Go Profit Share Before Giving Away Shares to Your Business

Setting up a business with another person of equal shares can become problematic when relationships become challenged in the future. Equal shareholdings between two people means equal decision making and it can eventuate into a stale mate position when a hard decision arises that may need to be made.  To avoid this situation, one party should also retain the ‘controlling interest’ and you may have already heard of the 51%/49% approach that enables this.

This is simply good business practice and has the benefit of enabling better governance and overcomes a blockage to making critical decisions.

Strategic decisions for an organisation are usually made by its governing entity. Legal entities, such as governments, local governments, not-for-profit organisations and private and public companies have a governing entity. Australian and State / Territory Governments in Australia call them ‘Parliament’, local governments call them ‘councils’, universities tend to use the term ‘council’ or ‘senate’, not-for-profit organisations use ‘committee’ and private and public companies use the term ‘board’ (including variants like ‘board of management’ or ‘board of directors’).

Most of these entities have multiple board directors (otherwise known as parliamentarians, senators, councilors, council members, committee members etc dependent on the actual legal structure), however a private company can operate legally with only one director who can then make all the key decisions. Most likely in this scenario, the CEO is the owner and they are effectively the Board Director as well, so they are making all the strategic and operations decisions as they have full control.

Depending on the Constitution (often referred to as a Rules of Association for not-for-profit entities), the Board Charter or a related policy document will set out the voting rights, and typically each Board Director will have an equal vote. Where there is a tied vote event, usually the chairperson will get a casting vote (an extra vote), which would be documented as the method of dealing with such situations. It could be argued that if a decision voting outcome is so split in the board directorship, more conversation and informed discussion is likely needed.

Board directors can be either ‘executive’ or ‘non-executive’ directors. Executive simply means they also have a job role in the entity, whereas non-executive means they reside on the board as their only function. Given that the term executive means to have a job, you can see where the term Chief Executive Officer (CEO) comes from – they are the chief (head of) of the people that work in the business.

Now back to shareholdings (representing the ownership of the company, which only applies to private and public companies (e.g., not-for-profit entities do not have shares per say, rather they exist for the benefit of a defined membership), has a bearing on both control and value. Shareholdings can be held by people, trusts or other entities, so this article is focused now on the individual shareholders of a private company.

The term ‘parent entity’ is used when another company owns most or all of the shares in a subsidiary company.  This article is most applicable to individuals coming together for a private company where they negotiate shares between themselves as opposed a public company that sells shares through a stock exchange.

Any such shareholder relationships should be supported by a shareholder’s agreement that explains what happens if a party chooses to separate, sells their shares or even dies or goes bankrupt. Do not rely on a friendship with the hope that nothing will go wrong, as these can change with the pressures of being in business, conflicts or interest or simply differences in opinion or vision. It is simply good business practice to start on a commercial front and treat the whole relationship as a business transaction.

Just imagine if your business partner suddenly dies, and the son who you don’t have a high regard for and has not business acumen suddenly inherits the estate and now overnight becomes your new business partner. Circumstances change, people change and external factors can also influence our thinking and the operation of the business.

When you have an established business, particularly one that has commercial value, bringing in new business partner could lead to a loss of shares and ownership upfront, which ultimately may lead to diluted control or less income from and reward from a sale. Consider the situation that a person having grown a business for 10 years gives away shares for the intent of getting buy-in to attract a new partner, only to then have a take-over bid for such a great price that the person just has to sell, yet the new partner reaps the rewards and the original person walks away with less profit from their years of hard work.

New shareholders may also be ‘silent partners’, which means they do not have an active part to play in the business or a role within the business (other than a potential board director). When you are needing money, sometimes we are happy to bring in silent partners who are providing the funds, however later we may become irritated that we are doing all the work when they are sharing in all the benefits. This means you have to consider the consequences upfront and be happy with your decision from that point.  Their counter argument will be that without their capital injection, the business may not have succeeded to its current level.

Worse than just losing control and shares, what happens if the new person comes in as an employee that does not perform or the relationship goes horribly wrong. They now own a part of your business.

Sometimes allocating or selling shares (including ‘options’ that allow employees to buy at a discounted or set rate that may include being able to exercise it in the future) is a retention strategy of giving shares for loyalty or employee performance. Consider when a high valued executive employee is offered shares to have ‘skin in the game’ (ownership) that leads to likely greater buy-in, loyalty and commitment in the future and to minimise the risk of them leaving.

So what is the advice? Well before you give shares away, consider a model that is in a legal binding agreement based on performance.  Being legally binding will give both parties confidence that the opportunity is real (i.e., how many times to do hear someone say “when I came in to the business they promised me I would get…” that never is provided).  Effectively, this allows the shareholdings to be automatically allocated to the new executive partner when they reach an agreed performance level or result. They have to earn the right to be a shareholder and its tests the relationship and ensures the upfront expected benefits are realised.  

The likely best approach is to start off with a ‘profit share arrangement’. Such arrangements mean that they benefit from the work they are doing by getting a payout of the share of profit, but they hold no shareholding. They only get to share in profits while they remain an employee in the business.

Then you can progress to a second stage where those who become invaluable performers also  become shareholders.

A performance-based model will tend to keep all parties focused and therefore the recommendation can be summarised as to start with a profit share approach and then extend into a shareholding position. This is simply a two-step process that provides a safeguard, whilst getting the benefit of a stronger executive leadership team.

About the Author - Todd Hutchison

Todd Hutchison is an international bestselling business author, a Nationally-accredited trainer and certified speaking professional (CSP), and a global strategist, project management and behavioural specialist. He is listed in the Who’s Who of Business in Australia. 

Todd is the Global Chairman and CEO of Peopleistic (including the Business Education Institute and Film My Video businesses), an executive with law firm Balfour Meagher and resides as the Chairman of the International Institute of Legal Project Management, as well as being a Board Director of Leadership Western Australia.

Todd is also a qualified company director, having served on boards in Australia, the United Kingdom and the United States, and has led international businesses. He has worked in over 160 organisations in 13 countries, including global corporations like AT&T, Microsoft, Coca-Cola, Deloitte, Sime Darby, Genting, Schenk Process, JP Kenny and Honeywell.

He holds adjunct positions with Edith Cowan University and Curtin University, and teaches international business as part of the MBA academic staff at the Australian Institute of Management.

Todd’s qualifications include an MBA and a Master of Commerce and he is now progressing a PhD.