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Give An Employee A Piece of The Action

Howard Scott |

Your key person is capable. He (or she) follows directions well. He doesn’t miss work days. He gets along well with customers. You trust him completely. But something is missing.
Perhaps it’s a certain fire. A desire to see the business take off. An active mind that comes up with new ideas constantly. A knee-jerk dissatisfaction when cashflow needs are not met. In other words, the entrepreneurial spirit.
How can you nurture that missing ingredient? How can you get him to act as if he’s an owner? One way is to give or sell the person an equity interest in the business. Make him a minority owner, and he’ll care as much as you do.
“No way,” you say. “I’ve worked too hard to build up my business, I’m not going to give it away to a Johnny-come-lately.” But hold on — the idea is not to give the business away, but to transfer a share of ownership to your key person or persons.
It could be 10% to your second-in-command. Or an arrangement for your two managers to buy in through a three-year payroll-deduction program, up to 15% ownership. Or — instead of a raise or bonus —your general manager could take a 2% equity share each year for five years, resulting in 10% ownership.
Why give away a piece of the rock? Because it might be the best way to get your key person to think like an owner. Do you know what that means? The person cares when you’re not achieving a targeted profit margin. In major decisions, you have someone to bounce ideas off of.
What’s more, the tough jobs — from firing staffers to fighting with vendors to renegotiating a lease — don’t always have to fall on your shoulders. If you decide to open a drop store, having a second-in-command will be a big asset. When someone has to work late to cover special events, it doesn’t have to be you. You can go away on vacation and rest assured that the business is being run as well as if you were there.
Low-Cost Leadership. The great thing about this strategy is it doesn’t cost anything. Unlike a store makeover, there’s no $60,000 outflow. Unlike hiring a consultant, there’s no string of invoices. There’s just a signed contract.
When the time comes to sell, the company’s improved performance will increase its value considerably beyond what it would have been if you were running a one-man operation. Would you rather sell 90% of $500,000, or 100% of $350,000? That’s the issue when this strategy breeds success.
Finally, giving up a share of the business shows the appreciation you feel by bringing him in as a partner. And as a minority owner, it will be harder for him to walk away. A bad year means management must roll up its sleeves and turn things around — not search for a new job. He will shun attractive offers to run competitors’ plants. After all, now he’s an owner and has a stake in the venture.
“Tom, we had a great year,” you’ll say. “And I’ve decided to do something special for you. Not just another $1-per-hour raise like last year. I’m giving you a partnership share of the business. As of today, you own 10% of Fabulous Fabricare.
“You’re a co-owner,” you continue. “What that means is we share everything 90%/10%. If I sell the business, you receive 10% of the proceeds. I estimate that 10% is worth about $10,000 today. If we play our cards right, the business could be worth half a million dollars in five years.”
Or you could even say something like this: “Tom, I have a proposition to offer you. I want to make you a 10% owner. To do that, I’ll withdraw $10 from your paycheck for three years. That’s $1,500 in return for 10% of Fabulous Fabricare, which is worth about $10,000 today. And I’ll guarantee to buy your investment share in three years for $3,000 — if you want to sell.”
Tom might be quiet at first. After all, he’s not getting anything in-hand. But the realization sinks in that he’s getting a great offer. “Owner” ripples through his mind; he sees himself in a different light. He thinks, “The boss wants me in… I have a real future here; I’m not just a token flunky. Now I can make this business great, because it’s mine.”
If you use the second offer, the promise to pay double his investment helps get him over any fears. But it’s ownership that will help your business win his heart and soul.
Sharing Set-Up. The configuration of shared ownership depends on the people involved, the size of the business and the goals of the owner. Do you want to give the share away or offer it at a discount? What percentage do you want to offer? How many individuals should be included in the offer? How will the change impact the business? How will you use shared equity to improve business?
Let’s look at each decision. First, giving away an interest is obviously a better deal than making your key person pay for it. Is your business small enough to warrant a giveaway? Are the individuals involved able to pay for an interest? Will they mistrust a buy-in? Is the prospective minority owner so good that you just have to have him in on the deal?
