We tailor our BOLD Value BLOG posts below for owners of private companies with focus on Executive compensation, Equity strategies and Exit & legacy planning. Please click on the Title or Read More to go straight to the full-length BLOG post within this page.

If you wish to receive future BLOG posts directly, please contact Mark Bronfman via email: Mark.Bronfman@LFG.com.

 

Good Incentives, Bad Incentives

I have never met a business owner who made the following request: "Let's put in a long-term incentive plan to destroy company value". Sounds implausible, right?

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Which Succession Pathway Are You On?

After guiding over 100 ownership teams on runway planning, I am often asked: "what is the most powerful lesson leading to a successful owner succession process?" What leads owners to successfully take off and land?

[Read More]

Sheltering Solutions That Build Business Value and Personal Wealth

Business owners and executives understand the painful truth: taxes often eat up nearly 50% of their high-earner compensation. Once compensation is paid, a short list of deductions, losses, and credits are the only way to lessen the tax bite.

[Read More]

Shape Powerful Equity Models via Sell·Pay·Convey®

Equity models are strategic because: “Who gets What” defines “Who You Are!” That is, the way owners share value with those who create it has a profound impact on the firm and the owners’ ability to attract, retain, and reward senior talent.

[Read More]

Solving the Buy-In Paradox

Here’s the buy-in paradox facing private companies. Top talent drives company growth and value. Higher company value dissuades top talent from buying into an illiquid company. Frustrated talent leaves and company value falls.

Public companies benefiting from daily valuation and immediate liquidity can readily solve this buy-in puzzle with stock options and restricted stock. Private companies are not so lucky.

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Profits Interest and Why We Need It

The challenge is how to provide incoming executives with attractive upside at low cost, risk, and complexity to the owner, founder. Profits Interests, an ownership and incentive planning solution under current US tax law, are often the right and best approach.

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Wide-Angle Lens for a Better Shareholders Agreement

We see many broken ownership structures in private companies. New execs can't afford to buy in. The company can't afford to buy out retiring owners. Executive comp plans promote out of date incentives with payout timing that is out of control. How do these companies' value architecture go so far off the rails?

Most often, no one ever did a "crash test" to assure these plans were built to last. You would never buy a car that did not have reasonable crash test results. Why would you "buy" a shareholders and capital arrangement without similar testing?

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Getting Beyond a Band of Experts

Owners of professional services firms (engineering firms, consulting firms, etc.) have a critical choice: Decide what type of business they want to be in the future. Do they want to be a “band of experts” where most of the company value is in the expert? Or do they want to create a true collaborative firm with material value beyond the expert? This is not a trick question.

[Read More]

Does 'Skin-in-the-Game' Really Work?

Private equity groups ("PEGs") often insist that new managers put "skin-in-the-game." A typical approach: a CEO buys around $250K of equity while CXOs buy around $100K of equity. Can a founder replicate the skin-in-the-game PEG model? As they say on TV, don't try this at home without adult supervision.

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When Conventional Wisdom is Wrong

Conventional wisdom is that an ESOP is almost always inferior to a strategic sale. The common view: an ESOP (Employee Stock Ownership Plan) provides liquidity at a painful discount. Real owners sell to strategic buyers, financial buyers or executives. Only the desperate use ESOPs.

Conventional wisdom can be a blunt object. The truth: the ESOP option can be a truly competitive choice for owner liquidity and value.

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Thinking Outside of 401(k) Box

Are you using your corporate retirement plans to foster raving fans that become loyal to your organization? Consider the following five design elements that can help you stand out in the crowd.

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Are Equity Grants Truly the Holy Grail?

"I am going to make you a 20% equity partner." These are some of the sweetest words that a 2nd in command will ever hear. Unfortunately, this could also be the beginning of the end. In many cases, the cost of transferring equity can starve the company of growth capital.

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Paying Fair without Distortion

Public company equity-based pay practices, such as stock grants, restricted stock, and employee stock options are often a poor fit for private companies committed to rewarding leaders for performance, growth and capital succession.

Equity based programs that make sense and work well in a public company come with many ills for private companies: they can be costly, tax-inefficient, static, ineffective, and sometimes downright unfair. In the worst case, equity pay practices can derail the owners' plans for growth and succession.

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Will Hidden Taxes Derail Your Succession Plan?

A new client asked us to help administer their new management buyout plan crafted by very qualified attorneys. Our review shocked her. I pointed out that her management buyout ("MBO") plan directs 60% of succession capital to the IRS and only leaves 40% for her. Unfortunately this outcome is all too common.

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Can Employee Stock Options Make You Sick?

Many business owners have a well-written mission/vision statement. Too often, however, companies use precious capital for the wrong things at the wrong times, leaving insufficient capital for eventual owner succession.

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Good Incentives, Bad Incentives

I have never met a business owner who made the following request: "Let's put in a long-term incentive plan to destroy company value". Sounds implausible, right?

Unfortunately, many business owners do just that. Their incentive planning process is devoid of testing. As such, they never consider the full range of what-if's - such as contingency planning or change in business direction.

As a result, we have been brought in to fix many incentive plans gone bad. Below are five examples of value-destroying incentives. Do any of these sound familiar?

