When a Key Employee Wants Equity

David provides a framework for one of the most important conversations in a creative agency principal’s life.

Links

"When A Key Employee Wants Equity" by David C. Baker for punctuation.com

"Pros + Cons of Having a Partner" by David C. Baker for punctuation.com

Transcript

Blair Enns: David, the topic today that you have selected is when a key employee wants equity. I saw the title of this and I thought, "Oh, I've seen this so many times. I've had so many firm owners talk to me about this situation." It's not my wheelhouse. They're really just telling me what happened, not asking me for my advice. You've seen this a lot, obviously. You've really thought through this. I thought it was a pretty obvious topic that we would cover pretty quickly, but there's a lot of meat, I sound surprised, there's a lot of meat to this topic of yours.

David C. Baker: You're always surprised when there's a lot of meat.

Blair: We could shorten this. If you have an employee, not a key employee, who wants equity, well, the answer to that isn't easy. It's just no. This is a key employee who wants equity. Got you.

David: When you asked Colette to marry you, I can just see you tense up, even though I'm not watching you on video.

Blair: No, I'm totally chill.

David: How long before you got an answer from her?

Blair: I don't think I gave her an option.

David: Oh, that sounds just like you.

Blair: [laughs]

David: Win Without Pitching. I think of that example because when you ask somebody to marry you, everything is going to change because you're going to get a yes or a no. The same thing is true when you get a key employee who asks you to be an equity partner, you can't ignore that. [laughs] When somebody asks you to marry him, it's like, "Oh, I didn't hear that, sorry." No, you can't ignore it. You're going to say yes or no.

You probably have had no experience doing this. You're terrified of losing this person. They're obviously key to what you do, even though there may be some little issues that irritate you, and so you better handle it correctly. That's the scene setting here. It's like, "This doesn't happen often, but you've got to deal with it when it happens."

Blair: All very good points. I do want to back up, though. When you asked Julie to marry you, I assume it was you doing the asking.

David: That's not what happened. No. She told me, "I think we're going to get married." You know Julie, that is so not like Julie. It's like, "Whoa, well, there's no arguing that point." I was thrilled. I did ask her later. I had reservations at this great restaurant. We got there and it was closed, so we went next door to Pizza Hut.

[laughter]

David: The metaphor for our marriage.

Blair: Oh my God.

David: That's good.

Blair: Yes, that doesn't surprise me. I had told my sister I was going to marry Colette while I was dating somebody else.

David: Oh, whoa. That's interesting.

Blair: Yes. I had this moment, I realized, "I'm going to marry this woman, I should probably break up with my girlfriend."

David: Wow. Okay.

Blair: Yes.

David: Now, that sounds a lot more interesting than this topic. [laughs]

Blair: You remember that episode we recorded that we never aired about working with your spouse?

David: Yes.

Blair: We should go back and listen to that.

David: No, let's not. [laughs]

Blair: We're talking about when a key employee wants equity. The question comes up rarely. You want to be prepared for when the question does come up. If the answer is no, you're going to have to handle it delicately.

David: Underneath all of this is this notion that, well, there's several, one is that partnership issues. Man, if you make the wrong partnership decisions, your life can be hell.

To me, partnership is either the best or the worst moment in your life. There's very little in the middle. There are people who don't have partners who wish they had a partner. They just kill that instinct from time to time and scratch that itch in other ways. They're probably better off for it. Then I know that a lot of clients that have fantastic partnerships, married or not married. Then I've got a lot of clients who are in a partnership who wish they weren't. That's one thread through all of this.

The other thread is that you can't just do what's best for you. You are obligated, as a person, to do what's in the best interest of that person who's asking to. That's what we're trying to surface here is whether or not this is a good idea, not just from your perspective, but from their perspective, too.

Blair: You're responsible for A, the business, B, yourself, and C, the person who's doing the asking. Interesting way to think about it.

David: Yes. What's the path forward?

Blair: When this happens, it better never be a surprise. If it's a surprise, the answer is no.

