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 top motives. Sharing ownership appears to elevate top employees into true partnership with the owners in the ongoing effort to sustain company growth.
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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 incent, reward, and retain top employees. Other potential problems and downsides create unwelcome surprises down the road. Sharing ownership backfires more often than it succeeds. If it backfires, the business owner’s ability to successfully exit from the business one day may be jeopardized.
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Here are seven reasons to avoid sharing ownership with top employees, whether you are contemplating selling or gifting to them a piece of your company:
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1. Top employees sometimes leave.
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No matter how loyal and trusted they are, it happens. Making matters worse, when top employees leave, they rarely switch industries. If they leave your company, likely they join or become the 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 in order to buy back your stock. That’s not fun.
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2. Sharing ownership with top employees complicates legal governance.
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For example, sharing ownership 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 that must be addressed is who has the authority to sell 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.
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3. Sharing ownership also complicates income tax planning.
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Certain laws regarding retirement plans – an important tax planning tool – require owner-employees to be treated differently for anti-discrimination 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.
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Once an employee has ownership, it’s easy for the line to blur between ownership and employment.
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4. Sharing ownership changes the employer-employee relationship, potentially in an undesirable manner.
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For example, 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 also is an owner. Firing that person, if ever necessary, can become more difficult and expensive.
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5. Sharing ownership with one or more employees creates precedent.
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You intend your company to grow, and that growth in the future likely leads to additional valuable employees coming into the picture, either promoted from within or hired from outside the company. Those future top employees may want ownership too, given that their peers already have it. You will either have to give it to them, further diluting your ownership, or deny it to them, which risks alienating them perhaps to the point that they leave the organization.
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6. With ownership comes potential perks and responsibilities that may complicate matters with your employees.
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Owners typically 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 too. You will either have to include them, which increases costs, or you will have to 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.
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7. Sharing ownership expands the possibilities the company can find itself exposed to outside creditors.
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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 difficulties. Sharing ownership increases the possibility that your company gets dragged into one of these situations.
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Because of these disadvantages, business owners should attempt to retain and reward top employees without sharing actual ownership. Alternative strategies exist, such as “golden handcuffs” plans including 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 potential risks and downsides.
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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.
