By David M. Wang, Esq.

Collective Insights on business ownership has David Wang posing the question to business owners, “Should I Give Employees Equity in the Business?” with added food for thought from our in-house attorney consultant.

 

Many business owners need to find ways to recruit and retain employees. The cost of training employees is high, and finding a great employee can be difficult and time-consuming. The reoccurring idea to solve this problem is handing out equity. In other words, giving them a participation in the upside as a way of recruiting and incentivizing employees to stay. However, giving employees a piece of the upside is the most complex way to give employees equity. There are many things to consider when making a determination to go this route.

Giving equity is a taxable transaction. You are giving an employee an asset of value.

It may not be cash, but the tax code treats it as income. Outright giving the equity to an employee means that the company will need to do a valuation to determine the value of that equity. That valuation has a cost. The employee will report that equity as income and have tax liability for the value of that equity. The employee will not see getting the equity as a positive experience unless you pay for that tax liability.

Many business owners ask about granting options.

Their friends that work for Texas Instruments and Frito Lay get stock options. Stock options work for a publicly traded company because the employee can sell the stock to convert their stock compensation to cash. This cash can go toward the purchase of a car and pay the taxes associated with getting the stock. The equity of privately held companies does not have a market, and you do not want employees selling your equity to just anyone that will buy it. This means that equity in a privately held company cannot be converted into cash. In fact, the equity in most privately held companies does not produce any cash until there is a sale of the company, which in many cases is a long time or never.

The most complex part of giving equity is how you get it back when the employee takes another job, is fired or laid off.

Most businesses do not want employees to be able to keep the equity after they stop working for the company. The concept is that the employee needs to be employed when the equity becomes cash. This means that you will need to have buy-sell terms that deal with the employee quitting, getting fired for cause, getting laid off, getting divorced, dying and becoming disabled. These terms will need to include what triggers the buy-sell terms (i.e. what is “cause” and what is “disabled”), how to determine the purchase price, payment terms of the purchase price, and other important terms. Then, the governing documents (i.e. company agreement for a limited liability company) need to take into account voting rights of the employee, manage participation, tax treatment and other complex issues.

As you can see, giving an employee equity is complex and must be documented with solid agreements. You cannot go with an “understanding.” Employees will remember the “understanding” the way they need to remember it. Getting all of this squared away could mean a few thousand dollars in legal fees and other professional fees, including valuations.

One way to look at equity is that the only people that should be equity holders should be people that are your true business partners.

True business partners, in this sense, means that they are people that can and will borrow from their 401K to make payroll. They are people who will not “go get a job” when the going gets tough. The investment that is required to take on and deal with a partner is significant and that person should be worth that investment.

So when asking, “Should I give employees equity in the business?” the decision should include a conversation with your attorney and CPA for why, how and which ones. You can also consider giving employees participation in the upside through bonuses and profit sharing plans. These alternatives are usually easier to structure, give you more control, and can require less in professional fees. These alternatives can be explored in future articles.

 

David M. Wang is a partner of Grable Martin Fulton, PLLC. He is a business attorney with over 21 years of experience. He can be reached at (214) 334-4755, or dwang@grablemartin.com.

 


Losing Sight of the Big Picture is Easy to Do

Challenge: To Recognize the True Value of an Acquisition, Not Just Focusing on Today

TVG represented a project-based business that had a few million dollars in current backlog. This backlog represented over 100% of the current yearly revenue. When we went to market, our valuation was based on several factors including the historical cash-flow as well as the strength of the future backlog. The buyers agreed to the valuation in the Letter of Intent (LOI), but during the due-diligence period, the buyers got lost in the minutiae and tried to negotiate a lower price. The sellers were ready to retire but did not want a “fire sale” either. The buyers took the sellers’ desire for a quick sale as a weakness and tried several different ways to reduce the price.

Approach: Confidence in the TVG Valuation

TVG was confident in the valuation that we prepared and felt this was a fair yet aggressive price for this business. There were many existing positive attributes of the business that were addressed clearly in the valuation for the buyer to have the full picture of the selling company.

