Employee Equity: Should You Give It, How to Structure It, and When It Goes Wrong

Speaker 1 – 00:00
You know, last 16 years, I’ve done this. It’s always been one of the most interesting topics because there’s so many
viewpoints on, you know, whether to do it, whether or not to do it, how to get equity, should you give equity, how to
give equity, what are all the options to your team members?
Speaker 2 – 00:13
A lot of people, they think they want equity in the business, but like being a business owner and a true partner, what
they really want is just cash compensation.
Speaker 1 – 00:23
You gotta have vesting schedule, the independent valuation done, and you gotta have a strong operating
agreement.
Speaker 2 – 00:29
If it’s done well, it can be a superpower. If it’s not done well, it can be like, disasters. We have so many stories on
just bad partnerships, bad business dealings, going south.
Speaker 1 – 00:38
Doing this framework of the equity forces you to start thinking as a business owner and really making yourself
irrelevant. Your companies become so much more valuable the more that you become irrelevant to the company.
All right, welcome, everybody. Today we’re talking about small business owners. How to get equity, should you give
equity, how to give equity, what are all the options to your team members? So, yeah, James, let’s get started. Like
what? You work with a lot of business owners throughout the. Look, you know, last 16 years, I’ve done this. It’s
always been one of the most interesting topics because there’s so many viewpoints on, you know, whether to do it,
whether or not to do it. Am I being too transparent, you know, with the finances, what am I exactly opening up the
books to, etc?
Speaker 1 – 01:28
So, yeah, what are your general thoughts before we get into it?
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Speaker 2 – 01:31
Yeah, I’d say it can be a good tool, has to be structured correctly. I’d say the first thing to think about is what. What
problem are you trying to solve? What question are you trying to answer are you trying to solve for retention, vision,
alignment, succession planning, you know, financial incentive, all those things usually come into the conversation.
And I think what some people misunderstand is you can do some of those without giving. There. There are ways to
structure, accomplish those things without giving true equity. And there’s a lot of things to consider if you’re going
to give, you know, somebody a piece of the business and be a true partner. There’s certain rights that, you know,
partners in types of businesses have. You can operate an agreement, can obviously govern a lot of things.
Speaker 2 – 02:18
But yeah, it’s a complex thing, can go really bad if you don’t do it correctly. Can also go really well. But I’d say the
first thing is just like, what do you, what are you actually Trying to solve. So like I guess just in your opinion or you
as a business owner, what do you think the what question are you trying to answer? What do you, what are you
trying to accomplish by giving employees equity?
Speaker 1 – 02:44
Yeah, so I would say, you know, just to give you a quick story, a buddy of mine who was part of a second generation
of a small business, they three, you know, three founders that had started this business about 20 years ago and
the company just blew up. They, you know, Fast forward like 15 years, they had 50 employees and they reached
$100 million valuation. Now they hadn’t done any of this planning. My buddy is one of the key employees, like
basically running the majority of part of the show there, like not doing everything. But he was like they would be not
good if he left. And so out of these 50 employees, there was probably like 10, 5 to 10 really key people.
Speaker 1 – 03:31
He described it and at that point it just got too expensive for them to purchase into, you know, $100 million
company. When they built this thing was probably started around 2 to 5 million and now, you know, we’re 15 years.
And so what they had to do with the lack of planning he described is they had a private equity company come in
and they bought 30% of the company. But what they didn’t realize is they didn’t realize is that private equity
company, although they own 30% of minority, they’re taking a fixed amount of top line revenue in exchange, you
know, they got the check. And there’s a lot of red tape they have to jump through now because now this is a
conglomerate of other companies in their industry.
Speaker 1 – 04:15
And so, you know, I asked him, and now Fast forward another five years, the company’s grown from 100 million
valuation to a $300 million valuations, they’ve tripled. And I, I asked him, I said, hey, do you think you needed,
because you guys had all this momentum, you know, clients were coming in the door from referrals and they’re
happy. Do you think you needed the private equity, like their brains, their strategy said absolutely not. We just
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needed their money. Like banks don’t understand our industry. So we couldn’t get a loan to buy out the three main
partners. So this firm was familiar with our industry and so we had to take them on. And he’s like, dude, if you can
avoid this at any cost, try to avoid it because you know what you’re doing. And so, but you got to plan early.
