Why you should never use the words “give” and “equity” in the same sentence.
Structured properly, sharing equity can be a valuable tool in attracting and retaining your management team and providing a powerful incentive for performance. It can also be an unnecessary complication with unintended consequences. Before you decide to give part of your company to someone, even if you think they have earned it, consider the following.
- Employees, even your senior management, seldom understand the rights and responsibilities of owning a piece of the company, particularly a closely held, illiquid private company.
- Owning part of an LLC or an S Corporation usually involves a flow through of income to the owners’ personal tax return, whether or not cash is distributed. Nobody likes or intends there to be phantom income, but it happens and when it does, the owners are not happy.
- Do you know how your personal tax plans may align with your prospective fellow owners? There may be issues such as timing of earnings and capital gains or losses where your position may differ from your other shareholders. Resolving these differences does not always result in a win-win situation.
- Minority owners have considerable rights and as the majority owner you have considerable fiduciary responsibilities to your other owners. Are you really prepared to disclose virtually everything about your company to your other owners? Everything?
- Are you prepared to provide your other owners with the same perquisites that you enjoy?
- Are your future equity partners really prepared to personally guarantee company debts, leases and contracts like you have?
- Will they be willing to forego personal benefits for the good of the company like you have?
- Do you really understand the difference between equity sharing and profit sharing? Profit sharing is much better understood by most people and is often the most meaningful benefit to an employee.
- Do your future equity partners understand that without a liquidity event, any gains in value are largely if not totally unrealized?
- Do you understand the tax ramifications of granting equity ownership? Do your employees understand? Are you prepared to pay for their education on these matters?
- Most employees want current compensation over the promise of future wealth. If they are interested in future wealth they usually prefer it to be safe, secure and separate from your control. That may be very different from your ideas.
- Have a simple conversation with a few key employees about what kind of rewards they would like. You may find that equity is not on the top of their list and often not even on the list.
- Having other owners necessitates a buy-sell agreement that addresses how ownership is valued and may change hands. These agreements usually require periodic valuations and insurance that adds to the total costs.
- When it comes time to exit your business, having more owners always adds complexity and seldom adds value.
- Have you considered the alternatives to giving equity? There are many ways to compensate and incentivize employees that may be more appreciated and effective that sharing equity.
These are all points that can come up and, if not properly addressed, can lead to disputes that can be disruptive to the company and contrary to the intent of the equity sharing program.
If you have considered all the above and conclude that equity sharing is your preference, get the right team of professionals to put together an ownership plan and agreement that clearly addresses your and your future fellow owners concerns.
If you would like to explore these matters further, please contact me.
562 370 0125