Engaging a new shareholder can be an exciting time for both a business, and for the incoming equity holder, but it really is just an abridged version of buying a business. In many cases, these agreements and equity sales are informal, a reward for effort and an attempt to tie key team members to the business, which sounds like a win-win situation, but success usually lies in how well the plans are executed.
We see a lot of schemes where businesses have tried a ‘do-it-yourself’ model. This usually involves agreeing to rather farfetched valuations (both above and below the market). A small amount of equity is released (often to pacify certain employees) with no detailed pathway as to where or how the new shareholder is expected to take over some of the management or liability for the business in coming years but doesn’t know it yet.
At Accru, we have helped hundreds of people bring in key team members, sell down equity, and buy equity. We have even done some of this ourselves. When we say we know, we mean it, and have learned a lot along the way.
Here are just a few things to think about:
A 5% equity release is a great starting place for a lot of employees, however with no pathway to equal ownership, would an employee share scheme work just as well? Make sure you consider why you are releasing the equity and what all parties stand to gain before you decide this is the best approach.
- Valuation Methodology
There is nothing worse than seeing a valuation methodology change halfway through a succession plan, or one that is based on the entirely wrong metric. Take for example a financial planning practice, where a lot of value is based on a recurring revenue or the ‘rule of thumb’ methodology. This methodology fails to consider the costs incurred in running the business. For a small practice it can over value the business materially. For a larger practice, it can undervalue the business. Getting this right, with all parties having an understanding and agreement is essential to a smooth transition.
We often hear people say things like ‘there’s not a seat at the table until they own x%’. If there is not a pathway for someone to get to that level of ownership, you have just created an expensive bonus pool the employee is buying into. There needs to be appropriate channels for input by the shareholders. Otherwise, you are not tying them into anything maybe they’d rather have input than dividends.
A lot of people say that the employee ‘can’t afford’ to buy shares. It’s important to separate the financing decision to ensure that the right people are connected to the business, not just those who can afford it. It’s also important not to assume your employee’s financial positions. Even if they are at the stage of life where they’re raising a young family or purchasing property, they may have capacity to fund or finance shares.
Whilst you and your original business partner may have done an earlier transaction on a handshake, that is not how it works these days, nor is it how it should work. There’s too much room for misconceptions in verbal or informal agreements. Informing the party by writing down expectations, like a letter of offer and documenting agreements (with support from legal and/or financial professionals), helps all sides understand the transaction now and the implications into the future.
Planning ahead, and being thorough in your discussions and decisions, will lead to a better long-term solution for you, your business and any future equity holders.
Accru is available if you want to have a chat about your business and the best way for you to release equity.