Speaker 1 – 04:59
And so that’s what we find is with a lot of first generation to second generation with families different. You kind of
run in this crossroads where it become so expensive and then you also have really valuable. Businesses don’t
always have cash to pay the key people as well as they should. So you know, equity becomes a conversation. And
if you’re paying, if you pay the person the cash and you know that they should maybe you’re suffocating the
business from getting, you know, bigger growth of reinvesting cash. So I think equity can be. There’s also horror
stories out there.
Speaker 1 – 05:35
Small business owners that have given a little bit of equity and they’ve left and now they basically, they did it to
retain someone and then they ended up leaving and then they basically just created an expensive nightmare of you
lost someone and now you owe someone a big payout. So you have to structure this really carefully and with the
right structure, I’d say that too.
Speaker 2 – 05:52
Like a lot of people, they think they want equity in the business. But like being a business owner and a true partner,
what that actually requires, like people think they want that, but what they really want is just cash compensation.
And those are like two totally different things. And like we’ve seen like you get somebody in as a partner and then
like, you know, majority owner or the whoever’s running the show is still like doing all the work and that person’s not
doing what a partner needs to do because they’re not used to doing that and they just want their cash comp. And
so like you gotta be really clear on what the roles are and what the delineation between the two is because people
think they want it and that’s not.
Speaker 2 – 06:31
And then when you come to here’s what’s actually required to do it. It’s a big disconnect.
Speaker 1 – 06:36
Yeah. So just to give a personal story at ewa, you know, everyone has. And we’re in the process of setting up, you
know, something called profit interest. And basically the reason, you know, everyone will have a different. But we
want, you know, how do we answer the question what’s best for the. What’s best for our clients? What’s best for
our firm to, you know, to be here forever, as long as possible, what’s best for the team members and you know, we
believe it’s in our best interest to stay private at this point, not take on debt, to have a strong. And so we wanted the
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culture of, you know, everyone participating in the growth of the company. And you know, there’s some ways of
thinking of, you know, Only certain people should get it.
Speaker 1 – 07:19
You know, our way of thinking is we’re all rowing on the same ship. Everyone’s going to have much different
percentages or slices of the pie based upon what the work is and what the individual’s contribution to the
collective and how that’s growing the enterprise value. But yeah, there’s many ways to think about this, but let’s get
into and we’ve got more stories we can share. Good, good and bad.
Speaker 2 – 07:42
I’d say the biggest driver on how you structure this is number one. What are you trying to solve? There’s ways to
solve these things without real ownership. But the biggest driver is how is your entity structured? Is it an S Corp, a
C Corp, llc, a partnership, all of those things, LLC and partnership are similar as far as this stuff. But S Corp, C Corp,
llc, we’ll say those, that drives how you structure all of this from a tax standpoint, from a buyout standpoint,
evaluation standpoint, how you get the equity to them. That’s kind of the, going to be the pivot point of how you do
that.
Speaker 1 – 08:20
Yeah. And I would say, you know, you’re an equity holder at ewa, so like three things, right? It’s reward, retain,
recruit. That’s the way you know, I look at it. And so reward obviously for contributions, you can reward someone
with a cash bonus. You can work with equity, especially with someone that’s a high performer, they’re going to
understand the equity is going to be much more valuable than the cash up front.
Speaker 2 – 08:41
And you can also do phantom equity too, which we’ll talk about.
Speaker 1 – 08:43
That’s absolutely. And then retain, you can put vesting schedules on a lot of these options. You know, someone
can get partner stat equity status, start getting profit distributions, but if they leave in the next three, five, ten years,
depending on you have different options of how to invest it, they lose that value. Like so that’s again we look at it,
we’re a service business. Our people are the business. Right, Our relationships are the business. So retention is
really key. And then recruiting, I mean our field in the REA world, it’s, it’s a shortage of talent and there’s people
willing to pay, you know, big numbers to get the best talent.
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Speaker 1 – 09:19
And so you know, what we’ve done recently to just to guarantee that we get the talent we want is to, we’ll use it a
small sliver to recruit and say that make it a no brainer for us too. And if it doesn’t Work out. It’s not vested yet
away but they come in right from the get go of seeing okay, I’m part of this, I’m tied into the upside. Yeah. So those
were the three and there’s many other reasons you could or you couldn’t but there’s estate planning reasons.
Maybe you do it if you’re in a family but just want to give kind of a framework of how we think about it at ewa.
