Culture Trumps Money

“‘Cause I don’t care too much for money… money can’t buy me love.”  The Beatles from Can’t Buy Me Love

I think it is fitting to reach out to the Fab Four as we celebrate 50 years of their presence in the USA.  My one wish is that owners reflected on these simple words when they go to construct compensation packages… especially for their startup and emerging growth companies.

Salary, equity, bonus plans – Lord knows that I have had the chance to discuss loads of them with clients and prospects.  And, it seems new schemes are evolving every day.  When I am called in to advise on this type of reward plan, I can’t help but notice that there is usually something missing.  All of the talk is about crafting economic rewards; and very little is on the work environment or culture – the so called softer things.  Well, I am here to tell you, unequivocally, that spending time and effort on the culture you create is not only a best practice, but it can save you money in the long run.  Culture trumps economic reward and becomes a competitive advantage because you can’t create it overnight.  So, when you are fortunate enough to have it, you can win where others lose.

For students of management, I think this began with the famous Hawthorne Studies of Elton Mayo.  He started by installing brighter bulbs at the workbenches and saw productivity improve.  That seemed to make sense until he then lowered the wattage but still got improved productivity.  What Mayo found was that the workers thought that management cared enough to make sure they had the correct lighting – in essence it was the culture of caring and being part of a team that resulted in improved work output.  That simple concept has been taken to new heights by some of the great leaders of companies today.

So, given that culture works, how do you get there?  It is not easy but I think there are a few clues that may help you on your journey; and a good starting point is to realize it is a journey.

First, don’t view culture as a tool to improve productivity but rather as a core value of the environment you want for yourself and your people.  It should be a source of pride and comfort and should never be forced on people.  It has to develop from within your organization and can’t be prescribed.

Next, culture starts from the top and comes from the heart.  You have to be sincere and really want to share your vision of a culture.  A leader’s actions are multiplied a thousand fold when it comes to setting culture.  Your people will see right through you if you are trying to create something you do not truly feel in your heart.  It has to be part of your DNA.

Third, be honest with yourself and your team.  It is fine to have them see your pride when things go well and your disappointment when they don’t.  Please do not use that phony cheerleader routine to keep everyone in a positive state of mind regardless of the circumstances – it is “so over” as the kids would say.

Finally, be careful not to create a cult or sect type culture.  Laying out detailed principles which you drill your people on like thoughts from Mao (remember John Candy as Tom Tuttle from Tacoma Washington in Volunteers) does not a desirable climate make.  You get Stepford Wives behavior and you destroy your chance to develop a positive culture.

So, stick with these basic thoughts and most of all, have the patience to let your culture evolve and soon, you too will be able to share your success with all of us.

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C vs LLC – A Non-Technical Analysis

Colonel Sandurz – “Once we kidnap the princess, we can force her father, King Roland, to give us the combination to the air shield, thereby destroying Planet Druidia and saving Planet Spaceballs.”

Dark Helmut (to the camera) – “Everybody got that?”

One of the first questions I ask at the start of a new client relationship is about the current corporate form and how it was selected.  I am never surprised about some of the complex answers to this simple question, usually involving a combination of results from internet surfing, peer advice and some heresay – reminiscent to me of this great scene from Spaceballs.

So, if you are looking for a detailed legal/tax analysis of the differences between these two forms of organization, you can stop here.  These are just some practical pointers that I am passing along having dealt with this subject countless times.

Why an LLC?
This form is a great option for startups if you want to have the legal protection of a corporation, but a single level of tax.  The S corporation is another alternative but it has limitations that lead to the creation of the LLC which is much more flexible.  An LLC is the most common form of startup I see today.  So, some LLC pluses:
– One level of tax – (Partners – called members – pick up their share of income and losses on their personal income tax returns and there is no tax at the LLC level).  Owners who invest may be able to use losses to offset other income, so, it tends to work well for those who consult and use the money they earn to start their business.  This is particularly helpful in, what I call, the Ramen Noodle phase of your company
– Flexibility – Participation in profit losses or capital gains can be different (disproportionate) for each member
– Similar legal protection as any corporation
– Corporations and other entities can be members

Why a C corporation?
This is the traditional form of business practice in the United States.  It is well-recognized and lawyers are more comfortable using it.  Regulations are relatively well-established and case law is robust to deal with the issues that arise.  To me, there are really three common reasons you form a C corporation:
– Investors – An LLC can be an administrative nightmare for an investor.  So, if a fund has 50 or 75 investors, at the end of a year, when that fund is informed of its share of your income or losses (reported on the famed K 1), they have to figure out the amount to report to each one of these investors.  And, heaven forbid, there is some income and no cash (sometimes called phantom income.)  So, virtually all investors request that companies convert to a C corporation as a condition of their investment. With a C, there is no annual tax reporting to investors required
– Incentive plans – The structure for incentives, such as stock options, restricted stock, etc. are well known in a C environment so this structure is conducive to providing those benefits
– Potential tax savings – Qualified Small Business Stock is a relatively recent provision in the tax code which provides incentives for smaller companies.  Generally speaking, there are tax exemptions for certain gains from the sale of stock in a qualified corporation which is held for more than 5 years.  It only applies to C corporations and it has given me pause to suggest staying as an LLC for too long a period of time

One final note on tax losses.  Certain LLC losses are deductible on the tax returns of members but only to the extent of your basis – the amount you have ” invested ” in the business.  So, if you are starting up, your parents lend money to your LLC and you use it for certain early stage type expenses, you cannot get the deduction
(and if it is a loan, they cannot either).  One now has to weigh the benefit of this form versus moving into a C corporation where those losses are only available for future corporate income but, you can start the timeframe rolling for the QSBS exemption.

