Expanding shareholdings beyond the founders of a firm can be fraught with difficulties, be it setting a price, the governance or the fundamental issue of the founders sharing the pie with others.
Beaton Capital regularly surveys shareholder schemes and advises on the related strategy. Some schemes work well and facilitate orderly succession of leadership and ownership, but some firms are trapped with too much equity in too few hands often with the share price becoming barriers to a meaningful spread of ownership.
Here are some strategies that we have seen work well and not so well:
Start the scheme early – don’t wait
Identify the shareholding philosophy that fits your culture, will shareholding be limited to the leadership and senior staff, or to a wider group? Estimate the churn of that group, either through retirement or conventional change, how will the equity be redistributed through the churn, what will be the rules? Prepare a price path for the shares to understand the cost to the shareholders and understand the affordability issue.
New share issues or share sell down or both?
Retiring shareholders will want to sell out, and those with large holdings may just want to sell down. The share price and quantum relative to the internal market’s ability to absorb the sell down may be a problem. Some use the firm itself as a banker to finance a buy-back, but this requires a reserve account on the balance sheet and retained earnings, using bank debt to fund this gap is not a good call. If there are no reserves on the balance sheet be prepared for a debate with the tax authorities.
New share issues dilute existing shareholders, but promote a philosophy of growth and ‘we are all in it together’ – a ‘build together and exit together’ philosophy. But this may not be possible if there is a baby boomer bulge seeking to retire.
Pricing
One of the blocks to a successful transition of shareholdings is the internal share price. Too many firms mark-to-(external)-market (which is an artificial process that many ‘legitimise’ by using an external valuation) and use this for internal transactions. The result is a price that effectively is a surrogate for a trade sale but without all the earn-out mechanisms, guarantees and restraints that come with a trade sale. Furthermore the very people that have been instrumental in generating the goodwill are now asked to pay for it. Marking to market for internal share sales leaves very little on the table for the internal shareholders, it’s probable that the only scope to create a capital gain is restricted to profit growth, since a market multiple has been applied to the price.
The firms that have successfully implemented broader shareholdings have restricted the share price to an affordable level, for example based on net assets or very low multiples – determined by the board not a third party. The upshot is that the dividend yields are often exceptional and there is still the opportunity to make a significant capital gain when there is a corporate exit, as distinct from an individual’s exit. The SKM exit of 2013 is a good example of the latter.
Strong dividend yields facilitate the acquisition of shares, so a consistent trend should be managed, but obviously this depends on the underlying strength of the business. But there’s the rub, a factor of success is attracting and retaining the best talent, tying them to bottom line performance and sharing the pot with the people you can’t afford to lose is a smart growth strategy – one of the biggest disruptors to growth, client satisfaction and profit is staff churn.
Qualifying employees
However you determine who should be a shareholder, ensure that there is no overhang of shares when employees leave. They should be required to sell back at a price set by the board, at a time determined by the board, do not find yourself in a situation that you have to buy-back at a full market price. Some firms have a qualifying period where entry and exit prices are the same. Employee shareholders should not be rewarded for leaving prematurely.
Internal trading
Most firms do not allow trading between shareholders, unless it is an arranged sell down, usually it is between the company and the shareholder. Most firms have only one month when shares are issued or bought back by the company and maybe traded – often after the year-end accounts are approved. The reason? Don’t distract the employee shareholders, these are not publically quoted shares.
Forced sell down
Most firms require shareholders to sell down as they approach ‘retirement’. Some allow a residual to be held, some start at 58, most at 60, and end by 65. Re-circulating shares is seen as critical to maintaining the active momentum in the firm. The Gen Y issue is driving the issue of shares to employees earlier than in previous generations
Finance
Generally firms do not provide finance to employees nor do they provide collateral. Some allow the shares themselves to be used as collateral for bank loans, but it is rare. Other firms allow for staged payments, but generally employees either use savings or loans secured on their homes.
Employee shareholders – key takeaways
So in summary here are eight key takeaways:
- Shares for current staff only – no overhang to complicate a corporate exit.
- Since a firm’s size is important for increasing value and attractiveness on corporate exit, use the share scheme to proactively grow and retain the number of professional staff.
- Design an ultimate exit around a bigger cake.
- Be less hasty to claw back shares from the ‘old’. Relationships are often undervalued and can be critical in extending the pipeline beyond the apparent horizon.
- Be generous on setting the internal share price it makes the shares affordable, increases the dividend return to shareholders and is another means to reward staff without hitting the P&L. Shareholders can see their potential capital gain grow from an increase in both the multiple and the profit.
- Proactively retain a proportion of earnings to grow the business – don’t behave like a partnership if you are a corporate.
- Minimise the ability to trade in the shares, don’t make the valuation a ‘big deal’ – it should not be a distraction.
- A well-structured scheme will lead to a decline in staff churn, reduced recruitment costs, improved effectiveness, increased client satisfaction and a greater valuation.
Interested in knowing more? Register using the button below to attend our beatonlive Growth, Ownership & Exit Strategies Conference on 14 May 2015 in Sydney.
Other related blogs and thought leadership from Beaton Capital can be found here:
- Whose interests are served by M&A in consulting?
- Valuation and price are not equal
- Selling the firm – does size matter?
- How much is my firm worth?
- 20 questions to test your resolve: do you really want to sell your firm?
- Succession: trade sales – gain, pain, both?
- Takeaways from a recent sell mandate – points to consider when it comes to selling your firm
This post was written by Warren Riddell, of Beaton Capital and Beaton Research + Consulting. Warren’s details can be found at LinkedIn.
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