Speaker 2 – 09:50
Yeah. So let’s talk about so tactically now. Let’s start with C Corp because I think that one is somewhat
straightforward and then the S Corp and LLC is a little bit more nuanced. But a C Corp essentially your business is
its own obviously business own entity but the taxes get paid at a corporate level, corporation level.
Speaker 1 – 10:13
Yep.
Speaker 2 – 10:14
So whoever is employed whether you own the whole thing, you’re going to get a W2 for your job. Every employee’s
new W2 this is I guess I would say you have the most options. This is where you can do by.
Speaker 1 – 10:26
Far the most options. But you get double tax, operating entity and the dividend. So generally I think we figured this
out. For someone in the highest tax bracket you’re going to Pay effectively like 5 to 10% higher.
Speaker 2 – 10:39
Depends on the state.
Speaker 1 – 10:40
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Yeah, heavily dependent on the state but you are going to pay a higher tax. So you have to make sure is the
flexibility, is the optionality. And then really if you’re a small business owner, you know QSBS will be really the main
way you’re paying more taxes as you’re growing the business but on the backside you get exemption, you know,
per individual and you know 10x. I think it’s up to 10 million person that you can exclude. I know those rules are
just changing 2026.
Speaker 2 – 11:04
Yeah, it went from 50 million of assets up to 75. I think it’s still 10 million per income.
Speaker 1 – 11:09
Yeah but you could do, if you’re married you could do your spouse, you could do a trust for your spouse, your kids. I
mean you could get like stack with 10 million, 40, 50, 60 million we’ve seen tax free and so yeah maybe it’s worth
paying half a million dollars more in taxes if you’re doing a couple million of profits like for five years to save 10
million of capital gain taxes on the back end. So that would if you’re a small business owner in the right. Our, our
business type is not eligible for QSBS. So obviously it’s not something we’re doing. We’re not, we’re a partnership,
we’ll talk about the C Corp. But that’s the downside. You can make up for that on the upside if you’re QSBS.
Speaker 1 – 11:44
So we see a lot of startups and like tech do this but when it comes to equity, you know you have the most common
would be RSUs,.
Speaker 2 – 11:52
RSU’s, ISOs, non qualified stock options. You have a lot of flexibility. You can basically give those out. Not basically
you can give those out with. No, the employee doesn’t have to purchase it.
Speaker 1 – 12:06
Yeah. So if you think of that like if you’re a Amazon employee, right. And let’s say your base salary is 250, you may
get another 250 of RSU’s. So the year, let’s say, just say Jameson, you’re a software engineer. I’ve seen your work in
Claude. You basically are at this point. I’m just kidding. So let’s say you get 250 of RSU’s that first year. You’re just
paying tax on the 250. Now you could decide to pay tax on the 250 of RSU’s by filing what’s called 83B election.
The advantage of that is if that stock, that 250 goes up when it vests in three years, you get capital gain treatment
on the difference. Let’s say it goes from 250,000 to 500.
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Speaker 1 – 12:42
You pay, you know, let’s take a top tax rate 23.8% federal on that versus if you wait for three years from now when it
vest, you don’t pay taxes now you pay full income taxes maybe 37% on the full half a million when it vest in three
years. So you see this really common and the reason you wouldn’t want to do the 83B election is because if you
leave or get fired before it’s vested, you just pay taxes on something that you didn’t get. Right. So it’s a risky thing if
you’re one of these big corporations that, you know, Facebook laid off all these employees. Not necessarily seeing
a lot of 83B elections unless you feel really confident in.
Speaker 2 – 13:15
Your or we’ll talk about with a partnership it is more common.
Speaker 1 – 13:19
Yeah, for sure for different reasons.
Speaker 2 – 13:20
But the big thing between a C corp and then we’ll talk about an S Corp in a second is you can have a C Corp, you
can have multiple share classes. So you could do like whether you have RSU’s preferred common options. There’s
like all this flexibility on how you structure it versus like an S Corp. It’s just you can have voting and non voting,
which is one share class.
Speaker 1 – 13:41
So it’s yeah, the reason C Corps do this, I mean we work with a lot of clients to get these RSU’s and it’s like they’re
getting recruited by these other companies in the industry and they’re like we look at, okay, whether you have, you
know, 200,000 of RSU’s that are investing in December, another 2 5th, 250,000 that are vesting next December, and
another 400,000 maybe performance stock units that are investing three years from now. So it’s like we’re leaving,
you know, whatever 600 grand on the table. I was just looking at a client the other day and so if you leave, you have
to negotiate like you have to get some RSU’s granted with that new company if they’re publicly traded. If they’re not
publicly traded, are you getting equity?
