|Building A Foundation For Success (Part 3)|
|David Grau Sr., JD Wednesday, June 30, 2010 17:53|
For most owners, it is a combination of factors and misunderstood issues that sidetrack the process before it even begins.
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The following is a summary and explanation of the various elements underlying an internal ownership track for the average financial advisory business:
Control: The issue of control is both real and emotional, but providing one or more key employees with an ownership opportunity is not about surrendering control. An internal ownership track isn’t about providing a certain quantity of stock – the goals under consideration in this posting can be easily accomplished with just 1% to 5% of the company’s stock. The stock can be non-voting (even in an S-corporation), and will certainly have “hooks” attached to it that ensure it doesn’t leave if your employee does.
Compensation: Ownership and compensation are separate issues. Compensation is for doing a job, while ownership is about investing in the future, building value, and creating or contributing to the company’s ability to continue beyond the lifespan of its founding owner. It takes years for an employee to hone their skills, learn and implement the company’s vision, and to earn the right to be an owner. “Equity compensation” is addressed under “Gifting” below.
Risk: Ownership involves risk. This is not an opportunity to acquire passively owned, liquid, publicly traded stock. Many employees see nothing but positive growth numbers for the business year after year, and well into the foreseeable future, but a small business, lack of control, and lack of marketability still equals a risk. Just as you tell your clients, every investment carries with it a risk. In fact, some employees will choose not to invest their money into your business. That’s OK. It’s good to know how people think.
Gifting: The issue of gifting stock is deceptively complex. An owner can give stock to an employee, but it is just like giving them cash – it is a taxable event and taxes must be paid by the employee on the fair market value received. Shares of stock in a privately owned small business should not be used as a reward. Instead, create the opportunity. Let your employees decide if they’re willing to write the check and make an investment in their own future.
Value/Valuation: Begin every ownership discussion with the concept of “fair market value” and obtain a neutral, third-party valuation to aid this part of the process. Both sides will benefit from an objective opinion of value at the start of the process and once a year thereafter so that value and equity and can be monitored. Apply a minority discount if applicable, to the fair market value. NEVER use a multiple of revenue to determine your value. You will always be wrong, and your employee will choose a different multiple than you do.
Coninuity Planning: In addition to the growth aspects, an internal ownership track is an excellent protection measure against the founding or majority’s owner’s sudden death or temporary or permanent disability. If a key employee has even just a 1% or 2% ownership stake (a value of $10,000 or more in an advisory firm valued at $1 million for example), which they paid for themselves, it becomes their value, and an investment that they work to protect. In addition, the clients come to know the key employee as a principal rather than a staff member. The size, value and complexity of an advisory practice, as well as the skills and business acumen of the employee, often dictate whether the ownership track leads to a controlling, succeeding interest or not. Ownership for the next generation is a privilege, not a right or an entitlement.
Minority Discounts: Although not required, a minority discount can be used, if applicable, to reduce the fair market value of the ownership opportunity. In terms of minority discounts to the fair market value, the range is generally between zero (0%) and a maximum of forty to fifty percent, depending on the circumstances. Owners and employees, including sons and daughters in family-run businesses, agree in most cases to what is fair and reasonable after consultation with their tax counsel and after considering the circumstances of the transaction.
Providing the next generation with an opportunity to be owners, even in a very small way, can have a profound and lasting impact on the success of a financial advisory business. The advantages achieved by providing an ownership path to key employees includes not only better retention of those employees, but often increased productivity, especially when equity is monitored on an annual basis. In addition, employees who become owners provide an excellent means of protecting the practice from the sudden death or disability of the majority owner while creating the possibility of a long term succession plan.
While people don’t live forever, a business can, if each succeeding generation plans appropriately and recognizes that their work can be extended to many future generations. This is a great benefit to share with your clients and their families as your business grows and endures over time. In fact, combining the talent and energy from multiple generations of advisors is the first step to running a real business.