David: Yes, exactly right. If it's a surprise, the answer is no, or if somebody asks you for equity during the interviewing process, the answer is always no. You should always work with somebody first. You may have worked with them somewhere else, so that would cover that base. It's never a surprise because this is a person that's already leading. I just have this really core belief that leaders who have the title are always leading before they actually have the title, so this is not a surprise.

Parts of you are relieved that this is happening because you've entertained thoughts of how your life would be quite different if this person left. This is a signal that they don't want to leave. Now, the problem is that if you don't handle this well, they probably will, because if they are dead set on partnership and you don't offer it, they're probably going to either leave and start their own firm or go somewhere else.

Blair: They might leave even if you do handle it well.

David: Yes, right. That's just a part of life, and it's fine. It's like, "What's your alternative? Ignore it? No, we can't ignore it, so we're going to have to deal with it." Let's deal with it well. I do this for a living. Jonathan does all our traditional M&A, I do the partnership stuff, sharing equity, internal succession, splitting partnerships up, all that, so I've dealt with this sort of thing.

One of the first things I noticed years ago when I started doing this is that many people want partnership, but they don't really understand the downsides of it. They understand the advantages of it without understanding the disadvantages. Your job is to be open to this possibility, but to make sure that the person who's asking for equity knows what that really means. When you go through all of the reasons why they maybe shouldn't be a partner, the downsides that they haven't thought of, then you should have an alternative to suggest to them so that it doesn't just die and they get discouraged.

If they back away from that suggestion after they hear all of the things that come with partnership, and then you step in with an alternative that doesn't carry those bad things with it, then it's a win-win for everybody, and it's far less complicated for you and for them. That's the theory here.

Blair: Do you want to walk us through the list of the downsides or the cons of ownership that this key employee might not be considering?

David: Yes. There's eight of them, and I can just go through them really quickly. They don't all always apply, but you should have them on a list. There's an article on the website, punctuation.com, if you want to go back if we're going through it too quickly. One is you may need to be signing a personal guarantee on a line of credit or a loan, or something, and you won't have any choice in that.

Above a certain percentage, the bank is going to require that, "Are you okay with that?" Of course, you don't say this next part, but what they're thinking is, "Oh, so my personal credit will be revealed." It's like, "I can't keep that to myself." That's the first one. Second, you'll have some fiduciary responsibility. Let's say there's a bookkeeper who's stealing from the firm and is pocketing maybe some deferrals that employees are making for their retirement planning or whatever it is, then the shareholders are actually responsible for that. They're not going to go to jail, but they're going to have to make it right.

Even if you don't know about something happening, you're still going to be responsible above a certain point. Third, you might need to lower your pay and a business slowdown. Fourth, you may actually be asked to make a proportional cash infusion. If we all have to bring money to the table to keep this thing afloat-

Blair: Capital call.

David: Yes, capital call, exactly. Fifth, we'll need a tighter non-compete, and that'll be legal because you'll be an owner, and so certain things that wouldn't be enforceable are now enforceable. Your personal credit might be exposed. I talked about that a little bit already. This is the big one, number seven. We'll need your non-participating significant other, it could be a spouse or just somebody you live with, to sign an agreement that acknowledges how your shares will be valued and what purchase terms will apply.

That's something, I don't have a prenup, I don't even know how I would talk about one. It's just the whole thing just sounds so weird. If I were a billionaire, I could get used to the idea of talking about a prenup. You're going to have to have an agreement, a consent from your spouse who doesn't participate, because let's say this new person is going to be a 10% owner, and they get divorced, well, absent any other agreement, that non-participating spouse owns 5%. He or she is not going to agree on what that's worth or the terms of the payment, so that'll have to be part of it.

Then eight, equity is normally purchased, not given. Like, "Where do you think you'll get this money?" You wouldn't say it like that. Those are the eight things you walk through. All of a sudden, somebody that was really excited about equity says, "Oh, is there any other way we could do this? Maybe I'm just looking for a raise." "Yes, right," so that's it.

Blair: Now, there are eight cons, when you said in that moment, that they might talk themselves out of it, or they might just be a little bit less enthusiastic about the idea. From there, you suggest putting forward an alternative path, something other than pure equity. What is it?