Speaker 1 – 14:20
So companies use this smart, very, in a very smart way to lock you down. I mean that’s really the goal for the
company is they want two things. They don’t want you to leave or they want the control if they can fire you still at
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any point. But they don’t want you to leave. And then secondly, they want you bought in to their share price, their
stock price going up. And the RSU is perfectly accomplished, both of those things. So you just have such a big part
of your competency compensation always hanging out there when those ones vest, guess what, you have new
ones that are vesting in the next one, two or three years. So it’s a constant rolling clock.
Speaker 2 – 14:51
I’d say there’s two, that’s one use case like a big established company, you want to retain, give them financial
upside. But then the second would be it’s also a good way to align if you’re gonna have an exit. If you’re C Corp and
you have an exit, it’s a really easy way to like, hey, you’re gonna get this financial incentive on the back end. When
we sale, you’re going to be, when we sell, you’re going to be tied into the sale. So I’d say those are two use cases
for the C Corp. There’s a lot of flexibility ways to do it. We won’t get too into the weeds.
Speaker 1 – 15:21
But yeah, and one other thing with C Corp you can do an employee stock purchase program, 25,000 a year. You can
put in that you can give your employees opportunity to do it at a discount. We see it like you put cash in every six
months. You purchase the stock at a 10% discount and typically you can sell that right away. So most employees
would recommend to max that out and maybe you sell it right away. You pay, you pay tax, short term tax, but it’s
still, it’s guaranteed rate of return if you’re giving the stock price at a 10% discount. So that’s one of their option.
But anything more on C Corp before we move to. You want to do that S corpse next?
Speaker 2 – 15:51
Yeah, C Corp’s I mean again more common in like certain industries like tech or if you’re a big publicly traded
company. You want to be publicly traded. But yeah, lots of options there.
Speaker 1 – 16:03
In general, you know S and P big mega companies are C Corps startups that are going after QSBS or C Corps
companies that are not eligible for QSBS and are smaller business owners that are not going to sell. We rarely see
a C Corps does not make sense. So.
Speaker 2 – 16:21
So in an S Corp just high level review S Corp similar thing where the you know business is. Is a corporation.
However the difference is the instead of the profits being taxed at a corporate level they get passed through so
that Everybody gets a W2 as even if you own it as an employee. But then the profits flow through to.
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Speaker 1 – 16:44
The in the exact percentage that you own. So if you’re 60% owner, I’m 40% owner. 60% Of the profits no matter
what are going to go to your tax return. 40% Are going to instead of the.
Speaker 2 – 16:56
C Corp it stays pays at the corporate.
Speaker 1 – 16:58
At the corporate level.
Speaker 2 – 16:58
Yep. So the difference is with an S Corp you can have voting and non voting shares which makes a ton of sense
for. There’s a few reasons to do it. One big one’s for estate planning purposes moving into a trust or like a family
partnership or something a family entity. But in general with S Corp you only have one share class. So you can’t,
you don’t have the flexibility like a C Corp to have you know like a profit. You can’t do a profit interest or it’s just one
share class of stock and you’re at a hard cap of 100 shareholders and all shareholders have to be US individuals or
qualifying trusts. But you can do ESOPs with, with an S Corp I’d say in General and ESOP.
Speaker 1 – 17:46
Explain what ESOPs an employee stock ownership plan.
Speaker 2 – 17:49
Yeah. So like we’re working through this with one client. Basically it’s a way that you could sell all or part of your
business to the employee. So it’s pretty Complex you have to get financing involved. Generally it’s a lot of, yeah, a
lot of legal work. But let’s say Matt owned business 100% and he said I want to give some of the ownership to the
employees but I also want to like get some cash out of this. He could say I’m going to take the whole business, sell
it to my 50 employees or they now have an ESOP. You know, there can be vesting on it. You have to buy, you know,
may have to buy it back if they leave.
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Speaker 2 – 18:25
But it’s a way for the owner to get the cash compensation out versus just like handing out the equity for free in a
sense.
