Engaging a new equity holder can be an exciting time for a business, and for the incoming equity holder, but it really is just an abridged version of buying a business. More often than not, these agreements and equity sales are informal, a reward for effort and an attempt to tie key team members to the business, however not all of them are well executed.
We see a lot of schemes where businesses have tried a ‘do-it-yourself’ model. Where they have agreed to ridiculous valuation schemes (both above and below 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 business in coming years but doesn’t know it yet.
At Accru Hobart, 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. 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?
- 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, a lot value these based on a recurring revenue ‘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 it is essential to a smooth transition.
We often hear people say ‘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. They may have a young family or have just brought a house. Separating the financing decision, e.g., by attaching the debt to the business, or vendor financing. This ensures that the right people are connected to the business and not just those who can afford it.
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 how it should work. Informing the party by writing down expectations, like a letter of offer, helps all sides understand the transaction now and the implications into the future. This will avoid the ‘oh but I thought’ moments in the future.
Planning ahead, and being thorough in your discussions, will lead to a better long-term solution for you, your business and any future equity holders. Accru Hobart is available if you want to have a chat about your business and releasing equity.