Equity ownership: How and when to distribute

Of the myriad decisions faced by firms in today's market, none are more important or have longer-term implications than those surrounding the distribution of equity among existing and future owners.

Of the myriad decisions faced by firms in today’s market, none are more important or have longer-term implications than those surrounding the distribution of equity among existing and future owners.

There are two key considerations when distributing equity: 1) Establishing the appropriate funding alternatives for the firm. 2) The implementation of mechanisms to ensure affordability among individual owners.

The likelihood of current and future events will often dictate the nature of the most appropriate combination of funding alternatives for the firm. Although there is no “one-size-fits-all” remedy for every firm, there is a right answer for your specific situation that is based on the events that you and your firm are experiencing.

One situation that, at some point, is likely to be encountered by most firms is the untimely departure of an existing owner due to termination or some catastrophic event. Although most firms have some provision in place for the dispensation of the departing owner’s equity, fewer firms and individual owners are prepared to fund the purchase of the departing owner’s equity.

A practice that is becoming more common, especially within firms where affordability of such a purchase would prove difficult, is the integration of life or disability insurance funding mechanisms into a buy-sell agreement for the firm. Three commonly used provisions are that of a cross-purchase, stock redemption, or a hybrid including elements of both. The hybrid offers the luxury of flexibility. Once a triggering event occurs, the remaining owners can carefully examine the capital needs of the firm and the existing tax laws at the time of the buy-out to determine the most appropriate choice for themselves and the firm. This provision is most common in firms that also utilize some type of owner financing of the purchase.

A cross-purchase agreement is one in which each owner of the firm purchases an insurance policy on the other shareholders in which the purchaser is both owner and beneficiary of the policies. Stock or equity redemption refers to an agreement in which the firm owns policies on the lives of the shareholders. When a shareholder dies or becomes permanently disabled, the firm buys the deceased shareholder’s interest in the company with the insurance proceeds. A third version of the provision is a hybrid of these two types with the most strategically and tax appropriate elements of each being selected by the firm.

The ability of individual current and future owners to afford equity offered or granted by the firm offers its own set of considerations and alternatives. These alternatives may consist of either internal or external direct funding of the equity, various long term incentive plan designs, or any combination of the three.

If equity is made immediately available to existing or future owners as a condition of employment or through some type of purchase plan, it is common for the firm to implement some type of plan for the financing of the equity as well as the potential tax burden on the recipients. The firm or its senior owners may choose to finance junior owners directly or bank debt to fund the purchase. Depending on the strength of the firm, the bank will likely require the existing equity in the firm as collateral and have the junior owners provide personal guarantees for the financing. Another alternative is to have the senior or funding owners also personally guarantee the loans with the junior owners. This alternative will likely be viewed as more attractive to an external funding source or bank and slightly less attractive to senior owners.

The use of long-term incentive plans is also becoming a more popular approach to addressing the affordability of equity ownership, due to its increasing flexibility and dual use as a performance-base motivational tool.

A long-term incentive is a form of compensation, in addition to an employee’s base salary or annual bonus, which provides financial rewards to eligible participants, in the form of cash or equity, based on a firm’s longer term performance, typically a 3-5 year period. When linked to the long-term financial performance of the firm and combined with an appropriate vesting schedule, these plans offer participants both a funding mechanism for the purchase of equity, and an ongoing link to those elements of the firm’s ongoing success which they may most directly influence. These plans are extremely flexible and may be designed to meet the specific strategic goals and tax profile of individual firms.

There is no shortage of alternatives from which to choose when considering options for the funding of your firm’s equity distribution. The key is to carefully consider each alternative and select the portfolio of solutions that is most appropriate for your current and long term success.
Scott Feraro is Founder and Managing Director of Pepin Consulting, a talent services provider focused exclusively on the financial management industry.