Speaker 1 – 18:32
No doubt. Well, so S corps we see pretty common because a lot of CPAs will recommend these because the
advantage if a CPA is telling a you know, owner of a company, an S corp does give a lot of benefits. You know, your
sal, you can pay yourself a reasonable salary and then when you distribute money like let’s say you’re 100% owner
of the S corp and let’s say your profits are a million dollars, you could pay yourself a salary of a hundred thousand
and then distribute 900,000. And so that 900,000 first of all is your Social Security cap is going to be what’s the this
year? 170 Something. So you’re 70,000. You’re avoiding you know, 6.2 on the employee and the employer side. So
12.4% on 70,000. So about 10,000 of savings.
Speaker 1 – 19:19
And you’re avoiding Medicare tax 1.45 employer and employee side that’s about 2.9% on the next 900,000. So
that’s almost 27,000 of savings. Plus there’s a Medicare surcharge that you’re saving. So all in, you’re probably
saving about 50 grand in immediate like federal taxes because that all gets lumped together your Social Security,
Medicare and federal. You’re immediately saving 50 grand in taxes by being an S Corp versus just a sole
proprietorship or an LLC filing as a flow through sole prop or even a partnership. So that’s why we see S Corp. So
common is it does give you the most tax savings today on a year to year but it is the most rigid from an equity
standpoint. So if you’re trying to do, let’s say we have an owner that’s 100% he wants to give someone 1%.
Speaker 1 – 20:11
That 1% owner now gets every time a hundred thousand is distributed out, the original owner gets 99, that owner
gets 1000 and you can just do the math. So it’s basically, you’re making your books very transparent to every
person that has equity. You know, you could have vote. You could still have voting control of the whole company,
but it is very rigid from a distribution standpoint. So equity is definitely possible. You know, there’s multiple ways.
You can just have the employee purchase it. You could do it through a loan that you pay after tax, you know,
bonuses. They give the money back to you over. You know, you have to assign an afr, an interest rate to that.
There’s many. You could get a third party to finance it, a bank to finance a transaction.
Speaker 2 – 20:53
In general, there has to be a. There’s. Yeah, most of the time there’s going to be a purchase. It’s less flexible, which
we’ll talk about in a second. With partnerships where you can do the.
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Speaker 1 – 21:02
Two workarounds will be the SARS or the phantom equity. So you give a quick hit on those.
Speaker 2 – 21:06
Phantom equity is a way to nobody. So let’s say you’re an S corp. Instead of giving somebody a percentage where
they now would get a K1, they get W2 and a K1. You essentially say we’re going to align you on the back end. So
like if we sell, say you have a business, Matt, a hundred million dollars, I’m working for it. And you said, I don’t want
to give you real equity, but we’re going to sell in five years for $500 million. I want you to participate in that. Instead
of issuing real equity, I get a K1. All these complexities involved. You could say I’m going to give you phantom
equity. And what that means is when the business sells you just. Or at any triggering event, you pay me out a cash
W2 bonus.
Speaker 2 – 21:57
So if the business sells for 500 million and you want to reward me with 10 million, part of the sale would be I get
bonus $10 million that W2 deductions from me. Yep. Less tax efficient for the person receiving it, but it’s much
simpler where you don’t have to be a real partner.
Speaker 1 – 22:13
Yeah. And so the process while you’re growing leading up to that point is business as usual. There’s no changes.
You know, so. And then SARS work, stock appreciation rights, right?
Speaker 2 – 22:24
Yep. Similar to phantom equity, but it’s only on. There’s a strike price. So let’s say you have $100 million valuation.
It’s essentially you’re getting and you sell for 500. You are getting the employee or the partner at that Point they do
get a K1. They would be real partners, different than phantom equity. They’re comped on the difference of that 100
to 500 million. So it’s like a go forward basis.
Speaker 1 – 22:51
Gotcha. Okay, well, yeah, not to be biased. We’re an LLC partnership. This is our favorite one.
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Speaker 2 – 22:59
Yeah.
Speaker 1 – 22:59
And there’s a reason, you know, most private equity firms, OpenAI does something similar to this.
Speaker 2 – 23:07
A lot of. Yeah, a lot of bigger companies. Yeah. When we dug into this for our own equity, I’ve like, you know, the
people talk about how tax advantageous C Corps are. And once we dove into this, I’m like, partnerships are
awesome. They’re so like, there’s a reason every private equity company does it. These complex like equity
programs and deal structures because it’s just like, it’s so flexible. So much you can do.
Speaker 1 – 23:29
So first of all, operating agreement’s key.
Speaker 2 – 23:31
With a partnership, with anything.
