You have heard the old adage “be careful what you hitch your wagon to.” As business owners this is extremely wise advice for those who are contemplating extending ownership to one or more employees. It is tough to know when and to whom extending the offer of purchasing shares (or interest) of a company can be beneficial and when it can be down-right nasty.
I come across business owners that are looking to extend some sort of ownership to key employees all the time. They desire to tie key personnel to the company for the long-term (also known as the “golden handcuffs”), find out how deep their loyalty lies, and/or drive company value by incentivizing key employees. The problems arise when it is not done correctly and the business owner “hitches the wagon” without the proper care and forethought.
Here is a simple example of big problems that can arise from haphazardly awarding ownership to key employees. James has been working at the electrical company for a couple of years. As lead estimator, his position makes him pretty instrumental to the success of the company. To keep him engaged, the current ownership elects to extend 3% ownership to James vested over 3 years. These years go by and James begins acting like he is one of the majority owners by bossing non-reports to do things out of his area, failing to submit vacation requests and skirting certain company policies. The company grows, not really because of James’s hard work, but because of ample opportunities in the marketplace. Soon, the majority ownership is ready to sell the company to a third-party when the value is at the peak. Unfortunately, James is not too big on the idea of working for someone else. He begins to throw up roadblocks and engages a lawyer to invoke his rights as a minority partner. He begins requesting all the financial books and records and demanding he be present at all shareholder meetings. “Doesn’t he know he just owns 3%?” the other owners wonder. The ownership quickly finds out that they will not be able to sell the company without the “fly in the ointment” being abated. He had them backed in a corner and knew it. Eventually, the company had to shell out an unnecessary $100,000 payment to James to settle the dispute plus they lost substantial value in the sale of the company.
What went wrong? How did this “benefit” turn out to be a huge hindrance?
1. The majority owners offered ownership to someone that a cash incentive plan may have been a better choice. There is no doubt that no one has a crystal ball to see how minority ownership will change someone’s behavior. In small firms with less than a handful of owners, there is a potential for a toxic combination when an employee that holds a key position also has minority ownership. As a mentor of mine taught me, there is a difference between ownership percentage and the organizational chart. A minority owner must be mature enough to understand the difference.
2. The owners made no provisions to buy back the stock in the event the employee needed to be terminated. Most of the time, business owners look at transactions like this through rose-colored glasses. They cannot imagine what can go wrong by, quite literally, giving an amazing ‘gift’ to an employee. As you have seen in the previous example, many things can go wrong; you must prepare for the worst and hope for the best.
3. There was no mechanism for fixing the value of the stock in the event of repurchase. Maybe you didn’t like algebra in high school, but I assure you a simple formula can save you truckloads of money and headaches. Outlining a fair buy-back calculation in a buy-sell agreement is a must.
4. The owners were totally ignorant of the substantial rights that a minority shareholder has in a corporation. Minority shareholders can have tremendous power. Particularly, in the event of a potential sale or other major decision. It is a big red flag not to extend business ownership to someone in your organization if you are not comfortable with opening all of your books, records, and sensitive discussions with them (including your total compensation!).
So, what are the other options? Building an incentive cash bonus plan with a multi-year payout is one good solution. You can build the program to align the benefit to the employees with the goals of the company. There are also times when extending ownership is the right play. Keep an eye for my next article about this topic. As you evaluate how to motivate and retain great employees, make sure you do your research and hire knowledgeable advisors when deciding with whom to “hitch.”
