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Giving your staff shares in your family business can be a bad idea

Aug 31, 2017
Giving your staff shares in your family business can be a bad idea

At some stage in a family business the question will come about: should I give my staff equity?

Almost universally the answer should be no.  This will come as a surprise to many but we will give our thoughts below

  1. Costly to set up

If you give staff shares in the business you will put in safeguards to protect you – what if the employee does not perform?  What happens if they die?  What about if they resign and go work a competitor?

These questions are all legitimate.  And every family business owner will rightly put mechanisms in place to protect themselves.

These mechanisms are lengthy documents created by accountants and lawyers.  They will require several meetings with different ownership groups and employees to get the message across and for the employees to understand what the share package will ultimately look like.

This will be a costly document to create.

  1. The staff do not understand the equity given to them

Sadly the documentation given to the staff member almost always confuses them with its complexity.  The staff member will see multiple hooks and levers against them in certain situations and even the most intelligent person will find the document complex.

This complexity often breeds an element of mistrust about the equity on offer.  The employees will often tend to discount, sometimes at ridiculously steep rate, the value of their equity stake and how it is of benefit to them.

In short: they will not understand it and they will ignore it.

  1. The staff do not understand that ownership has responsibilities.

If you own a business it is not always fun.  You will often encounter financially troubling business issues that will require shareholder attention – be it from a simple deferral of dividend payments to the need for shareholders to inject capital.

Often staff will not appreciate the financial obligations associated with ownership.  The shares are viewed upon as a bonus and not as an obligation to support the family business.

If the business encounters bad times the family will have to prop the business up.  They ultimate take on all of the obligations of ownership and forfeit the rewards.

  1. The staff do not want the shares

No family business gives shares to an employee that is not trusted.  Typically the senior person (or group) who are offered shares are valued, loved and in many respects, become part of the family business.

It is natural to assume that the staff you are offering shares want the same thing as the family want.  The grant of shares is seen as a simple step forward in getting the staff to have a more closely aligned interest to the family business owners.

However the horrible question remains – do these wonderful people want to own part of the business?  Would they simply prefer a bigger cash bonus at the end of the year and simply see you as a stepping stone to bigger and better things?

As an advice business we deal with new clients coming to us with a share option package – and almost universally we are asked “how much money will this be worth to me each year”.

If your key staff do not want equity in your business: do not give it to them.

  1. The cost of equity is very high

A business can reward its owners financially in two ways – the increase in value (or capital) of the business or through a dividend (or yield).

Typically the returns offered to private family business owners is the highest return by any asset class.   We are talking combined returns of 20% to 60% a year: year in year out.

If you give that return to another person you are taking it away from yourself.  In effect the value attributed to the equity given is costing the family that 20% to 60% a year.

Have you considered the alternatives?  How about you borrow money from the bank and pay it to the employee – that way you are only giving the bank a cost of 5% a year instead of 20%.

  1. A family business is not all about money

Many families run businesses for reasons that are not related to pure cash incentives.  The business might be a vehicle to give the next generation experience, provide connections to the extended family to allow those family members exposure to service providers that are simply not available to younger people.  The business might be able to make charitable donations that are not business related or to provide employment in a town close to the families ancestral home.

Sadly these ancillary benefits might not be connected to an staff outside of the family business.  Sometimes resentment will build up about “frivolous” money being spent on business matters where a better return could be spent elsewhere.

If you engage an outsider to the ownership group these family matters need to be considered and potentially removed from the business.

  1. Your staff (or anybody) can turn nutty

If you give non family members shares you will naturally have a whole bunch of hooks to protect the family (refer to point one).

These hooks can include put option agreements, buyback terms, trigger mechanisms and tiebreaker clauses.

However the often unasked question remains: what if the staff member ignores me or, even worse, becomes irrational?  What if my staff member simply ignores every legal document and refuses to sign the sale contract of their shares to me?

Well clearly the legal documentation to transfer the equity away from the staff member and back to the family business owner is the answer – but what if it is ignored?  Will the family be comfortable to take a former employee, who was clearly much loved, to court to ensure that a magistrate will issue an order to effect a share transfer (or a variation of that)?

Often the question is no.  Often the family will do a lot to get an irrational person to come to the table and act rationally.

This attempt to make an irrational person rational normally comes in the form of offering an amount of money, or inducement, that is so incredibly good that the irrational person cannot ignore what is on the table.