Speaker 1 – 23:33
So you can have an operating agreement if you own more than 51% of the company. You can, you know, you can
have an operating room that says you control the majority of decisions. Right. So first and foremost, like you think
of a partnership, am I giving up? You can structure it where you’re not giving up it or the control you give up is
under your control, essentially. Can people earn it over time? Which is great. But yeah. So there’s. With a
partnership, it allows you to do this very unique thing called profit interest. So the good thing about this is you can,
I guess the right word would be give a team member, key team member, profit interest. And there’s no taxes to you,
and there’s no taxes to them. So walk us through the mechanics of.
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Speaker 2 – 24:14
This basically with a part. So like with a S Corp or C Corp, there’s stock or shares. With an LLC or partnership, the
IRS classifies it as interest, ownership interest. So there’s a difference between capital interest and profit interest.
So capital interest is your paying capital to buy part of the business. So you have a hundred million dollar
company. Let’s say you have a hundred million dollar company. You say, hey, I want, you want me to come in to
own 25%. If I wanted true capital interest to buy in, to own 25% of that existing hundred million dollar business. I
have to pay you $25 million. Now, minority share, you can discount it. But there’s capital exchange for that. What a
profit interest is.
Speaker 1 – 24:57
And I have to pay capital gains like my basis was low. I sell it to you, I pay capital gains and my basis on that 25 is
1. I pay capital gains on 24 million.
Speaker 2 – 25:07
Yep.
Speaker 1 – 25:07
So there is taxes realized right away. Your basis then starts at 25 and anything above that’s capital gains if you
hold it for longer than a year.
Speaker 2 – 25:14
So that can be an option if like in your example you talked about at the beginning, if somebody wants to, you need
to inject capital into the business. You’re buying somebody out. Like that’s the way to go. You’re, you’re getting a
private equity company involved, whatever. Now what profit interest is. And so this is, it’s Revenue Proctor. 9327 I
believe is the tax code. What it says is the IRS allows you to give profit interest to somebody. They’re now partner,
they get a K1, they get a share of the profit of the whole company if you structure it that way. But it’s a go forward
basis. So let’s say you have $100 million company and you’re going to say I’m going to give you 25% of profit
interest. I now get 25% on everything going forward.
Speaker 2 – 26:01
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So if went from 25 million or sorry 100 million to 500 million, that’s and we and the company sold at 500 million,
it’s a $400 million delta there. So the original owner or owners would get the first 25 million or the first hundred
million. The next 400 million would be divided up in that property. So in that example of if I came in at 25%, I would
get $100 million.
Speaker 1 – 26:27
25% Of the 400 million.
Speaker 2 – 26:28
Yes, on that difference. So why that’s useful is there’s no purchase involved. So when the IRS treats it, you issue the
profit interest. It works similar to how we talked about in RSU. If I was getting capital interest of the existing
company, I’d have to pay income tax on that because I’m getting it in the form of income like an RSU. But what
profit interest is your basis is now zero because you’re getting it from. You’re starting at zero. Because it’s go
forward basis, you would file an 83B election. This is a use case where you would want to do an 83B election
because you’re electing to pay income tax on zero.
Speaker 1 – 27:06
It doesn’t cost you anything. There’s no downside. If you get fired, there’s no downside. If you leave, you lose your
equity. If it’s not vested, you’re not paying any taxes.
Speaker 2 – 27:13
But then that starts capital gains on if the business Sells now I pay capital gains instead of paying income tax on
the back end if there’s a liquidation event.
Speaker 1 – 27:21
Yep.
Speaker 2 – 27:21
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So it’s a flexible way to get people equity without having to be a purchase. And what I think this is like, awesome is
like you can, and if.
Speaker 1 – 27:31
You’re real quick on that, if you’re a business owner that’s trying to truly retain or you’re trying to stay private. Yeah,
you, that. So in that example you can make that a guaranteed payment which is tax deductible to the firm. So the
capital gains treatment, if we, if you know, if someone was to get bought out, private equity money, great. If you’re,
if you’re leading a company that’s still privately hold, that company can pay you a guaranteed payment, get a
deduction. So now if it’s a $10 million buyout, it’s only costing the company maybe 6 million.
Speaker 2 – 28:04
I forget what the tax code is.
Speaker 1 – 28:06
Yeah, but you can, and you can structure that also as a non solicitation agreement. So if that key partner wants to
retire, let’s say they go start their own business, tries to take clients their profits or their interest to get that
payment. Only get the payment if they follow the rules of the operating agreement as well. So that’s a really key,
you know, flexibility piece depending on your goals. If you’re selling to private equity, one thing or if you’re trying to
stay private, you know, you have the flexibility of how to structure the taxes on the back end.
