By Patrick Ungashick
Many business owners consider at some point sharing ownership of their company with one or more key employees. Sharing ownership can create powerful advantages. Retaining employees for the long-term and incentivizing them to increase business value are usually the top motives. Sharing ownership elevates valued employees into a true partnership with the owners in the ongoing effort to sustain company growth.
However, sharing ownership is not without downsides, some of which are immediately apparent. Obviously, sharing ownership dilutes the owner’s equity position. Consequently, sharing ownership can end up being the most expensive way to incentivize, reward, and retain top employees. Other potential problems create unwelcome surprises. Sharing ownership backfires more often than it succeeds. If it fails, it may jeopardize the business owner’s ability to successfully exit from the business one day.
Here are seven reasons to avoid sharing ownership with key employees, whether you are contemplating selling or gifting to them a piece of your company:
1. Key Employees Sometimes Leave
No matter how loyal and trusted they are, it happens. Making matters worse, when key employees leave, they rarely switch industries. If they leave your company, they may join or become competition. Now you may have somebody competing with you who owns a piece of your business. To prevent this, you will need to have employees sign an agreement obligating them to sell their stock (or units, if an LLC) back to you should they leave. This helps avoid a competitor owning some of your company. But you won’t like writing a check to a former employee to buy back your stock. That’s not fun.
2. Sharing Ownership Complicates Legal GovernanceOnce an employee has ownership, it’s easy for the line to blur between ownership and employment. Click To Tweet
Sharing owners requires creating (or updating) legal documents such as a buy-sell agreement, which outlines decision-making and ownership-transfer rules among co-owners. One important issue to address is who has the authority to sell the entire company one day. You cannot allow minority owners to hold up a potential sale in the future. This buy-sell agreement therefore also needs to give the majority owner clear authority to sell the entire company, further complicating your exit planning.
3. Sharing Ownership Complicates Income Tax Planning
Certain laws regarding retirement plans—an important tax planning tool—require treating owner-employees differently for antidiscrimination testing. Also, if you have an S-corporation (a popular legal form) and you wish to make a profit distribution, it must be in proportion to ownership. Sharing profits proportionately with all owner-employees might not be what you had in mind.
4. Sharing Ownership Changes the Employer-Employee Relationship
Ownership bestows rights. Employees who receive ownership typically gain the right to review the company’s financial information and records. You may not be crazy about employees seeing that level of financial detail. Once an employee has ownership, it’s easy for the line to blur between ownership and employment. It can become harder to manage an employee who is also an owner. Firing that person, if ever necessary, can become more difficult and expensive.
5. Sharing Ownership with One or More Employees Creates a Precedent
You intend your company to grow, and that growth will lead to additional valuable employees coming into the picture, either promoted from within or hired from outside the company. Those future key employees may want ownership, too, given that their peers already have it. You will have two options: either offer ownership to them, further diluting your ownership, or deny ownership to them, which risks alienating them, even to the point that they leave the organization.
6. Ownership May Complicate Matters with Your Employees
Owners typically enjoy some personal expenses paid by the company, such as vehicle, cell phone, meals, and so forth. Employees who receive ownership often expect to participate in such perks too. You must either include them, which increases costs, or temper their expectations, which risks alienating them.
With ownership also come responsibilities, such as personally guaranteeing company debt. Top employees may be hesitant or unprepared to share in this debt and risk, further taking away some of the excitement and appeal of receiving ownership.
7. Sharing Ownership Increases the Company’s Exposure to Outside Risks
Occasionally, employees might do things that put themselves and their ownership in the company at risk, such as get divorced, get sued, or find themselves in financial difficulty. Sharing ownership increases the possibility of having your company dragged into one of these situations.
Because of these disadvantages, business owners should attempt to retain and reward key employees without sharing actual ownership. Alternative strategies exist, such as golden handcuff plans that include phantom stock, stock appreciation rights (SARs), and executive compensation plans. Many of these programs can simulate business ownership, achieving the original goals without creating the inevitable risks and downsides.
There are a few situations where to share ownership with key employees may make sense. The most common would be sharing some actual ownership now as one step within a comprehensive plan to eventually sell or transfer the entire business to the employees. Otherwise, in most cases, it’s advisable to pursue a different course of action.
Patrick Ungashick is the CEO of NAVIX Consultants, a celebrated speaker on executive and business owner exit planning, and the author of A Tale of Two Owners: Achieving Exit Success Between Business Co-Owners. With his wealth of knowledge on exit planning, Patrick has provided exit advice and solutions to business owners and leaders for thirty years.