Share Ownership Plan

by Stuart Frost
CEO, CAD Partners - CFO On-Call

Quick Summary:
1. An non-obvious option for Business owners that could provide an exit from a business with a better bottom line.
2. A business model that's a win/win is s first priority.
3. How the writer set up a share ownership plan for his own business.
4. Why share ownership creates more profit how such plans work in Canada.
5. Start with a valuation that you and your people are comfortable with.
6. Share split to create the number of shares you need.
7. Advisors and the legal side and which “experts” to side step.

It makes sense to me that before you start a business you should plan the exit. But most of us business owners never do - do we? The problem is that when we're starting up, we're too excited about the blue-sky prospects of the business, to seriously weigh up the getting out options.

In the early days, we all think the business is going to be such a boomer, that when we're ready to sell, we'll get multiple offers from eager buyers keen to take over our brilliance ... and that almost never happens either. Typically a trade sale - that is selling out to a private or corporate business buyer, we assume is the most likely way we would exit a business.

There is an alternate and possibly a better option that could be infinitely more rewarding. That's a Share Ownership Plan and I 'd like to share my thoughts and experience with you.

The business I started with my wife, now some nineteen years ago, is a fairly unique service business, offering a monthly service to SME (small,medium enterprise) businesses, typically with revenues of $500k to $10M. It had some unique methodology and few competitors then and still does today. But the product or service is only as good as your ability to deliver it profitably.

For fourteen of those years, if I'm honest with myself, we were treading water. We had a franchise type business model, that had us reliant on selling franchises for our principle revenue. Profit was hard to come by because we genuinely felt we should spend as much as we could afford to support our franchisees. We often spent more! The water we trod barely kept our heads above the surface and slow sales impacted our income badly.  The franchisees were doing well, but we weren't. (Funny that. I'll bet the average person thinks it's the Franchisor that makes all the money!)

At that time we would love to have sold out. It was a $1M business with not much profitability but plenty of potential we reasoned. Deep down though, we knew you can't sell a business on potential and little profit. The only answer was to go back to basics. We down-sized and changed the business model to more sustainable fee share arrangement. This in turn changed changed our focus, in that it wasn't franchise sales that was so important, but helping the franchisees earn more because we would earn more in doing so.

Today we're a company with $3M revenue and a healthy bottom line and heading for $10M with a $1M profit within three years.

Do we still want to sell? Not desperately no. The business is more exciting now we're making profits and the profits will increase year-on-year. But we've worked nearly twenty hard years for the rewards, so we don't want to sell out too cheap or too early ... but we do appreciate it's time to put in place an exit plan that's a win-win!

The plan we elected to go with is a Share Ownership Plan (SOP). Also called an ESOP an Employee Share Ownership Plan. How does it work? In theory it's quite simple, but the chances are you may need a specialist firm to help set up a Share Trust (which is just a Unit Trust) to get the necessary tax rulings to explain the tax implications for your people.

Our business has a team of some seventy people, but in my opinion a SOP would suit a business with twenty times that or as few as six or seven. You may want to include all stakeholders, franchisees, employees, partners, distributors, managers. For this purpose I'll call them "people".

The simple unmoveable truth is that those who have a stake in the outcome, care as much about the bottom line as you do, so that's a good reason get them involved.

There are some fascinating articles and books on the subject. There are a few stats for Australia/New Zealand on www.aeoa.org.au

Also Google "ESOP-Canada.com" and see "Does employee ownership work in Canada?”
It will show you the following:

“The most definitive study to date in Canada was done by the Toronto Stock Exchange, comparing ESOP versus non-ESOP public companies. For ESOP companies:

Five-year profit growth was 123% higher
Net profit margin was 95% higher
Productivity measured by revenue per employee was 24% higher
Return on average total equity was 92.3% higher
Return on capital was 65.5% higher “

  Also look out for a book called ... yes ... "A Stake in the Outcome". From the book summary:

  “ The author Jack Stack, explains how he and twelve other managers began their journey in 1982, when they purchased their factory from its struggling parent company. SRC grew 15 percent a year, while adding almost a thousand new jobs, and the company’s stock price rocketed from 10 cents to $81.60 per share. 

