We’ve been working with a client on a buy side approach, that is, helping a client buy into a business they work in. Our client was given a copy of a 40 page valuation report and offered to buy 50% of the shares. But on what terms? What date? What was the actual offer?
When we see offers to employees they come in all shapes and sizes. It’s not uncommon for the employee to seek advice from us to determine if the offer is reasonable. However in this case, even we weren’t sure what the offer was. Our calls with the client led us to believing the valuation was materially overstated, that is it failed to consider a few important factors. This included:
- An unrestrained key employee
- The key person reliance in the business; and
- The small nature of the business
The multiple applied by the business valuer didn’t consider the reliance on the key employee who was buying in, and there was no discussion of recognising their value over their time in the business, such as sweat equity discount, or general discounting.
We assisted the client in a shadow valuation, considering their contribution with the information we had available and contrasting various methods they could use in their discussions with the owner. The key employee’s perspective was that the business was considerably over valued and he couldn’t justify the “price”. We agreed that the multiple was incorrect, however it was easier for him to justify a sweat equity discount. Sweat equity is a discount applied for your contribution in building the business valuation, it can be anywhere from 5 – 50% and largely depends on the size of your contribution and length of service.
Unfortunately, it doesn’t look like a transaction to sure up the business owners future is going to occur, and this process has damaged the previously strong relationship between the key employee and business owner. So how could this have been avoided?
If the business owner had gone to the employee with a letter of offer and discussion regarding the business valuation, setting out terms such as:
- Why they are offering the equity to the employee
- The offer of equity %
- The timing around the second 50% offered (or future tranches)
- The payment terms, including any vendor finance / funding they can offer
- How the valuation was completed
- How their value is being considered
- How the employees role may / will change
- Details of the business structure going forward – e.g. are they buying shares in the existing company, will a new company be established, will they be a director etc.
Clear communication is critical in reducing risk for incoming equity holders. Just as it is for those exiting to understand their position and the impact for themselves personally. In this case, poor communication has meant that a key employee is now disengaged in the business, and that’s not an ideal situation for employer or employee.
If you’d like to talk to someone about setting yourself up for success in offering equity to key employees, contact us today.