Hiring true “A” players for your small business can be critical to your organization’s success. To attract and retain senior, well-seasoned executives you may need to make equity part of the compensation package. While you would want to reward the new hire for the future value he or she adds to your business, you don’t want to compensate for the existing value he or she didn’t help to create.
The first thing you will need to do is establish a mechanism for valuing your existing business. If you are comfortable doing this yourself, great. If not, you will want to reach out for some professional help. We prefer valuation methods that consider the profitability of a business, but for simplicity sake, let’s say that you decide to value your business at one times revenue. If your business revenue is $7 million, obviously, that would make your business worth $7 million.
If, for example, you were to give your new employee 10 percent of the outstanding stock of your company, you would be giving him or her $700,000 for coming on board -- that’s quite a signing bonus. One way to avoid this is to allow him or her to purchase the stock. In this case, he or she would pay $700,000 for 10 percent of the outstanding stock, which is its fair value. You wouldn’t be giving away anything since the employee paid what the stock is currently worth.
Unfortunately, many talented employees don’t have $700,000 to invest in their new employer’s stock. Even if they do have the funds, they may not be willing to make such an investment. To address this issue, we have successfully structured deals where the company issued an interest-free loan to the employee to enable him or her to purchase the stock.
No cash need change hands. In our example, the employee would sign a $700,000 note from your company and the company would issue stock to the employee equal to 10 percent of the outstanding shares. The terms of the interest-free loan would require that it be repaid when the stock is sold. If you did this, it would enable your new employee to purchase the stock without putting any of his or her own money into the deal.
When the stock is sold, the loan is repaid with proceeds from the sale. The employee is rewarded only for growth that has happened since he or she joined the company. Returning to our example, let’s say that after five years, the company has grown to $20 million in revenue. Using our formula, the stock would now be worth $20 million. Therefore, the 10 percent stake would be worth $2 million.
If the employee with the 10 percent stake were to sell his or her shares back to the company, the employee would receive $2 million for the sale. He or she would repay the $700,000 loan and net $1.3 million. Your employee would be compensated for the $13 million of growth that the company experienced after he or she joined, but would receive no value for what the business had attained before employment.
Obviously, you could accomplish this in other ways. For example, you could use options. However, interest-free loans are a simple way of enabling your employees to purchase stock without rewarding them for value they did not help create and without requiring them to put their own money into the deal.