A big decision in every business owner’s life is deciding if/when to add an employee as an owner to the business. It is not always a legal issue either. In the case of a sole owner, this means giving up a certain amount of control of the business that they created. We often see situations where an employee was added as an owner fail, however, the reason for failure is not necessarily due to the “legal” paperwork. Rather, the reason is due to failure of personalities.
Here are a few wrong reasons to make an employee an owner:
Control: The existing owner(s) identify a high performing employee and want to prevent that employee from leaving, so they make that employee an owner. One of two things happens in this situation: (1) the high performing employee becomes a low performing employee because they think they no longer need to perform; or (2) the high performing employee becomes resentful because they feel stuck. Neither situation is ideal. Moreover, the high performing employee can still always leave.
Employee Demand: If an employee demands ownership in your company, chances are you should probably let that person leave. When an employee demands ownership, generally the existing owner(s) are the people who are the people who wind up resentful. The employee who demanded ownership, generally does not perform to the expected level and the situation turns sour.
Customer Demand: Sometimes a customer may demand that you make a certain person a shareholder or partner in the business. Chances are when this happens, you need to start looking to diversify away from that customer. If you comply with the customer demand, you are basically adding to two owners, the employee and the customer. Furthermore, this will create an incentive for that employee and other employees within that business to serve only that customer, which destroys your customer diversity. This type of scenario can end badly with you losing the customer and the employee.
Here are a few good reasons to add employee owners:
Succession planning: If you want to keep your business alive when you are no longer part of it, a good way to do so would be to sell to those persons already involved in running the business. You will likely receive the highest price from employees and you may still have the opportunity to be involved. What is more, selling to employees gives the business the best chance for success.
Reward: Another good reason for bringing on employee owners is to reward them for work that they have done. This could create an incentive from within to work hard and be successful and as a result, people will be rewarded.
When you are ready to add employees the key to success will be sharing responsibilities and control of the company. The new employee/owners will no longer just be employees and will demand new owner respect. It’s a fact of life and existing owners need to be ready for it.
As for ways of adding owners, there are a few ways to do so:
Sale: Sell ownership interest to the employees at an agreed upon price. This can be done in a lump sum or the existing owner can hold a promissory note designating payments at a certain time.
Simple Transfer: The corporation can simply issue shares to the employees. However, the employees will need to pay taxes on any shares that the receive. You should have a business valuation done when performing this type of transfer.
Gift: An owner can gift a certain amount of shares to the employee. The gift can be structured so that no tax is paid by the employee or the employer. However, there are limits on the amount that you can give each year. Again, you will need a business valuation.
ESOP: This might be the most complicated for of a transfer to employees. It involves transferring the entire company to a trustee to hold on behalf of the employees. The owner is general paid through a bank loan. I can be a very good way to exit the business and retire. Many professionals are needed to complete this transaction.
No matter what transaction you choose, you will need a good buy-sell arrangement to account for any employee/owners who want to leave the company. You do not want to have ex-employees owning a portion of the company.