Incentives Gone Bad

  • A company has a high visibility bonus plan that rewards one single thing: growth in annual profit. However, the long-term strategy is to sell the company to a strategic buyer. In the eyes of potential buyers, all profit is definitely NOT equal. Result: the bonus plan essentially defeats the growth strategy.
  • A company has the following stock ownership: two founders each own 50% and one key executive has 4% stock options. The executive with 4% stock option exercises for stock. As a result, the two 50% founders now each are relegated to 48% minority owners with an unexpected 20% discount - representing a material loss of value reflecting lack of control.
  • An engineering firm has great growth prospects. Growth continues and the company increases in value - which means the buy-in is very costly for next gen managers. The next generation of leadership jumps ship as they won't take on such large stock acquisition debt. Growth stalls and never recovers.
  • A high growth company installs a stock appreciation rights ("SARs") plan. The liability associated with a SAR plan spiked to be greater than the company's annual profit or in some cases, revenue - nearly strangling the company's growth plans.
  • A 30 year old services company has a mix of older and younger owners. Partners buy-in and sell out at book value. Now the older HUNCs (High unit/no clients) partners refuse to sell their shares at book value - effectively "retiring in place". Opportunities for emerging talent are limited and several execs eventually depart.

Best Practice Design Tests

These are not HR problems - they are strategic impediments to growth. Unfortunately, too many CEOs and Boards turn a blind eye to these issues.

Don't let the value destroying incentives happen to you. The best incentive programs, like the best IT programs, should go through several levels of testing.

Here are some of the key incentive tests you may wish to consider before implementation of a major incentive plan:

  • Affordability: Can we afford the plans now and in the future - even in the event extreme volatility?
  • Competency: Can we use these plans to attract and retain the most precious talent - regardless of whether this is the CXO or senior managers?
  • Succession: Can we use these plans to help us execute on our leadership and capital succession plan - such as: change in control, going perpetual, stay in the family or ESOP?
  • Simplicity: Can we explain the program easily to our key talent and the plan is easy to adopt from a book, tax and administrative perspective?
  • Resiliency: Can we modify or dramatically change the plans given changes in our competitive landscape, business priorities and people strategy.

Commitment to Good Incentives

No doubt, it is better to design and fully test your plans in advance. Commit yourself to designing "good incentives" that are affordable, flexible relative to competency and succession, simple and resilient.

For more information, see the Top 40 Rewards for Strategic Advantage.

Please contact us to learn.

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Which Succession Pathway Are You On?

My experience flying around the world did not prepare me for the scary approach and landing at Wellington airport in New Zealand. It was the stomach wrenching air-pocket that I remember. As we approached, the captain maneuvered the plane through an amazingly short and curvy path through jagged mountains.

No surprise - Wellington is listed as one of the world's scariest airports. 

Training Pays off

Even on normal runways, the events leading up to any take-off or landing can make the most time-tested airports a harrowing experience.

Just ask Captain Chelsey "Sully" Sullenberger - as told in the movie Sully starring Tom Hanks. Sully's US Airways plane lost power to both engines due to "a double bird strike" when taking off from LaGuardia, NY airport in 2009. Despite the terrifying situation, Sully saved over a hundred lives by engineering an amazing landing directly ON the Hudson River. Undoubtedly, countless hours of flight experience enabled this heroic outcome.

Unlike pilots, most business owners engaging in business succession simply don't have this "flight experience". Most business owners address the issues of leadership, capital and business succession just once in their professional career. When it comes to "runway planning" - the critical two to seven-year period leading up to change in leadership and/or change in control - business owners need help from specialized advisors to engineer a successful landing.

The Powerful Lesson of High Performance Succession

These specialized advisors help with issues such as personal objectives, growth, leadership, liquidity, taxation, culture and governance control.

After guiding over 100 ownership teams on runway planning, I am often asked: "what is the most powerful lesson leading to a successful owner succession process?" What leads owners to successfully take off and land?

Here's my answer. To succeed, a business owner needs to know which of following four major "flight paths" they are on:

  1. Change in Control: Owners proceeding to a change in control via selling the business to a 3rd party.
  2. Partnership: Owners fostering a perpetual enterprise while key owners enter and exit (a la large professional partnerships like a law firm or consulting firm).
  3. Family transfer: Preparing the next generation for leadership and governance roles often with the help of non-family professional management during the transition period.
  4. ESOP: Owner gaining liquidity as a result of sale to a broad base of employees most often via a tax-advantaged qualified plan such as an ESOP.

Each of these four succession pathways have dramatically different approaches for take-off and landing. For example, change in control pathways are typically supported with bonuses in event of change of control while partnership models must master the true transfer of equity ownership. An advisor skilled in one model may not be what is needed for a successful landing for another model.

Foster a Fabric of Advisors

Let's take it further. A successful partnership equity model requires an approach to "de-risk the buy-in" for new talent who may lack sufficient capital to acquire minority ownership. Conversely, a change in control pathway model may benefit greatly from an approach that rewards merit leading up to a deal using techniques such as synthetic equity. The value architectures of each of the four succession pathways are dramatically different.

The next time I fly into the careening runway of Wellington, New Zealand, I am hoping (and praying!) for a specialist New Zealand pilot. Not all flight plans are the same. Neither are all business succession advisors.

As a business owner, you should foster a fabric of advisors consistent with your flight path. Then, and only then, will you be prepared in event of major surprises.

Please contact us to learn more.

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Sheltering Solutions That Build Business Value and Personal Wealth

Business owners and executives understand the painful truth: taxes often eat up nearly 50% of their high-earner compensation. Once compensation is paid, a short list of deductions, losses, and credits are the only way to lessen the tax bite.

