Founder in Eleven

In discussions with different peer groups/boards, one consistent complaint toward employees was how they would make decisions without the company in mind.  Whether negotiations with clients/customers, cost decisions, or even determining company event budgets, founders/owners would complain that those decisions where not being made with the best interests of the company in mind.  When asked how the founder/owner would have wanted the employee to behave, the usual reply is “I wish they would act like owners!”

Benefits of employee ownership could include:

• Better decision making
• Better retention of key employees
• Better team
• Better valuation/profitability of the company

TSG’s Experience with Employee Ownership

TSG was founded in 1996 as an S-Corp with me owning all of the shares.  As I added employees over the first two years, I gave ownership shares to some of the key employees that helped me start the company.  My original thoughts were that, having come from Andersen Consulting (a partnership at the time), I felt strongly that consulting firms where people are the primary assets should share in the success of the company. 

As TSG grew, we moved to an ownership structure based on the following:

• Manager level – when an employee reached manager level (typically 4 years of experience), we would offer the ability to buy into the company and purchase additional shares in subsequent years, all after one year as a manager.  Exact quantities would be based on the contribution of the individual and decided each year by myself with some other owner input.
• Ownership opportunity – Ownership could be purchased at a fixed share price and subject to a buy-sell agreement.  Typically, we would give the employee the ability to purchase X shares at Y price.  If the employee wanted to truly buy into the company, they need to purchase the shares with their own money;  we felt it important for the employee to have skin in the game.  As the majority shareholder, I would sell my shares to the employee rather than issue new shares that could result in dilution of the value of everyone’s shares.  Every year I would offer current owners additional shares for purchase based on a variety of different factors that provided incentives.
• Ownership distributions – When the firm had excess cash, we would enact distributions.  Over the course of the year, the distributions per share typically came to about 50% of the cost of the share, resulting in a two-year payback period for employee shares.
• Employee/owner departures – When an employee left the firm, I would buy back their shares at the same price they had purchased the shares when they originally received them, per the buy-sell agreement.

At one point in time, we had tried to do a phantom option plan in addition to ownership.  We didn’t have much luck with the phantom option program as it was difficult to establish the value of the option. 

Employee Ownership – Better Decision Making

As employees that have a stake in the company keep their ownership in mind, they put the company needs first during the decision-making process, effectively “thinking like an owner.”

With ownership spread around the managers, we had more reasonable decisions made, notably in spending.  Rather than having a manager trying to plan an event and ask, “what is my budget?”, managers would get creative about finding cost-effective events.  When it came to hiring/firing decisions, owners would get passionately involved as they realized that these decisions affected their own bottom line.

Employee Ownership – Better Retention

In a tight labor market, the ability to offer compensation outside of salary can be a competitive advantage over other companies and opportunities.  Particularly in the tech/startup space where options are commonplace, leveraging ownership can provide a more consistent benefit than options where benefits are often valued based on circumstances outside of the option holders control.

Employee Ownership – Better Team

One of my TSG mantras has always been “don’t get greedy.”  From the beginning, showing that we were willing to share the profits with key employees resulted in a tight team of owners.

Employee Ownership – Better Valuation/Profitability of the Company

Having part of employee compensation come from ownership not only provides the above cultural and team benefits, but also provides better earnings and fiscal metrics for the company.

The better valuation/profitability can be difficult to understand.  To illustrate the difference, take a simplified example of an experienced employee with a market value of $200,000 with the company having a profit of $500,000 a year.  This example does not include 401K or other benefits.

• If all compensation for the employee is salary, the employee would be subject to 6.2% payroll tax resulting in $12,400 of payroll tax and a pre-tax compensation of $187,600.  The company would have additional payroll taxes of $12,400 with total expenses of $212,400.
• If the employee compensation was a $150,000 salary with 10% ownership, and average ownership distributions make up $50,000, the employee and the company would have payroll taxes of $9,300 with a total expense for the company of $159,300, a difference of $53,100 for the company combined with a savings of $3,100 for the employee.  Company profits would be reported as $553,100 before the distribution, as opposed to $500,000.
• All other things being equal, with the employee ownership model, the company would be reporting profits of $53,100 above if all compensation was from salary.

The employee ownership model often conflicts with many business books that will recommend the founder keep as much ownership as possible.  Many focus on the eventual exit event where the multiple of earnings results in benefits for the owner.  When it comes time to sell the business, let’s assume the company is valued at a multiple based on earnings of 10x.

• Under the salary model, the company would be valued at $5,000,000 with the founder receiving all $5,000,000.
• Under the employee ownership model and employees owning 10% of the company, the company would be valued at $5,531,000 with the founder receiving 90% or $4,977,900 and the employee owners receiving $553,100.

In the example above, it is easy to understand the ability to retain the employee given the potential payout of $553,100 (if the employee stays at the company) with the founder only losing $22,100 of the eventual payout.  If the employee was originally sold the shares in the company for greater than $22,100, the transaction would be a wash.

Skeptics might say that the procuring company will add the distributions back to the salary to reduce profits and therefore reduce the purchase price.  This was not the case in the TSG sale and, after consulting with multiple friends in mergers and acquisition, rarely happens if the employee ownership percentage is small.  Once the purchase is complete, the procuring company will have to find ways to keep the employee owners with higher salaries or other compensation vehicles.

Employee Ownership – Establishing Trust

Our key to a successful employee ownership was establishing trust through consistency.  Every year we would add new owners and would work our best to provide distributions in an even-handed method.  When it came time for the new owners to come up with the money, the existing owners would share their stories and encourage the new owner to invest.  With the eventual purchase of TSG, all the owners were able to realize the large benefits of ownership, as detailed above.