David: Yes. I don't really talk about this, but the other thing you could do is a title. In our field, we call, every other industry says CEO or president or whatever, we call them principals, and that's not a legal title. You could call somebody a principal even if they're not an actual equity partner. That's one thing you could do, but that usually is just icing on the cake. The alternative to real equity is what's called contract equity where you just say, "Hey, listen, instead of you buying 10% of the firm with all these cons that come with it that I just walked through, we could give you a 10% contract equity in the firm, which simply means that you'll get 10% of the value of the firm if it sells while you're employed, you don't have to accept the same terms that I negotiate on my behalf."

That's part A. Part B, and these could be done separately, they don't have to be done together is, "How about if I give you 10% of the profits every year?" That gives this person a much simpler plan. They get to call themselves an owner, they get some money if the firm is sold, so they don't have some weird disincentive to make the firm really valuable because they're participating in that payoff, and they get a profit. You get to benefit as the principal partner by somebody who's working for you, that's not just thinking about income but also expenses. They're thinking like an owner.

That contract equity, it's easy to write, it's very simple, it can be any percentage, you can make it contingent on all kinds of things. If somebody is nervous about getting fired, so that you get out of it, you could say, and if you were employed within, say, 6 months or 12 months of when the event occurred or whatever, there's all kinds of ways to do it. It's a pretty common thing, but for some reason, in our industry, I don't see many people using it. I love this tool. It can also be viewed as a stepping stone to real ownership, so you might start with this, if they start to get more money through distributions, they can set that money aside and use it to buy real equity to convert their contract equity into real equity.

The other huge advantage here is from a tax standpoint, there is no taxation on the sale of the thing unless it happens, right? It's not a tax event at granting, it's only a tax event when something happens. Now, obviously, they're going to pay taxes on distributions. Anyway, that's the idea. It's a little bit simpler. It's not always a good fit, but in many cases, it scratches that itch without complicating your life as an owner.

Blair: Is this also known as phantom equity?

David: No. Phantom equity, I would define that a little bit differently. It's more complicated, requires lawyers, and all that stuff. There's some overlap, but it's not exactly the same.

Blair: The alternative approach to pure regular run-of-the-mill equity is what's called contract equity. The idea is you take a certain percentage, and in the example you gave, it's 10%. Instead of giving them 10% of the business or selling them 10% of the shares, the promise is that if the business sells while they're in your employ, they get that percentage of the transaction value at the time of sale, and you could negotiate something where maybe they get that up to a year after they've been with you. That's completely negotiable. They would get that percentage of the transaction value and of the profit or the distributions.

David: If you wanted to, right? Those are separate things, and you could unbundle them, but many times, they're bundled together. Yes, a share in the sale, a share of the profit.

Blair: What don't they get? What are they leaving behind that they would get with proper equity?

David: They get no voting rights, and then they can't sell this position to anybody. It's not marketable to anybody else. It dies when the employee leaves or is dismissed for cause or not. Those are the two things they don't get in here in exchange for something being so much simpler.

Blair: What's to stop the principal owner from being on the brink of a transaction and saying, "Hold on, before I can sign off on this, I've got to fire this person that has contract equity?"

David: Theoretically, that's a real issue, but I've never seen it happen because you don't hardly ever get 100% of the cash at closing. The buyer wants a good transition with all of the key people, and this person is a key person. Now, if they've turned out to be a bad pseudo partner, contract equity partner, well, then that could happen. As long as there isn't some provision about within 6 months or 12 months or something, then that would be fine, it could be done. I've just never seen that happen because this just unites two people or two or more people. They're both pulling in the same direction, they appreciate each other. I guess it could happen, I've just never seen it happen.

Blair: I guess the acquirer doesn't really care who they're paying the money to. They don't want to inherit this legal problem by having you, the seller, do something that maybe is a little bit, I don't know if unethical would be the right term, but gray area or dangerous, they don't want to buy a legal can of worms.

David: No, they don't. They also don't want to buy a firm that has all these minority partners, too. [laughs] Yes, that's what motivates this, as you think ahead down the road to when you might sell your firm.