Finally, the seller was tired of the buyer’s indecisiveness and attempts to tear down the agreed upon price. The seller was ready to terminate the LOI and find another buyer. TVG understood the seller’s frustration. We discussed with the seller how we would make the buyer see reason and urged them to give the buyer another chance. TVG then went to the buyers and very bluntly explained to them that they were days away from the seller walking away from this deal. We showed them the solid facts that they would be missing a huge opportunity because they were trying to shave off a few dollars. The price of the deal was more than fair. On top of that, the value that this particular buyer would be able to bring to the company very quickly would more than make up for the feeling of overpaying for the company.

Result: Buyer Agreed to Honor the Original LOI

The deal was able to close in a relatively close proximity to the original closing schedule. Nine (9) months after the close, TVG followed up with the new buyers. The business had grown 25% in less than nine (9) months, and the new owner offered thanks and apologies for breaking down during the due diligence process.


Calling All Business Owners!

Exclusive event to current business owners only

 
8:15 am – 1:30 pm

Click the date above that best fits your schedule

 

Registration: 8:15 am – 8:30 am
Presentation: 8:30 am – 12:00 pm
Lunch and Q&A: 12:00 pm – 1:30 pm
 
A Four Person Panel to Cover All Aspects to
“A Business Owner’s Guide to Selling a Company”

 

It is never too early to plan a business Exit Strategy!

 
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*Breakfast & Lunch Provided*

 

Includes one-on-one Consultations with Senior Managing Directors
17766 Preston Road, Dallas, TX 75252
 
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Knowing and Understanding ODCF – Owner’s Discretionary Cash Flow

It cannot be stressed enough the importance of verifiable cash flow on a small business.

Replacing an income from corporate America is the main drive for a high percentage of first-time buyers. They are typically looking for a small business to “cut their teeth on” for their first or only business purchase.

What is ODCF?

ODCF stands for Owner’s Discretionary Cash Flow, which is simply defined as money able to be taken out of the business annually.

Why is it important to know about the seller’s ODCF?

A high percentage of first-time buyers come from retiring corporate America. Knowing what the seller is considering as ODCF will allow the buyer to know whether they will be able to immediately supplement their previous salary with the business income without dipping into operating costs. It is not just the owner’s salary that is considered ODCF, in fact, this number is often reduced so not to be overly double taxed with payroll taxes as an employee and an employer. There are many categories that can fall into this bucket on a balance sheet. 

Main elements that comprise the owner’s discretionary cash flow will include:

Net Income – The amount of revenue after paying all business expenses and before federal taxes have been paid. This can fluctuate to keep taxes down. Though prepaying expenses for a coming year might reduce the net income, it does not mean that the business is not profitable.

Owner Salary – This is not always a large amount as to not overly double tax as an employee and an employer.

Depreciation / Amortization – This is added to ODCF as these things reduce taxes as it decreases taxable income.

Interest Expense – This is not a category that is often taken over by the new owners. All previous owner loans and such type expenses should mostly if not completely be eliminated with the business transfer.

Non-Reoccurring Expense – This is a varying amount as the category suggests. However, it is important to see if the balance sheet can sustain this type of ODCF should the need arise.

Owner’s Perks – This is a common way to offset an owner’s salary. It can include things such as auto expenses, cell phones, travel, insurance and 401(k) contributions.

This overall ODCF amount may end up making a small business more appealing, but make sure it is all well documented.

How does ODCF affect the sale or purchase of a business?

Though it is true that many items can fall into the category of ODCF, a bank may not see it in the same light. This is not as much of an issue if the main financing for the business is seller-financed or the seller kept ODCF to just the basics of owner salary. An SBA or conventional bank will have other regulations to adhere to. Sometimes the only thing a bank will consider when making a determination to fund a business transfer is the EBITDA plus the owner’s salary.

 

Should you need to know more as a buyer or seller, the books by Alex Vantarakis, Entrance and Exit are available at our store.