Incentivising staff, avoiding multiples

First, some feedback: since writing a few weeks ago on how much money could be saved by switching between cellular service providers, I’ve been contacted by representatives of ‘Yellow’ who point out that their new offerings include BYOD (bring your own device) and are far more competitive with ‘Black’. I suggest you strongly consider whether you need a new device and look closely at the actual offerings that each of the cellular providers has in the market at the time, before you blindly upgrade. Your negotiating power is stronger than you think and the savings over a 24-month contract can be substantial. Your negotiating power begins roughly 5 months before your existing contract ends – most cellular providers offer existing customers upgrades and other deals around that time.

Back to business:

A client of mine approached me recently to help with the valuation of his business so that he could reward long-term staff with an incentive based on the growth in the valuation of the business over time. He is building his business for the long-term and it’s likely that he’ll want to sell it at some stage. So his thinking is in the right direction: if you want to sell then you have to build something that’s attractive and valuable to a potential buyer (an asset of value). In a services business like his, what someone is really buying are the people – their expertise and the relationships they have with clients. So the question becomes how do you attract the right people to the business, retain the brilliant ones, and keep them in the business long after the original owners have sold out? Answering this question is the key to reducing risk in the sale and thus making sure you get a fair price for the business. Building a long-term incentive that rewards key staff for the increase in the value of a business is something I whole-heartedly support.

My client wanted to give away real shares to the approximate value of 20% of the business to certain key employees (the amounts awarded to each were based on his discretion/feeling and not on any formal performance review). He also wanted these shares to vest over time, and lastly he wanted his staff to be able to sell the shares back to the company once they had vested or if the business was sold. Most importantly, he wanted to fix the price they would get for the shares if he sold the business or if they wanted to sell them back to the firm– and he wanted this to be 4x PAT. So where are the problems in this thinking?

Firstly, any awards of shares need to be done based on merit/performance. If you award different levels of shares to staff without a transparent and fair mechanism then you have to expect that sooner or later this will become public knowledge and someone will feel aggrieved (usually with a lot of angst and disastrous results). My suggestion is always to link any long-term performance award to the performance of the company and the individual in a given year (which must be formally and fairly reviewed), so that short-term performance drives long-term wealth creation. Secondly, while vesting over time is the norm and his thinking was right (a 3-5 years is the norm), it’s dangerous to fix a price on the shares now – the shares could be worth more (or less) at the actual time of sale that will irritate one party at least. The other major issue is that the firm might not have enough cash to buy the shares back at that price at the time; being forced to do so could put the firm at risk. Lastly, the structure my client was proposing would have allowed his key staff to walk out of the business with real wealth in their pockets if he ever sold it (when you ideally want them to be able to leave with a lot more upside in two years time!). So some re-thinking was required…

My suggestion was to make use of a phantom share scheme rather than actual shares. Phantom share schemes mimic real shares but are far easier to administer – you simply update a spreadsheet. For phantom shares to have any real value the amount of dividends they get must be part of your shareholders agreement. What should ideally happen is that the business sets a dividend policy that pays out a fixed portion of profits above the threshold needed to de-risk the business (i.e. provide working capital for 6+months of operation). Then from the dividend that is declared, a portion e.g. 20% goes to the phantom shareholders and the balance to the actual shareholders. The phantom shares can vest over time and can be allocated based on the persons salary + bonus in any given year, thus linking actual performance to long-term reward in a meritocratic way. If someone resigns or leaves they can be sold for a pre-arranged price or simply deleted, and if the business is sold then the new owner needs to carry on the arrangement or face losing key staff. The flip side is that phantom scheme benefits the new owner because they won’t lose key staff when buying the business, so its raises the price of the sale.

Note that phantom share schemes and other long-term incentives linked to the financial performance of the firm need care in their design and implementation.