as well), my typical approach is to discuss the pros and cons of various instruments or techniques. I discuss stock options, restricted stock, phantom plans, profits interest (if an LLC), stock appreciation rights, ESOP’s and the list goes on and on. Inevitably, many instruments are met with disdain much like Béarnaise assessment of Count de Monet’s wardrobe in this famous scene. I must admit in most cases I “feel their pain.”

There always appear to be two challenging issues; the first is offering liquidity and the second is taxes. So let me add a little color to each. First, it appears few entrepreneurs are willing to write a check to buy out a partner / employee / shareholder when they need that cash to grow their business. For a sizable amount, bank financing is not a viable option and introducing a private equity player or sponsor is another kettle of fish. Second, spending an inordinate amount of time structuring the best tax position is not always worth it as it is usually the buyer of the company who will determine tax structure. Simple point; we advise that if you are dealing with a Company transaction, you buy assets and sell stock. Since you can’t have it both ways, if a good deal may not be a great tax deal, you will probably still take it. So what to do?

I have used a technique I call an Equity Bonus Plan for a number of years. It has a handful of simple components:

  • It only “kicks in” at the time of sale or IPO: in other words, a liquidity event;
  • You determine in advance a “pool” you will set aside upon achieving certain levels of net proceeds to the owners. Doing it early avoids emotional quagmires;
  • You allocate the pool to employees you choose. Some choose to select key people who will drive the business; others use the “chicken in every pot” method and set aside something for all;
  • Employees vest and have to be employed at the time the transaction is executed; there are also some protective provisions;
  • You can communicate what each person gets based upon certain proceeds without revealing financial results.

This plan has now been popularized (I might say plagiarized but imitation is the sincerest form of flattery) by Chobani who announced earlier this year they were adopting a similar plan. (I sound like Al Gore saying he invented the internet.) Though details are a bit sketchy, it appears it will follow a similar path. The liquidity issue becomes a moot point and while proceeds are taxed using ordinary rates, tax payments coincide with the receipt of cash.

It’s Time to be a Shareholder Not a CEO

Max Bialystock: “So you’re an accountant, eh?”

Leo Bloom: “Yes sir.”

Max Bialystock: “Then account for yourself! Do you believe in God? Do you believe in gold? Why are you looking up old lady’s dresses? Bit of a pervert, eh?”

Dialogue from the Mel Brooks classic “The Producers.”

A few years ago, I was working with a long-time client who followed a very democratic process when dealing with his senior management group who also had ownership through an ESOP. There were 5 key management members but the CEO would really not make a move unless he had unanimous agreement. The company had grown nicely in 20+ years but had started to plateau. The CEO approached me about getting an outside board member. He knew things had to change, but he was not sure what to do and felt some independent insight might be a solution.

A couple of years earlier, the CEO of one of my clients had sold (I can do a whole blog on that story), and he was looking for a board seat. While both CEO’s were highly technical (PhDs from top schools), the one who sold was more aggressive and I was reluctant to introduce him into this very democratic environment. After warning both sides, I arranged a dinner. The client who sold asked for some basic data and was very prepared. After exchanging some small talk, the potential board member began interrogating my current client. His basic line of questioning was simple; why was the democratic CEO not acting like a shareholder and avoiding decisions that could increase shareholder value? Did he not realize his fiduciary responsibility? The above noted dialogue came to mind and there wasn’t enough room under the table for me to hide; and after dinner, I felt I had to apologize to my current client for my experiment. To my surprise, he looked at me and said, “Your guy is right; we have to change our point of view.” Long story short; my former client ended up joining the company and becoming a change agent, including helping them with a successful IPO.

I tell that story because I recently met with a good friend of mine who is a middle market investment banker. In many ways, we see the same issue with the need to change the mindset of many of our owners so they can take the steps to maximize the value of their company, especially if they are thinking of an exit. The most successful solution is to build a strong management team who can take over. We both agreed that while our roles were different, getting CEOs to think like shareholders was a key part of what we had to do to help owners. This is especially true if the CEO is perceived as being one and the same as the company. Getting this point across is particularly hard when CEOs point to others who have tried it and failed. Steve Jobs and Apple come to mind.

So as in all things entrepreneurial, it is not easy. You have to stay involved sufficiently to help ensure your vision is executed but not so involved that you are seen as the only one who can run the show. As another good client of mine always said, “Says easy; does hard.” So all I ask is when you go into the office tomorrow, ask yourself if you are acting more like a CEO than a shareholder. Realizing there has to be a change is the first step on the road to your goal. This client (and others I had) did and had great success. With the right mindset, you can do the same.