  In the process, Stack discovered that long-term success required constant innovation–and that building a culture of ownership involved much more than paying bonuses, handing out stock options, or setting up an employee stock ownership plan. In a successful ownership culture, every employee had to take the fate of the company as personally as an individual owner would. 

  Achieving that level of commitment was extraordinarily difficult, but Stack realised that the pay-off would be enormous: a company that was consistently able to outperform others in their industry."

So how can you set up an ESOP in your business without it costing a fortune in consulting, legal and accounting fees?

Step one get a valuation. Now valuations can cost many thousands if you go to, say, a second or first tier accounting firm. My experience is that accountants often differ on what is a fair valuation or valuation method. It's in their interests to make it sound confusing and highly intellectual. My advice is save your money.

In the end they will agree and it's a universal truth, that the valuation is, whatever someone will pay for it.  Do some research on valuations and settle on a valuation that you feel is genuinely fair for both you and your people.

In our case we agreed on a six times multiple of pre-tax profit plus a fixed figure for goodwill being intellectual property, brand value, the cost of establishing a database of over six thousand clients and contacts.

Now some would immediately say that's high. But is it? Valuation is all about risk. The lower the risk the business faces from competitors, market conditions, currency fluctuations, government intervention, suppliers and customers, the higher its value. Another reason why it was fair in our case, is that (a) our people readily accepted it as reasonable and (b) the profit the year-on-year was almost certain to keep increasing.

A web site that may help is www.bstar.com.au. See their Business Value Gap Calculator.

Step two is decide how many shares you want to hold and issue. In our case we had a typical Pty Ltd company with one hundred shares. The one hundred shares were equal to value of the company. We changed that with a share split so that one hundred (100) became four million (4M) shares which represented the same value. Now our plan is to sell down to a lesser shareholding over five years, so that the original shareholders will still hold around fifty percent of the company for a while yet, but your circumstances will determine how you sell down.

In three to five years, it may be also that we consider listing the company if growth and profitability continued. In that case the valuation would likely be ten to fourteen times pre-tax profit. So, for our business, the first share offer to our people was a further 400,000 shares which was (a bit less than) ten percent of the company. That will mean, that up to twenty people now have a small "stake" with an opportunity to buy more each year if they wish to. If you have key people, who you see as eventual successors, it may be better to offer them a larger share first before offering it to others.

Step three avoid the hassle of having a lot of small shareholders ... create one! You can do this by creating a Unit Trust. A unit trust has units, each of which can be equal to one share, so your people can buy their allocation of shares in the trust and that trust becomes the shareholder in your company. This means you only have to deal with one shareholder, not twenty or however many buy shares.

You may also choose to finance your people in. You may give shares in lieu of bonuses, part wages or other entitlements.

Before you start down this track, make sure your business is worth selling shares in. If you have doubts that you can sustain profitability, there are people who can help. Find a financial person part-time, who can help assess where your business is at present and set a path to better profitability. Every business category has performance benchmarks or KPIs (Key performance Indicators). Find out from such a person what yours are, so you know how much improvement you need to find.

Then there's the legal side. What ever you do has to be within the Corporations Act which covers such things. The section that covers shares transfer in an unlisted company is Section 708 Chapter 6D. What we're discussing here is loosely know as the 20/12 rule. It  means that without a prospectus, you may offer no more than $2 million worth of equity to no more than twenty (20) people, within twelve (12) months.

There are advisors who offer help set up a share plans and do it well. There are also plenty of "wannabe" advisors on the margin who say they can do it all. Choose carefully. Many accountants, lawyers and independent consultants may say they can help.

I went to one lawyer who said corporate strategy was his passion. He spent two hours with me, listening to my plans, asking questions and looking intelligent. Then he gave me general advice which was in practice quite useless and charged me near $1000 for the privilege!

Go with a small expert firm and ask to see what share offers they have helped set up for others. Get a fixed price for setting up the unit trust and for the unit trust plan administration. If yours is an established business, don't consider a small listings board that is there to help with capital raising, unless it's capital raising you need.

My conclusion is that there are many established businesses looking for a better option to a "trade sale". It took me two years to get to understand what's involved with setting a SOP for our business and I'm still learning. Good luck with yours.

 

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