Shelter Income, Growth, and Succession

This "everyone for themselves" approach to tax reduction has limited benefits. There is a better way. Overall, a pivot to three sheltering can deliver meaningful enterprise and personal benefits. These three sheltering solutions include:

  1. Sheltering Income before compensation is recognized via qualified profit sharing, nonqualified deferred compensation or LTIP programs.
  2. Sheltering Earnings on investments via temporary or permanent deferral via Roth 401(k), 162 bonuses or Profits Interest.
  3. Sheltering Tax on Capital Transactions or converting ordinary income to capital gains via Synthetic Equity, ESOPs and Business Continuation LLCs.

Collectively, these strategies provide owners and key executives with wealth-building opportunities and position the company as an employer of choice. Ideally, these strategies also improve company performance by reducing executives' and owners' financial stress.

The Powerful Effect of Sheltering Solutions Nudge

Want these programs to succeed? Try incorporating "opt-out" strategies rather than opt-in strategies.

Here's an example. Take a portion of annual bonuses and positon them into insurance based programs (aka, 162 bonus), thereby helping executives to exclude earnings on these bonuses over the long term. Or adopt automatic enrollment for some of your qualified plan benefits. Certainly, give executives and owners the right to opt-out if they want. Most will stay in the programs and reap the benefits.

Want to learn more? Nudges are cues embedded in the design of a tax reduction program that direct human behavior without dictating it. Behavioral economist Richard Thaler just won the 2017 Nobel Prize for Economics showing the astonishingly powerful effects of the "Nudge" (Thaler's book).

Keep More of What You Earn

See our recent white paper entitled "Keep More of What You Earn" and see if you can nudge your co-owners and executives to do better financially both in and out of the business. Shelter income, growth and succession and see the rewards for yourself.

Please contact us to learn more.

Please click HERE for the full article "Keep More of What You Make".

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Shape Powerful Equity Models via Sell·Pay·Convey®

Equity models are strategic because: “Who gets What” defines “Who You Are!” That is, the way owners share value with those who create it has a profound impact on the firm and the owners’ ability to attract, retain, and reward senior talent.

Equity and the Agile Enterprise

Private companies often use a variety of innovative tools, individually or in combination, to navigate and conquer major changes brought on by the urgent concerns of affordability, competency, and succession or “equity inflection points”.

That is, they use equity to gain a strategic advantage when addressing challenges such as:

  • Affordability: “Our success has driven up the price of ownership. Key executives can’t afford to buy-in and we may lose our best people.”
  • Competency: “Our core markets and strategies are shifting fast, and we don’t have the right people in place. We need to realign our leadership.”
  • Succession: “Some of us are ready to retire, but our equity model is getting in the way of our exit strategies. Our succession plan is at risk.”

5 Equity Rules for Strategic Advantage

Many business owners and boards turn to equity as the default technique to attract, retain, and reward senior members of their team. But they do not always use it to their best advantage. The following 5 Equity Rules help to design an equity model that best serves owner needs:

  1. Confirm that equity is the right tool. Equity awards are “all-for-one and one-for-all” and so are less effective than rewards tied to individual contributions, such as improvements in a function or business unit.
  2. Know the full cost of an equity program. Cash is king and equity awards look like a non-cash expense but equity is often the most expensive value-sharing alternative and entails a near-permanent transfer of value to an executive. As such, it usually is not the best option for rewarding growth over a short time period.
  3. Ensure that the equity model aligns with owner exit plans. Different exit paths are best served by different reward strategies. If owners plan to sell to insiders, an equity program may be appropriate. A family business that plans to keep the business in the family may be better off with intra-family trusts.
  4. Ensure that equity follows engagement, not vice versa. If an executive team is not highly motivated, throwing equity at them is not likely to make a difference.
  5. Make the Sell·Pay·Convey® equity transfer framework core to company strategy. The Sell·Pay·Convey® decision framework helps owners know how and when to: sell equity (typically via an installment note); pay equity (as a compensatory bonus); and convey equity (at no cost to the executive). Variations on the Sell·Pay·Convey® spectrum can be combined into self-correcting equity models that drive leaders to perform and grow using a variety of approaches. See examples below.

Use Sell·Pay·Convey® to Shape a Powerful Equity Model

  • Sell: Transfer ownership to new owners by selling them a stake in the company. Sell examples include:
    • Valuation discounts
    • Affordability financing
    • Non-recourse debt
       
  • Pay: Transfer ownership to new owners by paying equity via a grant. Pay examples include:
    • Compensatory stock grants
    • Restricted stock grants with 83(b) election
    • Nonqualified stock options (NSOs)
       
  • Convey: Transferring ownership to new owners with no out-of-pocket cost to executives. Convey examples:
    • Profits interests in a partnership
    • Stock bonus with a tax true
       

The Equity Rules white paper provides a case study illustrating the full power of the Sell·Pay·Convey® framework to simultaneously get key executives to put skin in the game, reward superlative performance, and encourage entrepreneurial behavior.

Please click HERE for the full article “Equity Rules”.

The best practice for owners is to transfer equity distribution as a strategic company “fix”, not a one-off transaction.

Please contact us to learn more or visit BOLDValue.com.

Please click HERE to go to Intelliven website that features our article.

Also, visit our BLOGs on executive compensation, equity strategies and exit & legacy planning at our website. Please click HERE for Blogs.

Please contact us to learn more.

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Solving the Buy-In Paradox

Here’s the buy-in paradox facing private companies. Top talent drives company growth and value. Higher company value dissuades top talent from buying into an illiquid company. Frustrated talent leaves and company value falls.

Public companies benefiting from daily valuation and immediate liquidity can readily solve this buy-in puzzle with stock options and restricted stock. Private companies are not so lucky.

