By: Patrick Ungashick
Many business owners consider at some point sharing ownership of their business with one or more key employees. Sharing ownership can create powerful advantages—retaining employees for the long-term is usually a top motive. Sharing ownership appears to elevate top employees into a true partnership with you in the ongoing effort to grow the business.
However, sharing ownership is fraught with potential problems. In our experience, it backfires more often than it succeeds. If it backfires, the owner’s ability to successfully exit from the business one day may be jeopardized.
Listed below are fourteen reasons to avoid sharing ownership with top employees, whether you are contemplating selling or gifting to them a piece of your company:
- Top employees sometimes leave. No matter how loyal and trusted they are, be realistic. It happens.
- Top employees rarely switch industries. If they leave you, they will likely join or become the competition. Now you 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 is commonly called a buy-sell agreement.) This arrangement 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.
- Speaking of the buy-sell agreement, sharing ownership with top employees increases governance and legal costs, such as creating and/or updating this buy-sell agreement.
- Sharing ownership complicates decision-making on critical issues, such as selling the entire company one day. You cannot allow minority owners to hold up a possible 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.
- Sharing ownership bestows rights. Even minority owners have certain rights, commonly including a right to review the company’s financial information and records. You may not be crazy about employees seeing that level of financial detail.
- Sharing ownership with one or more employees creates a precedent. You intend your company to grow, and that growth in the future may lead to additional valuable employees coming into the picture, either hired from outside the company or promoted from within. Those future top employees may want ownership too, given that their peers already have it.
- Once a top employee has ownership, it’s easy for the line to blur between ownership and employment. It can become harder to manage an employee who also is an owner. Firing that person, if ever necessary, becomes harder and more expensive.
- With ownership, come perks. You likely enjoy some personal expenses paid by the company, such as your vehicle, cell phone, meals, etc. Employees who receive ownership often expect to participate in such perks. Either, you will have to include them, which increases costs, or you will have to temper their expectations, which increases your work and their disappointment.
- With ownership comes responsibilities, such as personally guaranteeing company debt. Top employees who have ownership should not be exempted from sharing in the responsibilities and risks of ownership. It takes additional time and work to explain all of this to new owners, and to include them in a creditor’s underwriting procedures.
- Occasionally, employees might do things that put themselves and their ownership in the company at risk, such as getting divorced, get sued, or find themselves in financial difficulties. Sharing ownership increases the possibility that your company gets dragged into one of these situations.
- Sharing ownership complicates your tax and wealth planning. Various strategies that owners use to reduce taxes and build wealth get more complicated with more owners. For example, certain laws regarding retirement plans require owner-employees to be treated differently for anti-discrimination testing. Also, if you have an S-corporation and you wish to make a profit distribution, it must be in proportion to ownership.
- Sharing ownership dilutes your equity position. That can be more expensive than using cash to incentivize, reward, and retain top employees.
- Sharing ownership can put your exit goals at risk, particularly if you intend to sell the company. Employees with an ownership interest will receive their portion of the proceeds upon sale. Consequently, you may create a situation where these employees are now flight risks immediately after the sale, if they receive enough cash to contemplate leaving the company.
Because of these disadvantages, we try to accomplish business owners’ objectives without sharing actual ownership. Owners and key employees are often surprised to learn that alternative strategies exist which incent and retain top employees, without the risks of sharing actual ownership. One of our favorite tools to reward, retain, and incent employees involves using golden handcuffs plans in lieu of shared ownership.
There are a few situations where sharing ownership with top 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 is advisable to pursue a different course of action.