Sadly that cost is very large to a family.  It is often justified on the grounds that the offer will save on the legal fees of a lengthy court battle; but the question remains – is that the best way to proceed in the first place?  If we know that the documentation we are paying, which almost always costs in excess of $20k to produce, will require a magistrate to effect it, why bother getting it done?

A simple answer is to not give the staff the shares.  You can offer the shares to a trust – where the trustee is compelled to act in accordance to the shareholder agreement and other documentation.  This will allow the dividends and capital to go to your valued staff member, and also mean that a trigger event, if created, will be acted upon as anticipated in the deed.

  1. You will confuse your banks

Do you assume that the credit department at banks are highly educated business people who fully understand what is going on with time to investigate and explore your business?

No.  The credit department is often run by an overworked 27 year old university graduate with lengthy forms to complete in the correct sequence to keep their job.  Sometimes the forms will ask for stupid things like the personal credit check of all shareholders or the personal guarantee of the shareholders.

Now you can work through these issues with the bank and clarify what your structure is: and if you have a high level of debt you will have a senior relationship manager you can talk to and explain these things.

But do you want to?  Will that conversation just be another example of dead time in the business that could be better spent on actually doing things?

  1. Your family will get jealous

You might dearly love and value the enormous contribution that your beloved staff member has done for you.  And the decision to give them equity might make sense on every level.

Except for the family.

If you do not clearly articulate the purpose and strategy of the equity purpose: some family members might become jealous.  And, sadly, the impact of that jealousy is not an insignificant thing.

Look at how your family will treat the new non-family shareholder in the event that you pass on.  If the granting on equity has been, for whatever reason, percieved as a slight against the capability of the family, your decision to create longevity in your business by involving outsiders might simply guarantee and termination notice arriving on the outsiders desk within 24 hours of your death.

The grant of the outsider equity does affect your extended family: and it should only be done with extended, empathic and tough conversations with different family members.

  1. The outsider might make you accountable

The concept, for a family owner, becoming accountable, sounds great.  It has a nice ring to it and we all want that person to create a sense of accountability to our day to day lives so the business thrives.

It is all great except when it happens.  If you get an outsider in the business the outsider, rightfully, has a say in how the business runs and what you are worth to the business in what capacity.  They can, rightfully, track your annual leave, monitor the type of expense claims you put against the business and monitor your key performance indicators.  Alternatively, the outsider might rightfully decide that sponsoring your local golf club, or the corporate box at the Dockers is a waste of money (which is understandable given they have never won a grand final – go Eagles!!).

If you really want to have an outsider review what you are doing – you have to be prepared to change how you are acting.  This could be a good thing; but we often find that it is not well received.

  1. The outsider might demand a dividend now

Many family owned businesses have done it tough.  The planning has been very long term and the profits of the business have often been re-invested, often for many decades, to make the business great.

Sometimes the outsider does not appreciate this.  The dividend is seen as part of their salary in a way.  Once you click through a certain income to a person it is often taken as guaranteed future income and the lifestyle adjusts to meet that income.

If you want to stop dividends and make a long-term investment decision the non-family member might have a hard time dealing with that change.

  1. It might make it harder to sell

Despite the best of intentions families who own businesses do sell.  If they recieve an offer that is well over market value the best decision for a family can be to sell the business and use the sale proceeds to invest in a different business (at market value).

Including a non-family member in the equation can make this decision harder.  Often a purchaser will want to deal with one party selling and the non-family member may not want to sell.

Yes we have seen contracts like “drag along tag along rights” and variations of that – but staff equity still requires the need for the staff member to be consulted on the sale of their shares.

If the staff member does not own equity the family business can be sold and the employees can be cared for in a way that the family thinks is best for them.

This makes life simpler.

So.  Is the concept of getting outsiders involved doomed from the start?  Well no – their are clear instances when it can and does work.  Does this mean it will work for you or it is a guaranteed failure?  The jury is out.

What we do know is that the ones who have made it work have spent a lot of time getting it to work.  This is more than just an expensive shareholder agreement prepared by a competent lawyer.  You will need to invest time and money in understanding the drivers and motivations of yourr staff and the family: and strike a balance between the different interests without offending anybody and getting the result you are looking for.

We also know that no one professional, or no one professional services firm, can do this.  You will need great accountants, lawyers, insurance brokers and family business advisors on board to thrash out how this will work.  A collaborative approach across specialist advisors who are focussed on family owned businesses will be a key element to get it to work. For more advice on business succession planning and employee share schemes, get in touch with our experts today.

 

 



Category: Family Owned BusinessPopular

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