New Professional Services Ltd Company - Shareholding

[Anonymous Director]

Evening all!

It's a bit of a long one this, so bear with me please.

I'm a long standing (10 years) member posting under an anonymous account to protect my identify, i'm looking for some advice on a new start-up I'm working towards launching. Specifically in relation to incentivisation / shareholding and bonuses for the first employees.

Bit of background:

I joined an existing consultancy business a few years back with the mandate to 'set-up an office, win some work and build a team', I was promised shares but it never happened despite me pushing. I now run a profitable business stream employing 25 staff, whilst the salary is great the shareholding never happened and it's just not enough for me.

So I'm going it alone.

The initial plan:

I'm in the final throws of negotiating a contract which will cover circa. 75% of my time & income for the first year. Initially my plan was to use the remaining 25% to build up slowly as a one-man band winning work and then delivering via. a combination of myself and external sub-consultants. I'd then employ people before becoming overwhelmed with work.

Some figures for context

Let's assume 1600 productive hrs at £75/hr (average) with a 30% margin, so each member of staff would turnover circa. £120k with a gross margin of £35k per annum.

My 5 year business plan looks like this:

Y1 - Staff = me + 1 / EBIT = £80k
Y2 - Staff = me + 4 / EBIT = £160k
Y3 - Staff = me + 7 / EBIT = £245k
Y4 - Staff = me + 11 / EBIT = £350k
Y5 - Staff = me + 13 / EBIT = £410k

[b]Onto the actual questions: [b]

Question 1:

I'm considering poaching some key staff from my existing employer and one in particular would be someone I'd consider incentivising with an offer of shareholding. I doubt I could convince them to come with me on salary alone, there has to be a long game reward for them. I'd like them to hold shares so they're invested in growing the business and are properly rewarded .... but I obviously don't want to give too much away from a business that has the potential to grow exponentially.

How would one structure such an arrangement? Would I award them say 10% shares on day 1(when they're worth nothing) or say after year after certain targets are met. Do they have to buy them? Can I give them for free? Are there tax implications? What happens if they go on maternity / long term sick leave the business?

Question 2:

An opportunity has arisen to employ someone who could bring with them 2 x contracts with an initial income of £150k but more importantly the potential to expand by building a team around this individual (say 4 people to a turnover of maybe £500k over the next 2/3 yrs). How best to incentivise this person? I don't think shareholding is appropriate (although they have expressed an interest in buying shares in the future) - i'm thinking a slightly above market salary plus a defined bonus scheme based on the profitability of the 2 x contracts. Say 20% of net profit?! Is this just a case of writing it into the employment contract? Any pitfalls or issues I need to consider?

Thanks for all the help!!

[LooneyTunes]

The simple answer is don’t give away too much (any) equity too soon.

Several reasons:
The % you give away early on may seem trivial but as businesses grow you can face serious dilution as a result of external investment;
What you give the first employees sets a precedent for others, especially if you talk in % terms;
Some others you hire later, as you scale, are likely to turn out to be more strategic hires. They will demand even more, even though their risk is arguably lower.

If you do do it, think about the impact of control: those factors above, can lead to loss of control if you give away shares with voting rights. Also, the more people you have on your cap table, the harder it is to perform actions that require shareholder approval.

By far the best approach, in my view, is to set ip a pool of “shadow” equity or profit share pool whereby each of those eligible for inclusion gets a % of the payout (that % being determined by factors such as length of service and/or seniority).

If you feel the equity badge is important for hiring/retention then a ring-fenced employee stock/options scheme without voting rights and structured appropriately for tax would get my vote. As a further tip, in the very earliest days, talk of % is tempting. Flip that to talking in terms od £ as soon you can - for example, someone may thrilled at getting say £10k of employee stock but think 0.001% derisory.

If you feel you need an initial employee pool to get it off the ground, lock it down after the first x employees.

People will always moan that others did better out of a startup than they did but in most cases those people weren’t there on day 1.

Last tip: think about good leaver/bad leaver and vesting times. You’ll kick yourself if you give someone a significant %, they quickly bugger off leaving everyone else to do the work then cash in. I have seen situations where it has happened and situations where the risk of it happening has scared off investors.

