Should Your Firm Finance Rising Shareholders’ Stock Purchases?
An expert explains the pros and cons of financing employee stock purchases through loans.
The smooth internal ownership transition of an architecture, engineering, or environmental consulting firm requires years of advanced planning. One of the key steps in the process is identifying the firm’s future partners and bringing them into the ownership group by selling them stakes in the company. For this to occur, it may be necessary for the firm to finance employee stock purchases through loans.
The AE Valuation & Ownership Transition Advisor spoke with Morrissey Goodale principal advisor and internal ownership transition expert Alexander Tepper, PhD, to learn more about the upsides and downsides of assisting the stock purchases of rising shareholders and how to best approach the process.
AE Valuation & Ownership Transition Advisor: What are the primary benefits of offering financing to assist future owners in purchasing stock?
Alexander Tepper: Offering financing tends to increase the demand for shares and makes ownership more affordable for your future leaders. Giving the ability to buy stock to those who might not otherwise have the resources is important not just in making an ownership transition successful, but from an equity and inclusion perspective as well. If you don’t offer any financing, many of those being asked to write checks will probably lack the monetary resources and comfort levels in making that size of an investment—unless they have family wealth or prior entrepreneurial success. Offering financing also demonstrates to employees that the firm has some stake in the transition. It’s a cooperative type of approach.
AEVOT Advisor: What’s the drawback of financing stock purchases?
AT: It can be a financial burden on the firm to do it. The financing being offered by a firm has to be paid for by some source—such as from ongoing earnings, sellers cashing out more slowly, or a bank loan. Whichever way, somebody is paying for that financing. Also, some sellers are wary of making buy-in too easy because they believe requiring significant skin in the game makes better entrepreneurs.
AEVOT Advisor: Based on your experience, how are you seeing AE firms tackling the issue of financing?
AT: Sometimes we see firms offer no financing at all. It’s rare, but it does happen. We also see firms that offer some financing but also require rising shareholders to put some money up front—whether that’s writing a check, deferring a bonus, or foregoing a bonus—something that’s a real sacrifice.
The third approach we see is that firms provide financing to offset the entire amount of a stock purchase—or a combination of financing and some modest bonus to cover the entire amount—so that the rising shareholder spends nothing out of pocket. The upside is that it makes ownership affordable, but the downside is that owners may not feel as committed as you’d like.
The fourth approach involves firms giving employees the money to purchase shares through a special one-off bonus or on an ongoing basis. The firm is basically giving the shares away, which means the new owners have no skin in the game at all. However, I would distinguish that from firms that give a one-off bonus in recognition of a milestone in becoming a shareholder or a raise if they move from being an associate principal to being a principal. That’s not technically financing to buy shares, but it nonetheless can assist employees in affording buy-in.
AEVOT Advisor: Do you see any generational factors at play in how firms deal with this issue?
AT: Yes. There’s a bit of a difference between the older and younger generations. The older generation tends to have a different view of what it means to own a business and the level of commitment and risk tolerance that implies. The younger generation is entrepreneurial, but their dream is often different. Many older-generation workers dreamed of starting a company in their 20s or 30s, building it up to something really phenomenal over the course of 30 to 40 years, and then selling that company to retire. The typical dream of younger-generation workers, however, is to do a startup, raise some capital, build it, scale it quickly, and exit within 5 to 10 years to do it again. You also have a younger generation that is a little more risk-averse than the older generation of business owners. Combine that with the missing middle of managers, and it’s often difficult to find folks who are prepared to take over the reins.
AEVOT Advisor: Do firms tend to pull out money from each paycheck or just once a year?
AT: I’ve seen it done both ways, and either works. When it’s pulled out of each paycheck, it’s easy for everyone. When it’s once a year, the shareholder really feels the impact of writing that single check.
AEVOT Advisor: Which experts should you engage with to guide you through this process?
AT: You do want somebody who has experience with small firm ownership transition, ideally in the AEC industry. Otherwise, you are going to wind up spinning your wheels or—even worse—ending up with something that doesn’t make sense but could actually get you into trouble down the line. We have worked with firms in their second and third ownership transitions that have done it sub-optimally the first time, and it has real hangover effects.
AEVOT Advisor: What are some of the common mistakes that AE firms make?
AT: A common mistake is when firms structure the financing or purchase price that is unsustainable, so that people have to be treated differently on the way in and on the way out. If the new people coming in are being treated differently from the legacy shareholders, that’s very difficult from a fairness perspective. And it goes both ways. If people feel they got a really good deal coming in, the next generation will want that same deal, and you may not be able to afford to give it to them. On the flip side, if people had to put up more coming in, they are going to be reluctant to offer better terms than they received to the next generation.
To connect with Alexander Tepper, email him at [email protected] or text him at (917) 291-1410.