Employee ownership can be risky: Answer these 19 questions before you share equity

Employee ownership can be risky: Answer these 19 questions before you share equity

During Executive Coaching, an agency owner asked me:

“As we shift from ‘fun agency’ to more of a ‘professional firm,’ I wonder if we should establish some kind of structure for there to be Partners within the firm. I admire Pentagram for their work, and there are many other creative firms with a Partner owner structure, and I was curious to hear your thoughts and if you have any resources for how to go about making this shift to that model?”

Most agency employees like the idea of “making partner”—especially if you just hand them free equity—but reality (for employees and current owners) tends to be less fun.

Pentagram is an outlier, in its longevity as an independent firm. Be sure to read their 2018 reprint of the 1992 article by co-founder Colin Forbes, in terms of how they got here. (And note that legally, they aren’t a partnership like a law firm; the article indicates that they’re incorporated.)

19 questions to answer before they “make partner”

Thinking specifically about your agency—what are your “why” goals behind sharing ownership? Equity partnerships are like a business marriage. Do you truly know the person you’re marrying?

Many partnerships start in that form out of necessity: the founders needed to pool their cash. If you’re choosing to later create a partnership, you have more flexibility—but also more headaches—to head-off.

“Why” is the big initial question. Once you dig into why you want to share ownership, consider at least 18 more questions about the risks (and rewards):

  1. Would people buy-in via cash, vested sweat equity, or something else? (Here’s a bizarre situation, when the agency said a key employee could become partner if he closed X million in business… and he invented fake contracts to “close the deal.” He went to prison for fraud.)
  2. How do you address the value that you—and any other current partners—have built so far, since founding the agency? (Pentagram started at £0, with—as far as I can tell—five 20% partners.)
  3. How would you value the business at each buy-in? (Pentagram’s solution is for people to buy-in at asset value… and to cash out at asset value.)
  4. Do key employees have the financial means to buy-in? (A majority of people have barely any savings, much less investment capital; the median U.S. household net worth was $97K in 2019. And if they need a loan, can they pass SBA underwriting?)
  5. Do future minority partners have the ability to pay cash taxes each year on their share of the annual profits? (This is especially applicable since you’re choosing to reinvest profits in the business: to an extent, you owe taxes regardless.)
  6. Do future partners have the ability to infuse cash if something bad happens? (Like in Mad Men season 4, when the junior partners have to kick in the equivalent of $450,000 today to collateralize a bridge loan after losing the Lucky Strike account.)
  7. How much equity would you reserve for yourself? (Specifically, would you ever go below 51%, or—more complicated—create multiple share classes?)
  8. As the partnership count increases, is there a point where the financial rewards of an ownership stake become “de minimis” and thus unmotivational? (With one of my clients, the founders made a key employee a junior partner… and the new co-owner complained when her take-home compensation dropped the first few years, since she no longer received employee bonuses.)
  9. What’s the personal financial impact to you on a decrease in annual distributions, as you reduce your share from 100% to something smaller? (For example, relative to the general “20% net profits” benchmark—20% on $3MM is $600K in potential distributions to a 100% owner… but if you’re 60% owner on $5MM, 20% net profits are… still $600,000. And in the smaller example, a partner with 5% ownership gets just $30K in share of profits… on which they owe full taxes, but would likely not receive a cash distribution for the full profits.)
  10. Could you accomplish your goals via phantom stock or another form of “synthetic” equity? (Some of this depends on whether you’re running a Lifestyle agency or Equity agency; an agency designed to never be acquired has different ownership benefits compared to an agency that theoretically operates in perpetuity.)
  11. What happens if one of your business partners dies, gets divorced, or becomes incapacitated?
  12. How would you resolve disputes between non-majority partners?
  13. What would you do if a minority partner wants out, but no one wants to buy their shares at the price they want? (In that case, they might receive liquidity—cash—until there’s an exit event. And there may never be an exit.)
  14. What other restrictive covenants would you include?
  15. What will you do if a new owner keeps acting like an employee (rather than acting like an owner)?
  16. What if a partner isn’t meeting their bizdev quota, or is otherwise not doing their job? (You may be able to fire them as an employee—but depending on the equity terms, they’re still an owner; you’d want to create a covenant for this.)
  17. What happens when a non-majority owner acts like they’re in charge of everything? (This is another reason why character counts… and why it’s dangerous to start a business relationship with someone you don’t know very well.)
  18. How will you ensure that owners [generally] put the business first? (Pentagram’s model has each partner build and manage their own team, and where they serve as a primary client-facing contact for their clients; what negative externalities would this siloed “fiefdom” approach create at your agency?)

Deciding how to approach employee ownership

I’m not saying you shouldn’t share ownership; it’s good for incentive alignment. But as you can see from the list above, it might be more complicated than it initially seems.

In terms of my client’s initial question about “how” to share ownership—eventually, a lawyer would help you on the specific pieces, and everyone would pay for their own legal representation. For example, Matchstick Legal specializes in creative firms; they created my MSA. But as with any negotiation—you’ll save money if everyone agrees to what they want before the lawyers come in.

QUESTION: What are your goals in making an employee a partner in your agency?

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