Success Creates its Own Challenges

In the early stages of a start-up, buy-in capital may be cheap, perhaps $10,000 for 10%. Grow to $10M in value and now 10% is $1M, beyond the comfort zone for the typical executive. Grow to $50M in value and at $5M, buying a 10% ownership stake becomes nearly impossible for an individual. Clearly, success creates its own challenges.

Typically there is no single solution to solve this buy-in paradox. Solutions differ for newly promoted executive owners coming into the ownership suite versus a proven CEO who deserves greater percentage of ownership.

Trio of Solutions

Here’s the buy-in challenge: how do we simultaneously increase shareholder value while making the buy-in more affordable for critical executives? We call the portfolio of solutions to address the buy-in paradox SELL • PAY • CONVEY®. Notionally, we can make it easier for key executives “get-in” to the ownership suite in three major ways:

  • SELL: The company (or the existing owners) SELLS executives equity with attractive terms to mitigate risk.
  • PAY: The company PAYS executives with equity - typically called a compensatory grant.
  • CONVEY: The company CONVEYS ownership to executives with no buy-in or compensatory cost.

Here is a single example from each of the SELL • PAY • CONVEY® strategies:

  • Sell equity using a mix of recourse and non-recourse debt to mitigate buy-in risk.
    • Most equity buy-ins involve installment notes. If the executive buyer defaults on the note, the non-recourse portion of the note is satisfied with the return of the shares. Borrow $1M at 50% recourse and 50% non-recourse, and the maximum cost in event of default is $500,000. Be careful here. Many tax practitioners advise that equity purchases with more than 50% non-recourse note can trigger stock option treatment (ordinary income tax rate), rather than the desired capital gains treatment.
  • Pay equity on a favorable basis reflecting minority interest discount.
    • The use of minority interest discounts in a buy-sell agreement is not required, yet often advisable. Grant an executive 10% of your $10M company and how much tax on compensation is due? If no discounts for lack of marketability and lack of control, compensation is $1M. After a 40% discounts, the compensatory income is much less at $600,000. Apply a 40% income tax rate and the tax due before and after discounts are dramatically different: $400,000 vs $240,000.
  • Convey equity via profits interests in a partnership or a qualifying LLC.
    • Provide profits interest which is a unique type of ownership with no cost at transfer. A grant of profits interests provides an executive all the upside of a grant without the need to pay the underlying “threshold” value. Further, qualifying a profits interest grant conveys property rights and is taxed at capital gains rates. See our recent article on Profits Interests by clicking HERE.

Overcoming the Core Challenge of Succession Planning

Just about every business owner must ask and answer the key strategic question: how do we efficiently and effectively provide some “taste of ownership” to our top talent? Mastering strategies of Sell, Pay and Convey helps address this critical succession planning challenge.

How many of the “Sell • Pay • Convey®” strategies has your ownership team explored?

Please contact us to learn more.

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Profits Interest and Why We Need It

Founders who still own and run their businesses may bring on executives to get to the next level and/or to free themselves from being a slave to their success. The challenge is how to provide incoming executives with attractive upside at low cost, risk, and complexity to the owner, founder.

Profits Interests, an ownership and incentive planning solution under current US tax law, are often the right and best approach. This powerful equity incentive plan requires no buy-in; is not taxable at grant or vesting; and, its capital liquidations are taxed as capital gains.

To borrow a concept from architectural engineering, the profits interest is a “cantilevered” approach to equity transfer a la Frank Lloyd Wright. Essentially, profits interests extend a stake in the economic future of a company to key executives without requiring payment for the underlying capital interest foundation.

Advantages

Profits interest offer many design advantages, since:

  1. Profits interests are accretive: The value of a profits interest accrues from the future success of the business with no value at grant. Hence, owners and founders can be assured that they are only giving away a portion of the upside growth of their companies.
  2. Profits interests are taxed as capital gains: When designed properly, the recipient pays no tax at grant and no tax at vesting. Recipient pays capital gains taxes upon liquidation. In these regards, the profits interest is a truly unique tax vehicle in the realm of long term incentives.
  3. Profits interests are flexible: All profits interests are composed of two parts: an annual profit allocation and a liquidation value upon certain triggering events. Based on design, different and creative combination can be a powerful yet flexible tool.
  4. Profits interests also provide high performance incentives as they share in the success of future achievement. They facilitate leadership and owner succession via equity transfer. And they strengthen high-performance cultures by promoting equity and fairness, helping to attract and retain the right key employees.

Qualifications and costs

  1. To qualify for the tax and design benefits profits interests, the grants must pertain to a privately-held partnership or an LLC taxed as a partnership, a form of ownership that has exploded in popularity over the past 20 years. Several other qualifications must be met as well.
  2. Given certain costs and concerns, profits interests are not for all companies or situations. Profits interests are issued without any cost to the executive so there is less “skin in the game”. The variety of profits interest design options and choices for can create complexity.
  3. The set-up and maintenance costs of profits interests can be relatively high as compared with alternatives such as synthetic equity. The grants need to be drafted with consideration of changing tax laws. Still, many of these costs concerns can be mitigated by using an experienced advisory team.

Future prospects

We expect profits interests to become increasingly popular as many more middle market companies choose to be structured as an LLC taxed as a partnership. Designed properly, profits interests offer many advantages despite potential cost and other complexities.

Want to explore more?
Please contact us to learn more.

Please also visit the Intelliven website to see our article.

