When you’re looking at rewarding a valuable employee the idea of giving him or her a piece of your company often comes up. It’s a quick, easy solution, that doesn’t necessarily mean you come out of pocket (at least initially). That can be great for a cash-strapped start up. But is it always a good idea?
It’s certainly an option, but it is one to approach carefully. The biggest problem I see is people who issue ownership interests in their businesses in happy times, with no strings attached … and then want to undo the transaction later, when things haven’t worked out. It’s a tough place to negotiate from – you have far more of a vested interested in getting those shares or membership interests back than the other party has of keeping them.
So, if you want to give someone else a piece of your business, the first thing to consider is a good Buy-Sell Agreement that gives you the right to buy back the shares, no questions, no argument, if certain things happen (i.e., that person leaves the business, your relationship dissolves, etc.). It’s also a great way to protect your business from events in that person’s life. For example, if that person suddenly died, you could find your business’s shares being passed along to their estate. If that person divorced, you could find your business’s shares being divided up between the spouses, or even transferred to the other spouse outright.
Something else to consider is how much money you’re potentially giving up. This is a little easier to predict in a corporation. Because you are issuing a set number of shares in a corporation you can easily do the math to see how much profit those shares will generate. In a C Corporation it’s even easier – as long as you’re the majority shareholder you can choose whether or not dividends will be issued, and exactly how much per share those dividends will equal. In an S Corporation it’s a little tougher. S Corporations split profits strictly on a percentage of ownership basis. Still not impossible, but you need to do the math and see how much net profit will be going out the door.
In an LLC though, you’ve got a bit more flexibility. LLC’s don’t always have to follow a strict percentage when it comes to distributing profits. So, you could set up a guaranteed payment instead. Remember to consider taxes though. Both LLCs and S Corporation owners pay taxes based on their percentage of ownership – which isn’t always equal to the amount flowing to them each year. Talk to your CPA on that issue before proceeding.
The other option is to hang on to your business’s ownership and do something else. How about a performance bonus? A paid holiday? A pay raise? Or other fringe benefits like a car allowance? If the idea is to show someone that they matter to you and are an important part of your business’s success, there may be other avenues that are just as effective as giving up a piece of your ownership.