Of course, if you’re thinking of this other guy as a co-founder that might change things a bit.

[MustangGT]

One thing that struck me is contracts of employment. Do your existing staff and yourself have any restrictive covenants in place regarding working in the same line of business and/or poaching of staff?

[Anonymous Director]

MustangGT said:

One thing that struck me is contracts of employment. Do your existing staff and yourself have any restrictive covenants in place regarding working in the same line of business and/or poaching of staff?

The only restrictive covenant in our contracts is that we mustn't undertake any work whilst employed ... nothing else. Seems an oversight to me!

[Anonymous Director]

LooneyTunes said:

The simple answer is don’t give away too much (any) equity too soon.

Several reasons:
The % you give away early on may seem trivial but as businesses grow you can face serious dilution as a result of external investment;
What you give the first employees sets a precedent for others, especially if you talk in % terms;
Some others you hire later, as you scale, are likely to turn out to be more strategic hires. They will demand even more, even though their risk is arguably lower.

If you do do it, think about the impact of control: those factors above, can lead to loss of control if you give away shares with voting rights. Also, the more people you have on your cap table, the harder it is to perform actions that require shareholder approval.

By far the best approach, in my view, is to set ip a pool of “shadow” equity or profit share pool whereby each of those eligible for inclusion gets a % of the payout (that % being determined by factors such as length of service and/or seniority).

If you feel the equity badge is important for hiring/retention then a ring-fenced employee stock/options scheme without voting rights and structured appropriately for tax would get my vote. As a further tip, in the very earliest days, talk of % is tempting. Flip that to talking in terms od £ as soon you can - for example, someone may thrilled at getting say £10k of employee stock but think 0.001% derisory.

If you feel you need an initial employee pool to get it off the ground, lock it down after the first x employees.

People will always moan that others did better out of a startup than they did but in most cases those people weren’t there on day 1.

Last tip: think about good leaver/bad leaver and vesting times. You’ll kick yourself if you give someone a significant %, they quickly bugger off leaving everyone else to do the work then cash in. I have seen situations where it has happened and situations where the risk of it happening has scared off investors.

Of course, if you’re thinking of this other guy as a co-founder that might change things a bit.

Some very good points, thanks for the advise.

Would you mind expanding on what you mean by setting up a pool of “shadow” equity or profit share pool?

I've never even heard of 'good leaver/bad leaver and vesting times' ... will do some reading this evening.

[Panamax]

LooneyTunes said:

The simple answer is don’t give away too much (any) equity too soon.

Yup. Either this or get some proper, paid advice on employee incentivisation, trusts, tax etc.

Equity in a private company is worth very little to employees. There's no market for the shares and dividends may be very modest on a small shareholding. There's a lot to be said for cash bonuses, and defer them/part of them if you want to achieve retention of staff.

[LooneyTunes]

Anonymous Director said:

Some very good points, thanks for the advise.

Would you mind expanding on what you mean by setting up a pool of “shadow” equity or profit share pool?

I've never even heard of 'good leaver/bad leaver and vesting times' ... will do some reading this evening.

No problem, happy to help.

Shadow equity is essentially equity that doesn't actually exist but provides for reward to be given as if there was actual equity in play.

It can either mirror actual stock, or work in a similar way to a profit share pool whereby you allocate a notional % to a collective "pot", then assign employees a number of units (perhaps leaving some unallocated initially) and then pay out profit/a share of sale proceeds to them in line with the ratio of their holdings to the total pool.

The advantage of a pool approach is that you've set a cap on what you'll allocate but not capped the number of people who can participate. Typically, because you hire in expectation of growth, the dilution that employees might experience by there being more people involved is offset by the increased size of the pot.

Good leaver/bad leaver is simply to take into consideration what happens when an employee leaves the firm. A good leaver will typically retain their accrued and vested shares/rights or cash them in (which some companies prefer), a bad leaver will forfeit them.

Personally, I favour approaches that see company stock not leave the firm. Most people change jobs from time to time so unless you restrict stock ownership it'll be almost inevitable that some ends up being held by people who no longer work for you. That becomes a problem because you may then need to find more equity for those you want to replace leavers.