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A Wide-Angle Tool Saves Taxes while Achieving Objectives

A building contractor granted 10% of the company to a newly promoted COO. Given its large accounts receivable balance, the company had to borrow nearly $2M to cover the taxes on this grant.

We shared there is an alternative to achieve a near identical outcome and zero tax cost (meaning a $2M tax savings). Hearing this, the owners almost blew a gasket. Our suggestion: issue Profits Interests in their LLC with a catch-up provision that, over time, looks and feels just like traditional restricted equity.

For more information on Profits Interest, see Mark Bronfman's article on "The Profits Interest".

Logical Analysis first, before Legal Articulation

The lesson: embrace the logical before the legal. We develop a "value sharing curve" model prior to having the attorneys draft the legal plans. The model tests the value architecture, specifically in regard to how executives and owners get in, share value and eventually leave the business in style.

The value sharing curve has a critical advantage - it works the problem from the end, not the beginning. Outline what the financials of a business could look like in the extreme. Keep iterating the design until you enhance the chance of success. Reduce the risk of cash flow or value failure. Try things like:

  • Use profits interests instead of restricted equity.
  • Model long term cash flows based on extreme scenarios
  • Use multiple values in a single shareholder agreement for buy-in and buy-out
  • Add SARs to a phantom stock plan.
  • Consider time-to-value rewards via EVA or Performance Share Plans
  • Consider choice of entity across C, S or LLC to achieve an end goal.
  • Promote control incentives (such as vote, right to hire/fire) in lieu of traditional incentives
  • Add debt governors to installment buyouts

 

These modifications viewed through the wide-angle lens of the value sharing curve can do wonders for a buy-sell arrangement, a shareholders agreement or an executive compensation plan.

Want to know more about resilient executive compensation, equity strategies and exit planning? We can help.

Please contact us to learn more.

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Getting Beyond a Band of Experts

Owners of professional services firms (engineering firms, consulting firms, etc.) have a critical choice: Decide what type of business they want to be in the future. Do they want to be a “band of experts” where most of the company value is in the expert? Or do they want to create a true collaborative firm with material value beyond the expert? This is not a trick question.

The band of experts model attributes most shareholder value to the expert engineer, consultant, architect, IT designer – called personal goodwill. This approach brings a great advantage. New owners typically join the band of experts at a low “book value” price. Some people call this the individual contributor model.

Many band of experts firms eventually reach the fork in the road. They can stay small (say under $25-$50M in annual revenue) or choose to scale. Scale means ramping up via collaboration, investment in people and repeatable processes with the goal of creating shareholder value and take on bigger, more complex projects.

Enhancing Shareholder Value

To reach its value potential, the expert business needs to shed its skin and choose growth. Here are four clues that your professional services firm is ready leave the expert model and adopt the scalable model:

  1. Third party acquirers approach to buy your organization for true value. You quickly realize that an acquirer does not pay for experts that can just walk right out the door. Rather acquirers pay for the assets and capabilities such as client relationships, unique processes and intellectual property.
  2. Your business potential is well beyond the sum of the individual experts. Many of our clients are leveraging technology to be catalyst for scale. This may require investment in talent, business development, process improvement and perhaps acquisitions.
  3. You experience a flight risk of your top performers to competitors. Why do top performers leave? Book value caps the value to scalable expert. On the other hand, your competitors give scalable experts a platform to earn their value in the business with strategic upside of stock options, restricted stock, synthetic equity, or profits interests.
  4. Your HUNKs do not leave (HUNKs are "High Unit, No Client" experts). Buy sell agreements based on book value do little to encourage less productive senior partners to leave. Trying to force senior partners out can be difficult when book value is the only incentive and the HUNKs are getting their ownership share of profits.

Avoiding the Liquidity Crunch

Going from the expert book value model to the scalable growth model takes a lot more than just changing the top-line revenue model. The equity model and shareholders agreement need to change.

Scalable companies are asking the following questions:

  • What is the right choice of entity (C, S, LLC) especially if we may eventually merge or sell?
  • What are the different triggers and values in our buy-sell agreement for early retirement, full retirement, and change in control?
  • How do we manage the liquidity crunch of owner redemptions at strategic or fair market value?
  • Is there a sinking fund for buyout and does that sinking fund benefit from tax deferral?
  • How will our leaders afford to become owners?
  • How will we reinforce a culture of merit and ownership? What tools will make the overall program effective and affordable including equity, synthetic equity, cash based plans or control privileges.


Want to explore moving beyond the expert model to the growth model? We can help.

Please contact us to learn more.

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Does 'Skin-in-the-Game' Really Work?

Private equity Groups (PEGs) have a very successful model. Leverage access to equity and debt capital and acquire companies with lots of upside potential. Bring in proven, value-centric management to create material equity value via organic and M&A growth. All this with a single focus in mind: exit to pay back its investors.

From a human capital perspective, PEGs often insist that new managers put "skin-in-the-game." A typical approach: a CEO buys around $250K of equity while CXOs buy around $100K of equity.

