By Penny de Valk, Associate Director, Equiteq.
Knowledge-intensive services firms can achieve faster growth and reduce founder dependency through diversifying management roles, smart succession planning and equity incentive schemes. These steps support higher future exit values, better deal structures and increase the likelihood of achieving earn out targets if key people are retained and share in the earn out.
From the founder’s point of view, introducing equity incentives will probably be one of the largest investments the company makes so it’s really important to get this right.
Too often tax planning takes crowds out the more important process of designing a commercially effective scheme. Tax is important, but an approach that ensures the growth and exit vision is aligned by evaluating how much value to share, with who and over what time period should come first.
Here are some of the key considerations:
Is everyone receiving incentives aligned?
Placing equity incentives into the hands of people who don’t share the founder’s vision and aren’t aligned to the exit plan can cause significant problems.
This point is often glossed over, perhaps because talking about an exit is seen as destabilizing in some way or too difficult a conversation.
In fact, it’s key to get this out in the open with the key management team so that everyone who is invested in the success of the business are united behind a shared vision.
How much value to share?
Typically, equity incentives are a share in the increase in value of the business. This should be from a fair base so that people can see the potential of their incentives and see value growing over time.
Naturally, it’s important to consider how much value to share in the business and so its key to consider value now and in the future against a credible and thorough business plan which has team buy-in. Does a through written and financial plan exist?
It’s imperative that there is clarity and context upfront. For example, if the holders of incentives believe future value is too uncertain (perhaps they have not been involved in the business plan) or there is too steep a hurdle to realize value (they simply do not believe in the plan), incentives can have the opposite effect to what they are designed to achieve.
It’s also worth remembering that buyers will be more attracted if they think key management have skin in the game and are committed to achieving the earn out.
Is there an agreement in place?
When shares are held by more than one person, it’s vital to put a shareholders’ agreement in place.
With more besides, there are two key considerations. The first of these is ensuring a clean exit – which means when founders wish to sell, anyone else who owns shares is compelled to sell too so that 100% can be delivered to a purchaser. Secondly, it’s advisable that there is a mechanism that enables shares to be acquired and/or limits how much value accrues to ‘outsiders’ should a shareholder leave the business prior to an exit.
Parent company or subsidiary
In diversified groups, it’s often tempting to issue equity in the subsidiary which employs key managers. This can complicate the exit of the group when it becomes necessary to separately value and buy back the subsidiary shares. Generally, having all equity incentives issued by the parent company reduces the risk of last minute problems cleaning up group share structures. If a different approach is needed then extra care must be taken.
Types of incentives
Founders should consider the different ways of issuing incentives.
Incentive types include:
- Share options – these include local schemes for local tax-payers, such as EMI options in qualifying UK companies, which offer corporation tax benefits and low personal tax on gains and can be very effective. However, sometimes options won’t work – a tax efficient scheme in one jurisdiction may be tax inefficient in another, or key managers may simply feel that options are just not the same as holding actual shares.
- Annual growth shares – these provide an annual allocation of equity linked to financial performance and a pre-agreed formula for valuing the business. On the surface, this may seem sensible but risks confusing short-term performance with long-term value. Additionally, these can be tax inefficient for the individuals and the company if deemed to be equity awarded by virtue of employment rather than for being an investor.
- Hurdle shares – also described as sweet equity, these involve management subscribing for and owning shares. Capital structuring ensures the hurdle shares have a low initial value and so are affordable. For example, if a business is worth £30m and hurdle shares pay a proportion of the increase in value above £30m, the shares are worth zero on the day they are issued. These shares can be an effective way to incentivize managers in an international business (so there is one scheme which is broadly tax efficient) as well as for people who feel options don’t quite cut it.
With careful consideration of how best to create alignment with the growth vision and exit – as well as how to avoid pitfalls and accommodate practical tax planning – issuing incentives is a highly effective way to accelerate growth and achieve a successful future exit.
You might also be interested in watching our webinar on the importance of equity incentivizing your team.
If you are preparing to sell your consulting firm and would like to discuss your plans, please get in touch.
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