Vesting is simply the time it takes for a stock award to actually be the property of the recipient. It is almost never the case that an employee simply gets x%/£x and it's theirs straight away with no strings attached. Normally with startups you look to have benefits such as equity vest over an extended period (generous would be 1/3, 1/3, 1/3 over three years but I've seen 2-3 year front end delays to that process and some schemes where equity doesn't vest for a very extended period of time).

As Panamax says, the absence of a market for those shares makes it hard to give employees a significant "liquidity event" or exit. Unless you've got eyes on the IPO track you probably need to think about what happens when someone does want to cash in. Some schemes allow employees to re-sell vested stock back to the company within a certain time window each year - handy for employees and lets them decide whether to stick or twist, but does introduce a requirement for new awards to be made if they are to serve as a useful retention vehicle. Generally firms try to make the golden handcuffs heavier as time progresses.

There are many different ways to skin this cat, and we've not even got into tax treatment (which can be complex and important when it comes to employee stock). That alone would nudge me towards a profit-linked bonus pool approach and kicking the can down the road on actual equity until there's the money/business case to pay for the advice you'd need to structure that properly.

Whatever you do, don't forget that any smart employee will be aware that all the talk of equity and bonuses means bugger all until the money lands in their account. Which it might never do.

It's a hugely complex area and, no matter how much time you put in or how generous you think you're being, someone will always find cause for complaint! As a topic that provides ongoing fun for management, it's almost as bad as office car parking...

[Anonymous Director]

LooneyTunes said:

Anonymous Director said:

Some very good points, thanks for the advise.

Would you mind expanding on what you mean by setting up a pool of “shadow” equity or profit share pool?

I've never even heard of 'good leaver/bad leaver and vesting times' ... will do some reading this evening.

Whatever you do, don't forget that any smart employee will be aware that all the talk of equity and bonuses means bugger all until the money lands in their account. Which it might never do.

Which is basically what happened to me!

Thanks for all the great advise, seems pretty clear to me I should retain all shares and structure a bonus based profit share scheme for both employees.

I'm guessing key employees would expect this to be built into an employment contract?

[Anonymous Director]

Any thoughts on the following proposal?

General Profit Sharing Scheme:
Discretionary, not guaranteed, based on business performance, calculated as follows:

Profit share ‘pot’ = 10% of gross profit
Employee share = Pot Value x (Staff Salary/All staff salary bill)
Capped @ 25% salary
50% paid annually / 50% retained until year 3

Contract 1 & Contract 2 Profit Sharing Scheme:
Discretionary, not guaranteed, based on contract performance, calculated as follows:
Profit share = 15% of gross profit (Contract 1 & Contract 2 only)
Capped @ 25% salary
50% paid annually / 50% retained until year 3

Note: the profit share awarded will be the greater of the two listed mechanisms above (not cumulative).

[Panamax]

Anonymous Director said:

I'm guessing key employees would expect this to be built into an employment contract?

What they might "expect" and what you might want to "offer" are not the same thing.

The whole point of discretionary bonuses and benefits (i.e. shares) is that they're "discretionary" and not "contractual".

This is a complex area and you won't get to the bottom of it on a forum, there's just too much detail. IMO you'd be best to either drop the idea of using shares or get paid professional advice.

[Olivera]

Anonymous Director said:

Any thoughts on the following proposal?

General Profit Sharing Scheme:
Discretionary, not guaranteed, based on business performance, calculated as follows:

Profit share ‘pot’ = 10% of gross profit
Employee share = Pot Value x (Staff Salary/All staff salary bill)
Capped @ 25% salary
50% paid annually / 50% retained until year 3

Contract 1 & Contract 2 Profit Sharing Scheme:
Discretionary, not guaranteed, based on contract performance, calculated as follows:
Profit share = 15% of gross profit (Contract 1 & Contract 2 only)
Capped @ 25% salary
50% paid annually / 50% retained until year 3

Note: the profit share awarded will be the greater of the two listed mechanisms above (not cumulative).

How well paid (salary + benefits) are your potential key employees currently, and how does this compare to your basic package? A profit share is predicated on actually making a profit, furthermore in a consultancy business profits might at best be modest in the first few years. Are your potential key employees really going to jump ship to a risky enterprise on the lure of possibly taking a percentage of say a 10 or 20k net profit pot?