Replicating the private equity model can be hard

Can a founder replicate the skin-in-the-game PEG model? As they say on TV, don't try this at home without adult supervision. Asking new managers to buy into a founder company (not a PEG) often does not work. Here's why:

  1. PEGs typically have both the control and vision to maximize the value drivers for a company – such as product/service mix, distribution channels, vendor alliances, price reduction, etc. Most founders give this lip service. They are unable to get out of the way.
  2. PEGs are very leveraged so outsized equity returns on equity are possible. Most founder-owned companies have limited debt. So the upside is often limited for the candidate executive who buys in.
  3. PEGs are committed to their exit strategy from the start:  often, get out within 7 years of getting in. A skin-in- the-game executive can see the light at the end of the tunnel from day one. Most founders talk a good game but are not committed to exit unless the total deal works including fitting the founder's next career.
  4. PEGs use skin-in-the-game as a "gate." Founders use it as a validation of their valuable entity which is often counter-productive to a buy-in. The price a founder set may just be too high.
  5. PEGs are willing to take risk and either win or lose. PEGs invest across a number of different companies; not all will win. Founders on the other hand tend to be somewhat risk-adverse since they only have one business and one company. Founders have a powerful urge for self-preservation, often leading to avoiding risk.

The founder approach to strategic incentive

Bottom line: The PEG skin-in-the-game tool box may not fit a founder-based firm. A PEG portfolio company brings an integrated approach for both leadership and capital succession.

On the other hand, most founders seek leadership succession and then figure capital succession out later. Requiring a key executive to put skin-in-the-game to a founder-based firm can easily backfire.

Executives eventually want their money back and often a shareholders' agreement only provides liquidity when an executive leaves. Then the founder is back to square one: no CEO, no succession, and no path to liquidity

Know your options for strategic incentives across true and synthetic equity. Explore skin-in-the-game "lite" strategies that can be much more resilient and effective to fit the needs of founder-based companies.

Want to explore more?

Contact us to learn more.

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When Conventional Wisdom is Wrong

Conventional wisdom is that an ESOP is almost always inferior to a strategic sale. The common view: an ESOP (Employee Stock Ownership Plan) provides liquidity at a painful discount. Real owners sell to strategic buyers, financial buyers or executives. Only the desperate use ESOPs.

Conventional wisdom can be a blunt object. The truth: the ESOP option can be a truly competitive choice for owner liquidity and value.

Maximizing Shareholder Value

Here are five clues that an ESOP could be a winner for you:

1. High cash flow and no logical strategic buyer. Many very healthy companies do not have logical strategic buyers. One of our ESOP clients has contracts that can't be transferred due to conflicts. Other ESOP clients have a non-transferable royalty arrangement. Others can't novate government contracting set-aside contracts. An ESOP is often the most attractive buyer for a non-transferable cash cow.

2. Sell and keep control. Many owners cherish their identity as a business owner. Sell to a strategic buyer and you give up ownership and control. Sell to an ESOP and stay in control as the notes are paid off. Value is not all about money. Often a founder's post-sale role and responsibility is what matters most.

3. Older owner. Do you know the IRS permits the rollover of capital gains on certain assets like real estate and C Corp business assets? Defer the gain till your eventual death and get a step-up in basis and avoid all taxation on the sale. If done correctly, you can even borrow against the rollover proceeds and use the assets however you like. It's what you keep that matters.

4. Owner of C Corporation. Most strategic buyers want to buy assets, not stock, for tax purposes. Selling shareholders of a C Corporation are taxed twice: once at the C Corp level and then a 2nd time upon receiving C Corp distributions. Sell stock (not assets) to an ESOP and avoid double taxation. Savings: Avoiding the 15% tax trap of double taxation.

5. Greater Bank Leverage. Considering a management buyout? The sale to insiders is often limited by bank financing. Commercial banks will often lend 3X on a taxable company's EBITDA versus 5X on a tax-exempt entity's EBITDA (like an S Corp ESOP).That is $20 million more borrowing for a company with $10 million of EBITDA. 66% more bank financing matters.

Look before you leap

ESOP can be great for sellers. These same ESOPs can create complications for the insiders who now manage the ESOP, pay off the debt and seek to attract and retain the best talent with limited equity options. Many of these complexities can be reduced if managed correctly. So look and plan before you take the ESOP leap.

Bottom line: ESOP can be one of the most effective solution to unlock hidden shareholder value. Context is everything.

Want to explore more about ESOPs?

Please contact us to learn more.

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Thinking Outside of 401(k) Box

Want to double the value of your business? Bain Consulting says: work first on building customer loyalty.

The benefits: retain the lifetime value of a customer, reduce customer acquisition cost, reward yourself via higher margins from loyal customers. Customer loyalty is why AT&T, Subway, Nike, and Costco dominate their respective niches.

Who is your single largest customer? If you are a professional services provider, perhaps your most important customers are your own employees. Large hospital systems, for example, find that retaining a single physician specialist brings savings of $250K to $1M versus replacing the doctor.* Reduce turnover by 2% in a 500 doctor setting and the savings could be $5M per year. If your company is worth 10X profit, that is an immediate $50M addition to your enterprise value!

Strategic Use of Company Retirement Plans fostering Loyalty

Are you using your corporate retirement plans to foster raving fans that become loyal to your organization? Consider the following five design elements that can help you stand out in the crowd:

  1. Do you offer your high performing executives an opportunity to defer their bonuses into their tax-advantaged qualified profit sharing plan?
  2. Do you permit your employees to defer way in excess of the 401(K) limits as a way to prepare for retirement through a nonqualified deferred compensation ("NQDC") plan?
  3. Do you offer an incentive match to your corporate retirement plans - so you can share the wealth as the company performs?
  4. Do you permit your key employees to dramatically reduce their tax rate on equity or synthetic equity plan via re-deferral arrangements?
  5. Do you offer an advanced administrative system aggregating all your plans to increase visibility and employee engagement?