So, just some practical pointers on this subject.  However, I would suggest consulting an advisor before you decide what form to use now and in the future as your business grows.

Equity Pointers for Employees of StartUps

“Movin’ on up, To the east side.

We finally got a piece of the pie.”  The Jefferson’s Theme Song

I just spent another week having another dozen discussions with entrepreneurs regarding equity splits.  It is probably because I am a little slow to pick up but I realized that more than half of these discussions could have been avoided if the employees had been better educated about equity.  They work so hard to get a piece of the pie, but I am not sure they understand what they get.  Many of us spend our time guiding entrepreneurs on the difficulties of equity ownership that we never fully consider their challenge of explaining it to current or future employees.  So, I will try to help that cause.

While entrepreneurs have some common traits and core values, employees come in all shapes and sizes and from all walks of life with different capabilities and their knowledge about equity covers a pretty wide span.  So, here are some tidbits for owners to share with employees about equity:

  1. Hey, where were you when somebody had to write those first checks?  Most people know that if a business is starting to ramp up and requires investment, angels, venture capitalists and others command a relatively high price for investing in that growth.  Usually, the majority of that comes out of the owners “hide,” but what about the reward owners should get for their early funding of the business. Who took the risk to lay out the dough to get the Company to the point where there is something viable to bring to an outside investor?
  2. Why is equity so important?  I do not mean to imply that some form of ownership reward is not desired but equity is extremely difficult to deal with.  Let’s look at a couple of the challenges:
    • If the owner gives you equity at too low a price, you the employee can have a tax problem.  This requires coordination with professionals, obtaining an appraisal and other cool money and time commitments that may be better spent on the business.
    • Getting in is not as tough as getting out.  So, what happens if you have some type of ownership (stock options, restricted stock, whatever) and the Company does not sell or go public.  Where does the money come from to buy you out?  Just ask any banker how comfortable they are lending a Company a pile of money and watching it go out the door to former employees.  Not pretty, is it?
    • What about an alternative instrument?  This is the 21st century and there have been many great advances in other instruments which are equity like – they can provide you with liquidity and appreciation and come with a lot less bells and whistles.  Let’s face it, if the Company doesn’t go public or sell, your shares will probably not have significant value. Let’s be realistic.
  3. What makes you think a percentage point is not a lot?  For years, many venture capitalists and others financed deals and put aside 10% (or maybe 15) for the management team.  It is not unusual to have 5 or 6 members on the team (some more senior than others) so my advanced math skills tell me that averages to a couple of points each.

The purpose of any equity like plan is to motivate employees so why would an owner come up with a plan that is a disincentive for an employee.  It just doesn’t make sense.  Everyone is going to take some risk and a great reward is in place for those that succeed.  So, as Eric Schmidt the Executive Chairman of Google said, “If you are offered a seat on a rocket ship, you don’t ask what seat.  You just get on.”

Who Do I Leave My Business To?

Quote: Don Corleone: Well, Michael is now head of the family and if he gives his permission then you have my blessing.  Mario Puzo – The GodfatherMichaelcoreleon

This question is perhaps the most important decision for any parent who has owned a business.  Though ownership and leadership are often tied together, I want to focus on succession planning from the management… not the ownership perspective.  At times, other factors such as economics and estate planning may dictate successor ownership but it is the successful transition of management that allows the business to move ahead.

It is interesting to consider The Godfather as an example of succession planning.  If you recall this classic movie, no one thought that older brother Fredo (Freddy) was strong enough to be a leader and Santino was unceremoniously removed from the process.  However, even the Godfather stated that Santino would not make a good Don.  Michael was the strong, silent-type who effectively thought out strategies, was effective in execution (poor choice of words, here) and was able to command loyalty and respect.  These are some of the traits of a leader and that is what your successor should be.

Like many things in the business world, succession planning is a process and I have assembled a few pointers that may help you deal with it in your business:

  1. To start; are you ready to step aside?  As the current leader, you have to get yourself emotionally prepared for the fact that you will no longer be in charge.  Simply stated, if you are not ready to do so, I would not suggest implementing a succession planning process.
  2. Focus on the business.  This process should always have the major income generator front and center; a sustainable business that needs to continue to grow.  By design, this has to be an objective versus emotional process.  That is easier said than done when family is involved.
  3. Look for the leader.  In many cases, it is the person who has core values similar to yours even though their approach and methodology may be a little bit different.  It is those core values that will carry the day.
  4. Map out management, family and ownership and try to seek common ground.  Once you are out of the picture, these three constituencies will have to work together.  Consider that as part of your process.
  5. Don’t be afraid to use your gut.  In my experience, your true belief as to who you think will succeed has been right many more times that it has not.  Be careful of the advice of “influencers” who may only tell you what they think you want to hear.
  6. Use outsiders.  A close advisor like a board member, your accountant or your lawyer can bring an objective view to the process.  Good advisors are anxious to see the key economic engine continue to go forward.
  7. Finally, it is a process.  Keep in mind that it may not always go in a straight line but with some patience and structure, you will get there.

The success rates for succeeding generations are not high.  Studies have sighted the success of first to second generation transitions at about 33% and succession from second to third-generation at about 3%.  Not great odds, but, with a good process, some perseverance and the right intentions, you can beat those odds.  We help companies do it all the time.  Just think about The Godfather; it looks like he did just fine.