If you decide to offer the share at a discount, you must provide an easy payment method, a benefit that’s clear to the purchaser and a guarantee. Maybe the individual could forgo raises for five years as payment for his share. The individual might agree to have X dollars withdrawn from his paycheck for three years. Or he might pay a lump-sum amount.
Whatever the amount, it must be significantly below book value. In a closed company, that’s hard to determine, so the bottom line is that (at most) a token sum should switch hands. The reason for making the key person buy in is not to make money, it’s to get their commitment.
You should make it clear how much equity value is being exchanged for X amount of money. This determination requires a quick calculation of net worth. Plus, the owner should guarantee to pay the individual at least double his investment any time he wants out.
The agreement can be written out in a simple contract drafted by a lawyer. If the business is incorporated, actual shares will change hands. If it is a proprietorship, a letter will state the benefits of the partnership. The action produces no tax consequences; taxes only come when shares are sold.
How big a share to offer depends on the amount it takes to convert the person’s mindset from employee to owner, and you should structure the transfer so that it has the most impact. As a general rule, the amount should be less than 20%; 10% is a good start — depending on the results, more can be transferred later. Less than 5% might not make the individual into an owner. Another possibility is a “ladder” arrangement — for instance, 2% ownership each year for six years, until the individual has a 12% stake.
How many people should receive the offer? It depends on your company. But you only want to include true key people, and that will often be just one individual. But it could be two or three, as long as you feel they would make a good management team.
As to how the new structure affects the staff, you must consider their personalities. Will someone be disgruntled because he was overlooked? If you decide to share your business with two people, will they be compatible? Keep these variables in mind when announcing the change, and whatever you do, don’t attempt to transfer ownership under the table. It won’t work.
Finally, you want to have a plan. What will you do with your newfound power and partner? How will you put that key person’s abilities to use? Maybe you’ll focus on a marketing campaign, because that’s where his skills lie. Will you put the person in charge of a drop store? Does the person have such great operational abilities that you can focus on other matters? The change will free up your time, and you must find an outlet to use to your advantage.
You still may have a few objections:
“I don’t want to give up any portion of my business.” You will give up a portion of the business, but not control — and that’s where the power is. A minority owner is just that — a minority owner; whoever owns 51% controls the company. That’s why the Ford family retained 51% of Ford Motor Co. for so long. A minority owner can protest, but you have the ultimate authority — what you decide goes.
“I want to take a raise any time I want.” You can — a minority owner may protest, but you can overrule him. It’s to your advantage to remain amicable, however, as long as he has a vested interest in the company. Furthermore, taking a raise should be based on company performance, and you might want to include your key person in the good fortune. But you — and only you — have power over payroll.
“I don’t know what my retirement plans are.” It doesn’t matter — you can follow whatever course you want when you decide to get out of the business. You can decide to sell it, or transfer ownership to your children. Of course, you can also sell it to the minority owner. This could be an excellent deal for both of you: He knows how to run the business, and knows how much it’s worth. The last scenario is that you sell a majority share to him and retain a minority share yourself — perhaps the perfect transition into retirement.
“I don’t know if we’ll make a good team.” You should already have a good guess. His personality won’t change; only his motivation level will. If you feel he’s a positive asset now, he will be even better after the change. You’re both after the same goal (success), and with a stake in the company, he will be more motivated to achieve that next level of growth.
“He might sabotage me.’’ Sure, you’ll have to open the books to him, but what can he do with that knowledge, even if he becomes an enemy? As the majority owner, you retain the ability to hire and fire. Even though he is a part-owner, he holds no real power. If he becomes a nuisance, you can figure out a way to deal with it.
Two heads can be better than one. With a share of the plant as an incentive, your key person will think like an owner and help you build the business more effectively.

About the author

Howard Scott

H&R Block

Industry Writer, Drycleaning Consultant, and H&R Block Tax Preparer

Howard Scott is a longtime industry writer and drycleaning consultant, and an H&R Block tax preparer specializing in small businesses. He welcomes questions and comments, and can be reached by writing Howard Scott, Dancing Hill, Pembroke, MA 02359.

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