40 Different Strategic Incentives, Customized to Specific Objectives

At BOLD Value, we use over 40 strategic incentives to engage and promote loyalty with your most important asset: your people. We customize, design, promote and administer value sharing programs such as:

  • Qualified Plans (401(k), ESOP, Qualified Profit Sharing Plans)
  • Equity Plans (Restricted stock, employee stock options, SARs)
  • Synthetic Equity Plans (Phantom stock, value band plans, change in control plans)
  • Direct Cash Plans (NQDC, LTIP, Bonus Plans, lifestyle plans)

Take a fresh look at your retirement plans as a strategic asset, not a cost center. Engage and foster your raving fan employee base to increase your enterprise value along the way.

Please contact us to learn more.

This material is for general use with the public and is designed for informational or educational purposes only. It is not intended as investment advice and is not a recommendation for retirement savings. Lincoln Financial Advisors does not offer legal or tax advice.

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Are Equity Grants Truly the Holy Grail?

"I am going to make you a 20% equity partner." These are some of the sweetest words that a 2nd in command will ever hear. Unfortunately, this could also be the beginning of the end. In many cases, the cost of transferring equity can starve the company of growth capital.

Case Study -  Equity Grant for 2nd in Command

  • Your business has been thriving due to growing demand for your IT services and high performance execution led by your 2nd in command. As part of a retention program, you pay the tax cost to make your 2nd in command a 20% equity
  • Growth strains your working capital. As an owner, you are business rich and cash poor. Sensing lack of capital to expand, your 2nd in command "falls in love" with your competitor and exits your company.
  • How do you afford to buy out your 20% minority partner? What happens if your company or industry stalls due to higher competitive intensity or lower customer demand? Who ends up carrying the ball once your key executive leaves?

At Bold Value, we don't start with a presumed equity or capital structure; we start with the "value sharing curve." We define who gets paid what value at what time including the often surprising tax implications. Only then do we consider what we call the "top forty" structural ways to share value in a privately held business.

For example, are you better off offering "equity now" such as restricted stock or phantom stock? Are you better off offering "equity later" such as a change in control bonus? Alternatively, are "cash later" designs such as profit appreciation rights the best fit or is an old fashioned "cash now" annual bonuses the best solution? Might a custom solution work best for your team? When it comes to co-owner incentives, we are true believers that structure follows strategy, not the other way around.

Six Questions to Ask Prior to Making Equity Grants

Equity grants are powerful, but can be costly and inflexible. Before making true equity grants, ask yourself:

  • What is the "total program cost" to transfer equity such as owner dilution, tax cost, valuation, buy- in and buyout capital, revised buy-sell and corporate agreements, etc.?
  • Are we creating a low-friction pathway for high performers to enter and low performers to exit our organization consistent with our growth strategy?
  • Who gets cashed out first - when and why? When does the founder get liquid?
  • Who is diluted when the next key person becomes an owner?
  • How does the equity transfer impact the owners' estate planning?
  • What is the cost to unwind the equity grant if it does not work out? Can the grant be reversed at no or low cost?

One of our clients said it best: "Value sharing is all about the economics, not the legal structure. If we can achieve the same outcome for much less cost, everybody wins."

Next time you feel "deal heat" with your 2nd in command - take a deep breath and start with the value-sharing-curve in mind. Your 2nd in command will still love you.

Do you think you might have hidden surprises in your executive compensation, equity strategies, and exit & legacy planning?

Please call us for a 2nd Opinion.

Please contact us to learn more.

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Paying Fair without Distortion

Public company equity-based pay practices, such as stock grants, restricted stock, and employee stock options are often a poor fit for private companies committed to rewarding leaders for performance, growth and capital succession.

Equity based programs that make sense and work well in a public company come with many ills for private companies: they can be costly, tax-inefficient, static, ineffective, and sometimes downright unfair. In the worst case, equity pay practices can derail the owners' plans for growth and succession.

The Unfairness of Public Pay Programs

Dynamic synthetic equity presents a more tailored solution for private companies interested in leadership and capital succession. Restricted stock and employee stock options often distort outcomes for private companies. Consider that:

  • The underlying stock price in a private company gyrates as owners enter and exit from, for example, a living or a death buyout or even a recapitalization. Stock price can jump 50% - unjustly rewarding the owners of true equity awards.
  • Lack of a public company oversight may cause excessive risk-taking. Upside-only plans, like stock options, can encourage excessive risky behavior, especially when owners go passive.
  • Private company owners typically want an "equity waterfall" where the owner gets his/her capital back before upside is shared with others. A private company owner might want to say: "I get $10M before anyone gets anything"; which can be hard to implement using stock or employee stock options.
  • As private companies reinvent themselves, they need to be able to avoid a "first-in" bias and reallocate value to top performers as new stars emerge in the company. Reallocating value based on merit is hard to do if equity awards have been made before new leaders are brought on board.
  • Private companies have little or no liquidity for their stock. Typical private company stock plans only payout at separation of service which has the opposite effect of a "retention plan" in that it encourages executives to leave rather than stay.

Private companies are fundamentally different than public companies and should have executive compensation solutions that make sense in light of the differences. Dynamic synthetic equity is often the more ideal solution to promote private company business performance, growth, and succession.

