Yes, You Can Share Equity and Stay Private: Part One

Today's blog features guest author Corey Rosen of the NCEO on how companies can share equity and stay private.

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Yes, You Can Share Equity and Stay Private: Part One

By Corey Rosen, Founder, National Center for Employee Ownership

Recent reports show that more and more entrepreneurial companies are choosing to stay private for much longer periods of time. That may be because they do not believe the IPO market is ripe for an offering, or that they realize that the chances of actually having an IPO for most start-ups is comparable to high school basketball players making the pros. Some companies could find another company to buy them, but may not find the terms attractive. Still other entrepreneurs just don’t want to give up control. They may like what they do or, increasingly, have a social purpose that they believe the buyer will undermine.

Many of these companies share equity with employees, but wonder about how that can become liquid. Some are reluctant to spread equity too widely for just this reason, even though they like the idea of employee ownership.

In fact, there are lots of practical ways to share equity, stay private, and provide liquidity. In this two-part series, I look at how to do that. The National Center for Employee Ownership’s Staying Private: Liquidity Options for Entrepreneurial Companies, provides a detailed examination of these issues.

Design Your Plan with Liquidity in Mind

Many entrepreneurs I talk to say that equity stakes will become liquid when there is a liquidity event, but they don’t know when, if, or how that will occur. To them, this is not a big issue—they plan to stay until that happens and maybe beyond. But for employees, the uncertainty makes equity grants far less valuable than they really are because, as we know from behavioral economics research, people vastly overweight risk and uncertainty in assessing economic value. On top of that, some plans may have grants that expire if not exercised, but if they are exercised, employees have to pay a tax now for a benefit that can’t be realized any time soon.

To deal with this problem, companies should consider vesting on liquidity only. If liquidity is too far away and too uncertain, they should look for ways to provide liquidity in the interim, as described below. Companies can limit the cash drain of these approaches by using net settlements, where the employees get the net after tax value of the equity holdings on exercise in the form of shares. That way, at least employees aren’t paying out of pocket, something that makes the award look like punishment.

Second, you need a realistic way to assess value. Formula approaches like book value and multiples of revenues are frequently used and almost invariably wrong. A basic valuation by an outside appraiser is not very expensive and is well worth the several thousand dollar cost. It gives your plan a lot more credibility, it assures that you are paying an appropriate amount, and gives you a good sense of how your company can become more valuable.

So how can you provide liquidity?

Redemptions

The simplest approach is for the company to buy back the stock. This must be done with after-tax dollars. Equity holders who paid for their shares get capital gains treatment on the sale if they are effectively exiting the business; otherwise, dividend rates apply. Currently, there is little difference between the two, however, unless the owner has a substantial basis in the shares, in which case capital gains treatment is preferable. The shares can be retired (meaning the enterprise value of the company goes down, but the per share value of remaining shares remains the same) or made available for sale to other buyers or for awards to employees.

In part two of this article, we will look at four other alternatives: sales to employees, outside investment, secondary markets, and ESOPs.

Corey Rosen, Ph.D., is the cofounder and senior staff member of the NCEO. He co-authored, along with John Case and Martin Staubus, Equity: Why Employee Ownership Is Good for Business (Harvard Business School Press, May 2005). Over the years, he has written, edited, or contributed to dozens of books, articles and research papers on employee ownership. He is generally regarded as the leading expert on employee ownership in the world.