You need to sound them out on what they might expect.

[Anonymous Director]

Panamax said:

Anonymous Director said:

I'm guessing key employees would expect this to be built into an employment contract?

What they might "expect" and what you might want to "offer" are not the same thing.

The whole point of discretionary bonuses and benefits (i.e. shares) is that they're "discretionary" and not "contractual".

This is a complex area and you won't get to the bottom of it on a forum, there's just too much detail. IMO you'd be best to either drop the idea of using shares or get paid professional advice.

Point taken on what you're saying about what an employee might want vs what I'm willing to offer.

I've dropped the idea of shares, the above is just a profit share scheme.

Daft question..... who would I go to for professional advice.

[LooneyTunes]

Panamax said:

What they might "expect" and what you might want to "offer" are not the same thing.

The whole point of discretionary bonuses and benefits (i.e. shares) is that they're "discretionary" and not "contractual".

This is a complex area and you won't get to the bottom of it on a forum, there's just too much detail. IMO you'd be best to either drop the idea of using shares or get paid professional advice.

They can be contractual, especially when poaching staff but clearly the same bonus cannot be both contractual and discretionary.

Tbh, simple is best in the early days. Were it me I’d lean more towards something along the lines of:
The company will allocate [x]% of profit to a staff bonus pool. Distributions will be made annually, with discretionary allocations reviewed annually based on individual performance and alignment with company values. Each individual may receive up to [25]% of the bonus pool.

Whilst it gives you a question about what happens to any unallocated part of the pool, it stops very early employees from thinking it’s all theirs. Worth being clear that you intend that something more sophisticated will follow but, to get that right, you’d need to spend money and time that you don’t have at present. That’s not necessarily a bad thing for the employees as it means your thinking about what should be in place will be coloured by how things are developing (and, if you’re seeing greater value than you expected, it could turn out to be the case that you do then want some to have equity).

If you Google, you might find there are startup remuneration ‘ compensation consultants out there who can help further, but be warned: they often have exposure to sectors where equity is a normal part of the package (which may not be the case in yours?), and it’s easy to give away other people’s money/equity.

[biggiles]

LooneyTunes said:

It's a hugely complex area and, no matter how much time you put in or how generous you think you're being, someone will always find cause for complaint! As a topic that provides ongoing fun for management, it's almost as bad as office car parking...

LooneyTunes is right. Any conversation which involves "cap table" will not be short, nor fun.

Incentivisation is a huge topic, and painful to get wrong. (Like pricing.) Ultimately you want to align your employees with what you want, using £ (or alternatives...) to do so. In an ideal world it might be as simple as % share of "net" profit*, but the more mathematical/precise it gets, the more people focus on it. Sometimes it's easier to KISS and award annual "generous" bonuses, without leaking the imprecise calculations you use to get there.

(*) Net profit is important to consider - do you want to be *obliged* to hand out extra £ if the company is making a net loss?

[sideways sid]

A couple of thoughts from setting up similar stuff in sales teams and across recruitment companies.

As others have said, do not readily give away equity. Its value is indeterminable but whilst success might incentivise staff, realising that you have given away too much can disincentivise you.

Use bonuses, with different bonuses paid for different purposes.

Junior sales people want instant gratification, so monthly commission or similar. They have no control over bottom line, so reward them for top line revenue. Good ones will find a way to maximise any scheme for their benefit.

You may be thinking of a five-year plan from more senior people so reward them over that timeframe with an increasing carry of deferred bonus based on net profit / EBIT that - crucially - can be converted to equity should you sell.

Be ready for brighter ones to ask what happens to their valuable bonus pot if you go bust and what you will do to mitigate that.

Edited by sideways sid on Friday 2nd February 12:58

[Panamax]

Anonymous Director said:

. who would I go to for professional advice.

I would avoid "consultants" and head for a decent firm of commercial solicitors with experience in the field. Depending where you are in the country you should find a decent commercial firm in any big city. Bristol, Birmingham, Leeds, Manchester etc - and of course London, at a price.

[Anonymous Director]

Some great advise all-round thanks, lots to think about and try and get right!