The Four FAIR Principles Leading to Dynamic Synthetic Equity

Dynamic synthetic equity designs easily adapt to inevitable changes in capital structure, owner objectives, governance and strategic intent. Dynamic synthetic equity solutions can self-correct along four private company value sharing requirements:

  • FAIR Value: Base plans on Enterprise Value or formulaic value, not on fair market value per share. Enterprise or formulaic value reduces the distortion in share price and equity value which can be dramatic with the occurrence of unplanned entry and exit of owners or debt-holders. Not doing so leaves participants open to receiving windfalls and exposed to downside risks in the face of events well beyond their control
    • When FAIR Value is important, consider an ENTERPRISE VALUE PLAN
  • FAIR Share: Base plans on graduated rewards consistent with the owners' objectives. As opposed to phantom stock or SARs, which are both linear expressions of value sharing, a FAIR share approach can follow a waterfall type approach where key executives share value only after certain owner targets are achieved (e.g., associated with performance targets or personal wealth targets)
    • When FAIR Share is important, consider the VALUE BAND PLAN
  • FAIR Deal: Encourage owner-like behavior from key executives (including an entry cost for synthetic plans). Phantom stock and SARs are almost always granted for free - with no requirement for the executive to reach into their pocket and have "skin in the game" and pay something for the right to share in the upside. Imposing a buy-in cost can dramatically improve executives' behavior to risk-taking and a sense of co-ownership
    • When FAIR Deal is important, consider a DEFERRED PARTICIPATION RIGHTS PLAN
  • FAIR Team: Use plan designs that intentionally reallocate rewards to go the top performers over time and minimize the "first-in" bias. Privately-held companies can go through such dramatic growth spurts that the first-in value sharing bias can conflict with a culture of merit and strategic agility. Reallocating value to the "A-Team" makes the most sense
    • When FAIR Team is important, consider the INCENTIVE BONUS PLAN

To view Mark Bronfman's full article on this topic, please click HERE.

Do you worry that you may have hidden surprises in your executive compensation, capital structure, succession and legacy plans? Please call us for a 2nd Opinion.

Please contact us to learn more.

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Will Hidden Taxes Derail Your Succession Plan?

A new client asked us to help administer their new management buyout plan crafted by very qualified attorneys. Our review shocked her. I pointed out that her management buyout ("MBO") plan directs 60% of succession capital to the IRS and only leaves 40% for her. Unfortunately this outcome is all too common.

The Good, Bad and Ugly of the Management Buyout

The management buyout ("MBO") can be the ultimate emotional reward for the owner since it enables and perpetuates the company's leadership, customers, and culture. This owner/founder characterized her particular MBO plan as elegant, motivating and fair.

However, the tax bite of a traditional MBO can threaten capital succession - leaving a forced sale or liquidation as the default succession pathway.

Let's follow the money, especially the taxes with the typical management buyout in Virginia. Executives buy the founder stock with after-tax profits from the company. For every $10M of pass-thru profits, the executive owners pay Federal & State taxes of approximately 45%, or $4.5M, leaving $5.5M available to pay the founder. The founder then pays 25% (roughly $1.5M) Federal & State capital gain tax on the sale proceeds. The founder ends up with $4M.

So for every $10M in profits, the IRS gets $6M and the founder keeps $4M. Ouch!

Avoiding the Tax Bite of the Plain-Vanilla Management Buyout

Luckily, the IRS gives us tools to reduce or eliminate the hidden tax drag of succession. Consider:

  • Restricted stock with 83(b) elections that may enable owner exchange at deep discounts (assuming proper planning).
  • Profits interest in an LLC enabling tax-free grant of equity upside value to execs.
  • Qualified profit sharing plans that can be used as tax-deferred buy-out capital.
  • ESOP elections that may permit tax deferred, or even tax free, buy-out of the founder.

When designing a succession plan, do your due diligence first. You would never buy a company without doing due diligence. Why in the world would you ever sell your company without the same diligence?

Do you have hidden surprises in your executive compensation, capital structure, succession and legacy plans? Please call us for a 2nd Opinion.

Please contact us to learn more.

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Can Employee Stock Options Make You Sick?

Too often, employee stock options and similar ownership plans are put into the wrong hands for the wrong reasons. The result: these plans may infect your business and may be undetectable until a downstream leadership or capital event.

The Equity Grant that "Infected" Owner Group: A Common Example

  • Two founders start a business with 50/50 ownership.
  • The business thrives and grows to $45M in revenue with a key manager helping to fuel this growth.
  • Seeking to reward & retain this key manager, the ownership team awards  this manager with employee stock options equal up to 4% of the company.

The clear intention was to reward this key manager. However, can you see the three ways this equity sharing structure infected the founders?

Once the manager exercises the 4% stock options, the ownership structure is now 48% each for each founder and 4% for the key manager. As a result:

  • Owners have a value penalty. Each founder is suddenly a minority owner - whose ownership stake may be worth 20% less upon separation, death or disability. Ouch.
  • Managers may be incented on wrong metrics. Rather than create value at speed, managers with stock ownership may become risk adverse (endowment effect).
  • Governors are subject to the "Gang up" factor. The small minority 4% owner, in concert with one other owner, has now become the all-critical swing vote.

Value Sharing Screens for a Healthy Enterprise

Screening tests identify problems before symptoms show up when problems are easier to treat. When designing executive compensation, carefully screen your options. Think "strategy first" across all "OMG" roles in a privately held business: Owners, Managers and Governors (Board of Directors).

At BOLD Value, we  utilize dozens of strategic value sharing screens to test and design across the spectrum of value sharing options such as:

  • Equity Plans (like dozens of different restricted stock)
  • Synthetic Equity Plans (like dozens of various shadow stock)
  • Cash-Based Plans (like dozens of performance based deferral plans)

If you want a healthy value sharing environment, then measure three times and cut once. Avoid the OMG mistakes. Use Screens and Be Healthy.

Please contact us to learn more.

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