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.

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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.