So, you have a business idea, founders, and now you are looking at bringing more people on board. How do you share the fruits of your labor with them?
The first thing to recognize, is that the tools available to us are varied and flexible. As usual, the more options you have the more difficult it is to determine what to do. I am going to limit the discussion on tools available, and instead address the broader concerns people have when they are structuring,, creating, and sharing business value. First, here are some of the ancillary considerations you should be keeping in mind:
- Control of the business,
- Succession management for the business,
- Protection of your assets from creditors or seizure from third parties,
- Impact on your estate, and
Each of these could be a 2000-word treatise just to touch on the broad considerations, but it is enough for now to simply point out that the distribution of business value has a direct impact on, and is itself impacted by, the above five matters.
Value of a Business
I believe it is important to get a common understanding on the “value of a business”. Many assume that a business value is a single thing: if you own 10% of a business, then you own 10% of the value. While that can be true, business value is composed of four separate elements:
- The share of profits of the business,
- The share of assets of the business distributed on its winding up,
- The share of the proceeds on the sale of the business, and
- The control you have on the operation of the business.
We can separate out and structure the corporation, its shares, and the agreements between the corporation and the shareholders such that we can deal with the four difference elements of business value separately and differently. For example, we can create a situation where someone has no control of the business but receives all profits from it; while another entity has full control of the business, receives no profits from the business, but would receive all proceeds on the sale of the business. It is exactly this flexibility that makes corporate structures so useful, but also can lead to challenges.
Compensation: Time vs. Capital
We can use corporate and contractual tools to separate out the four elements of business value, but to what end? Before we can address that, we should further clarify the common drivers of sharing business value: time and capital investment in the business. But that too is over-simplified, because there are really six different elements to consider for most sharing of business value:
- Past investment of time in the business
- Past investment of capital in the business
- Current investment of time in the business
- Current investment of capital in the business
- Future investment of time in the business
- Future investment of capital in the business
While this appears trite, when you are sharing business value, it is important to not just recognize what you are apportioning value for but also to ask whether there are better ways to apportion the value based on what you are compensating for. For example, awarding a new employee profit share now and forever on the basis of what they might do for you tomorrow and a year from now looks like absolute nonsense when framed in that way. Yet many companies will turn over a significant percentage of the company to a new employee based on what they are expected to do. Instead, we can look to one of the tools in our “legal toolbox” and create an option agreement, where the new employee is provided the right to acquire a percentage of the company’s shares (which for simplicity’s sake we can consider as correlating to a share of the profits, control, proceeds on sale and assets on winding up).
All of this provides context for what I, as a lawyer, need to have in hand to provide options on how to structure the company now, and in the future. I can even further break this down to assist both in my framing of options as well as framing the discussion between business founders:
- In consideration of Founder 1’s current and past investment of time and capital in the business; Founder 1 will receive
o A1% of the profits of the business
o A2% of the assets of the business on its winding up
o A3% of the proceeds on the sale of the business; and
o A4% of the control of the business
- In consideration of Founder 2’s current and past investment of time and capital in the business, Founder 2 will receive
o B1% of the profits of the business
o B2% of the assets of the business on its winding up
o B3% of the proceeds on the sale of the business; and
o B4% of the control of the business
- In consideration of Founder 1’s planned future investment of time and capital in the business; Founder 1 will receive
o C1% of the future profits of the business
o C2% of the future assets of the business on its winding up
o C3% of the future proceeds on the sale of the business; and
o C4% of the future control of the business
- In consideration of Founder 2’s planned future investment of time and capital in the business, Founder 2 will receive
o D1% of the future profits of the business
o D2% of the future assets of the business on its winding up
o D3% of the future proceeds on the sale of the business; and
o D4% of the future control of the business
- A1+ B1=100%
- A2+ B2=100%
- A3+ B3=100%
- A4+ B4=100%
While there are many ways in which these sharing arrangements can be accomplished, we will be looking to the operational, family, tax and risk circumstances of the business and the founders (and sometimes even the families of the founders) to determine the right legal, contractual, and corporate structures for them. It is often the most efficient spending of time to explain to your counsel what you hope to achieve, and then allow your lawyer, often in consultation with your accounting, estate and tax advisors; to determine the best path forward.