Blair: Now, you went over your list of eight downsides fairly quickly. I think a lot of these are quite interesting. Can I just pull on a couple of them that really jumped out at me?

David: Yes.

Blair: The one you spent a little bit of time on, but I'd like you to speak more about, is this having the non-participating significant other, so maybe that's your spouse or just someone who's common-law, signing an agreement that acknowledges how your shares will be valued and what purchase terms will apply. Who's being protected there? Is it the employee who wants equity, or is it you, the principal?

David: Well, it's actually both if the marriage ends in a really ugly way. Most calls on the bylaws have nothing to do with partnership disputes. It's a divorce, so you're really protecting both parties so that the participating spouse gets half of the value and that the majority partner doesn't have this long, drawn-out legal thing that just is a mess. You, the principal owner, you don't want to be saddled with this potentially hostile shareholder that you didn't really sign up for.

Blair: Is that part of it, too?

David: Exactly. That's why in a normal M&A transaction, we strongly advocate that you do a lot of social listening and learning with not just the potential firm you're buying, but with the non-participating spouses as well, or significant others, because that's where things can go wrong. You want a relationship with all of those people. Even with the relationship, you want to protect yourself on the downside if something goes bad.

Blair: Your eighth point, this point that equity is normally purchased and not given, I'm sure you've encountered numerous examples where your new client is explaining the ownership structure to you and says, "Oh, I gave this person or these people equity." Does your sphincter tighten a little bit when you hear that?

David: I don't think it's always a bad decision to do that. I just think if you're going to give away equity, you need to have several provisions in there so that it can't be flipped back to you. In other words, if you're getting it at a significant discount as a new junior partner, then the same discount should apply. Maybe it slowly dies over the years, but the same discount should apply if you reverse this transaction down the road.

I know it's very common for somebody who would make a fantastic junior partner to not have much money. It's fine to discount it. You just need to do that very carefully, and also make sure that they do bring some money to the table. You have to assess their investment in this. Nothing says I'm invested in this firm's future more than taking a loan out against your home, or in one case, I remember somebody that I was negotiating with, they downsized their home and took out the equity to invest in this firm. Then they purchased the whole thing.

Blair: That's commitment.

David: Yes, it really is. This is on the list because a lot of people who pursue this path of junior partnership think that it's owed to them because of what they've done. I don't know, I probably shouldn't even say this, but I will. When I'm interviewing somebody like this, I'll say, "Hey, let's just talk a little bit about the recent past. Have you earned everything that the principal has paid you?" I just laugh, and they laugh. It's like, "Oh, yes, I probably overdeliver." Like, "Yes, I've earned everything they've paid me." I said, "Okay, has he or she paid you everything that you're owed? Has it been a fair arrangement?" They'll say, "Yes." They always say yes. Then I just file that away.

Then, say three weeks later, we have another conversation about them being a junior partner, and they'll say, "Well, this is owed to me." I'll say, "Well, wait a second. I just asked you this question three weeks ago." It's a little bit of a trap, but I just want them to think about the fact that what makes you think this is owed to you if that wasn't promised to you at a certain point? That's where them being willing to purchase this, I don't even care, like sometimes it's as little as $10,000. Other times, it's $800,000. It just needs to hurt in some way, and it needs to be largely irreversible outside of some major event. That's why money is on this list. It's just because it's one of eight, doesn't mean it's not really significant.

Blair: Now that you've given your little trick away, you'll have to come up with a new one.

David: Yes. [laughs]

Blair: I like what you said off the top about, as you were saying this, I could see faces of my clients come to mind. Some people should never have given up, whether they sold or gave away equity, should never have done so, and regretted it.

David: Then I can think of some businesses that are so much better because the sum is greater than the whole of the parts of the two or three individual partners. It's usually two things tend to start getting complicated, three, and my estimation, I've never measured it, you probably have a point of view on it, but yes, I can see both sides of this. It was like, "This business would not be what it is without this partnership, and this person should never have given up or sold equity." It's great or awful.

Blair: Yes. Every partner you add doubles your challenges. Thanks for this, David.

David: Thanks, Blair.