Speaker 2 – 28:36
So yeah, you pay that out in the form of a K1. And yeah, they would basically agree to follow whatever your terms
are to get that compensation. But what I think is really cool about this is so the term is a hurdle or a waterfall
which is again really common in private equity companies and private equity deals. So let’s say you have a hundred
million dollar company, let’s say you own 100% of the $100 million company and you want to bring me in. And you
would create a waterfall at 100 million. So the first hundred million goes to whoever owns that portion and then
the first waterfall you’d say is 100 million. I’m going to issue profit interest from 100 million on and you can like
draw a line in the sand and reissue these at any point.
Speaker 2 – 29:21
So you could say, okay, we’re going to issue this at 100 million to 150 million. First hundred million is, let’s say
that’s the people that have capital interest. The next hundred to 150, you’ve issued profit interest. Now you get to
150 million. And you say, well, these people that helped me get here now, they were great. They’re still going to get
rewarded, but they’re not really the key players. Now to go from 150 to 500 million, I’m going to draw a line in the
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sand issue another hurdle, waterfall profit interest. And now from 150 million to 500 million, these people can be
involved or they could not be. And you could bring in, let’s say you bring in somebody else from outside to run the
business. Now they’re going to be comped from 150 to 500, and then you get to 500.
Speaker 2 – 30:06
You say, okay, now I’m going to draw another line in the sand. New waterfall going forward. So you essentially
create these waterfalls. Let’s say you go up to a billion dollars. The first hundred million goes to these people. Next
to 500 million goes to these people, and 500 to a billion goes to these people.
Speaker 1 – 30:21
Yeah. And the one thing to watch out for, that’s, it’s an amazing part of the IRS code that, you know, partnerships
have the flexibility. The one thing to look out for, though, is if you issue a profit interest of 10% and it’s. It’s above
that hundred million, that person still gets 10% of the. So there’s two things. They get 10% of the sale price or the
value when they vest based upon the operating agreement. You know, ours would be if, you know, vest in 10 years
and someone leaves or wants to sell, the company has five years with interest to pay that note off. So the
company’s not suffocating. You know, that’s just personally how we structured it.
Speaker 1 – 31:00
Now the other thing though, to realize is if someone’s getting a 10 profit interest, they immediately do get 10% of
the profits of the entire business.
Speaker 2 – 31:07
That’s, that’s the def. That’s the default way you can structure the operating agreement. If it depends how complex
you want to get this, that’s the big driver in this is how. What’s your appetite for complexity? Yeah, but you can
structure it if you want to get where it’s just.
Speaker 1 – 31:20
The profits above that.
Speaker 2 – 31:21
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Yeah, you can structure it however you want, but that’s the default is. Yes, they would get a profit of everything.
Speaker 1 – 31:26
Everything. Gotcha. Okay, perfect. Well, any other. So you have, you know, really important. You need to have, you
know, a vesting schedule. You need to have the. Yeah. So talk about the optionality of the vesting schedule.
Jameson, is there any restrictions or is there literally the wild west where you.
Speaker 2 – 31:45
Profit, interest or anything?
Speaker 1 – 31:46
Well, for both,.
Speaker 2 – 31:49
Yeah, you can stretch whatever you want. There’s no IRS rule that says like you can’t have a 30 year vesting
schedule. But I would think about it as like it generally five years is pretty common. Five to seven and usually like
you’ll see a lot of a cliff. So like let’s say you give someone 25% year, you know, maybe after three years, 25 or 33%
vests. After year four, 33% vests. After year five, 33% vests. That’s like one way to do it. Or 25% every four years or
something. I would just say like it’s easy to think like, oh, I’m going to make this really long so that it retains people.
But like you gotta remember if you’re opening this up to most people in your business, a lot of people aren’t by
default gonna think like a business owner.
Speaker 2 – 32:43
So like they’re not gonna be long term thinkers enough to be like, oh yeah, I’m gonna like be here for 20 years. If
you hire someone that’s in their 20s right out of college, like they’re gonna flip jobs all the time. So like a super long
term vesting schedule can actually like work against you because people won’t view that as like middle ground you
want to try to strike. Depending on what your goals are, I would say generally five to seven is reasonable.
