Business owners are exposed to risk beyond generic market and environmental risks; privately-held businesses are concentrated assets that are subject to extreme value jolts. Based on the ten-year history of the Volatility Index for smaller public companies (often referred to as the RVX), the value of a typical business enterprise can easily swing up or down by 50 percent within a year. Recently, the credit crunch has exacerbated this volatility, which has lead to especially challenging times for many small and middle market businesses.
Many business owners still put “volatility blinders” on and then fall into the trap of giving (or granting) a significant portion of the company to key employees and family without much forethought related to what happens next. Often these arrangements fail to have appropriate buy-sell covenants, redistribution guidelines, or tax reduction strategies. This giving trap can severely limit the business owner’s flexibility for future equity strategies, such as stock redemptions or sizable cash distributions. In other cases, sudden business environment changes can result in stakeholder disharmony expressed by shareholder disputes, family friction, unnecessary taxes, and unexpected costs. We call the direct sharing of equity ownership a static plan; self-correcting value sharing plans are more powerful and a better fit for most business owners.
Self-correcting strategic design starts by answering the following question: how would a business owner prefer to share value assuming different business growth outcomes? More simply, how would value be shared if the business value over time goes (1) up a lot, (2) up a little, (3) down a little and/or (4) down a lot? For example, a business owner could say that if the business is worth under $10 million, all the value should be reserved for the immediate family. If the business is worth over $10 million, a portion of the value should go to the key executives who helped create value in the company. Above $20 million, an additional portion should be distributed to the rank and file employees who played a part in the firm’s success. Beyond $30 million, some value should be assigned to a charity that supports a cause in which the business owner believes. Essentially, the business owner creates value sharing rules; the higher the return, the more parties are considered for value sharing. Typically, the hurdle for value sharing can be a fixed/nominal threshold (e.g., $20 million) or a variable/risk-based return (e.g., return over the owner’s cost of capital, 20 percent).
Self-correcting strategies incorporate these dynamic rules-based value sharing approaches and tend to have one of four characteristics. One, the business owner shares the upside value rather than granting full equity ownership. When there is a strong equity growth scenario, all parties share the upside; if value falls, the shared value is temporarily “underwater” and the business owner retains the value. Two, the business owner builds incentive arrangements with a vesting schedule or performance unlocks that will control the final transfer of value. Incentive arrangements are the “strings attached” that could cause the recipients to forfeit the value if they separate from the business or fail to meet the performance targets of the business.
Three, synthetic equity can be used to grant business value in the form of long-term compensation rather than true equity. As a compensatory agreement, the business owner can customize the package to address many different dimensions that are difficult to address with a true equity design. And four, the overall plan may reallocate value among different categories of stakeholders (primary owner, key executives, line managers, family, charity, etc.) based on the total amount of value created for the company. This value allocation can occur through the use of what we call “value bands,” which predefine value sharing at various company or owner triggering events. For example, at the change of control in the band of $40 – $50 million, the value going to the owner is $X, the family trust gets $Y, the key executives gets $Z, and so on.