HOW TO PLAN FOR BUSINESS OWNERSHIP AND COMPENSATION (PART 1)
Two of the most perplexing issues faced by an entrepreneur heading a new corporation are how much of the company to sell to potential stockholders and how much to pay key managers. Whatever method is ultimately chosen, it should reflect the goals of the company and reward the contributions of the participants.
There is a tendency on the part of small, privately held companies to use minority shares as an incentive to entice investors and to pay key managers, primarily because new companies do not have the cash flow tom provide attractive compensation packages. The prevailing wisdom is that providing stock in the new company will increase commitment, cause management to be more cost-conscious, reduce cash outlay for salaries, and induce loyalty to the company in the long term.
But studies have found that this is not always the case. More often than not, the person who has been given stock in good faith will ultimately leave the company, possibly taking stock with her or him (absent an agreement prohibiting this), and this action creates the potential for future harm to the business.
In the initial growth stage of a new venture, it is difficult to determine with any degree of accuracy what long-term role a particular person may play in the organization. As a consequence of their limited resources, entrepreneurs typically are not able to attract the best person to take the company beyond the start-up phase, so they often hire a person with lesser qualifications for a little salary plus minority ownership in the company. In this scenario, the entrepreneur is literally betting on the potential contribution of this person – and it is gambling that that frequently doesn’t pay off.
Later, when the company can afford to hire the person it needs, it will have a deal with a minority shareholder who has developed territorial “rights.” Therefore, when minority ownership is an important issue to a potential employee, it is imperative to make clear to that person exactly what it means. There are a few legal and managerial rights associated with a minority position; thus, for all practical purposes, minority ownership is simply the unmarketable right to appreciated stock value that has no defined payoff period and certainly no guarantee of value.
Using a stock-vesting agreement is one way to make sure that only stock that has been earned will be distributed. With a stock-vesting agreement, a stock purchased by the team is placed in escrow and released over a three- to five-year period. A buyback provision in the stockholders’ agreement is another way to ensure that stock remains in the company even if a member of the team leaves in the early days of the venture.