Speaker 1 – 33:06
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Yeah. At the same point, if you’re offering it as a recruiting tool, that’s another way to weed people out is if that’s a
major part of the offer and it is a seven year and they’re like turned off and maybe it’s not the good a good fit. So
yeah, I could see that both ways for sure. So you can do it, you can do performance investing. This one’s a little bit
hard as far as administration goes and tracking disagreements. And would you say performance vesting? Oh yeah.
You’re allowed to do that.
Speaker 2 – 33:32
I think the caveat is it can’t be tied to employment compensation rate. It has to be separate. Like yeah,
compensation has to be one thing for services rendered in the business and then your ownership. So that the
performance would have to be tied to like the equity piece. Just like a legal side note.
Speaker 1 – 33:49
Absolutely. And you could have an acceleration on change of control as well. So if the company sells or you know,
sells a portion of it. That could accelerate vesting as well.
Speaker 2 – 33:58
Yeah, I’d say the big takeaway is like, the operating agreement governs all of this. And like, you gotta have that
buttoned up because that’s. You can dictate all of this in how you write the operating agreement. If you don’t have
that, there are certain legal rights, state by state specific, but there are certain legal rights that anybody that’s a
partner in a business has that will be the default if you don’t have a well structured operating agreement. Whereas,
same thing, like having a prenup. Like, you can have the government decide what happens if you get divorced. You
can have the government decide what happens if a partner gets out of business, or you can dictate it on your own
terms in a prenup or an operating agreement. It’s the same concept.
Speaker 2 – 34:36
And I’d rather, you know, it generally makes a lot more sense to agree when everyone’s happy versus trying to come
to an agreement when, you know, things are terrible.
Speaker 1 – 34:46
Yeah, no doubt. That’s, you know, have, you know, the vesting schedule. You got to have an independent valuation
done and you got to have a strong, you know, operating agreement.
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Speaker 2 – 34:56
Key to valuations.
Speaker 1 – 34:58
Key. You got to have. What happens if one of your partners, now K1s gets to like, divorce?
Speaker 2 – 35:03
I was literally just going out. That’s a huge thing.
Speaker 1 – 35:04
Yeah, yeah. Because that becomes your problem.
Speaker 2 – 35:06
Yeah.
Speaker 1 – 35:06
In a way.
Speaker 2 – 35:07
So let’s walk through that. So let’s say I come in as a partner, I get divorced. Well, if that business is a marital asset,
which it probably is, unless there’s a prenup that, let’s say I come in for 25%, business is worth $100 million, my
equity is worth 25 million, I get divorced. Ex spouse says that’s a marital asset. A couple things could happen.
Number one, somebody’s on the hook for now paying $12.5 million if it’s split, the business isn’t going to, like, the
person doesn’t have that liquid, probably. And the business isn’t going to want to pay that.
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Speaker 1 – 35:42
Yeah.
Speaker 2 – 35:42
Or the spouse could be added in as a partner because they’re now entitled to half of that equity percentage. So the
workarounds.
Speaker 1 – 35:51
And now the company is having to buy that spouse out over five years, which is just such an unnecessary. Yeah.
Speaker 2 – 35:57
So the ways around it, obviously, prenup. But this is an awkward conversation, but probably a good one to have.
When you issue the equity to somebody, you can have the spouse sign an agreement that says if anything goes
south, that they’re not going to sue for. You basically say that equity in the business is not a marital asset. In the
divorce, I guess is the simplest way to do it.
Speaker 1 – 36:29
That’s an interesting thing. What if someone’s not married, but getting married after the fact, you kind of, you can’t
do anything.
Speaker 2 – 36:35
Could it be a marital asset? I guess it’s up to how that.
Speaker 1 – 36:39
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Person does their own. Yeah, it’s interesting because there is a, you know, say business and personal life
sometimes for small business are blend together. If you, if you do this profit and trust or partnership thing, it’s,
there is some overflow that it’s worth discussing because, you know, we’ve seen this happen with clients and it’s, it
can get messy and it can be a distraction to a growing business for sure. So our decision framework, you know,
what’s your exit timeline? Less than three years, three to seven. Are you never selling? What entity makes most
sense? We talk about LLCs, partnership, LLCs, S Corps, C Corps. How many people are you including and how
much control do you want to give up? You know, and then obviously tolerance for complexity is key as well. So.
Yeah. But that bit in mind. Jameson, any. Any closing thoughts?
Speaker 2 – 37:32
No, I’d say it’s a, it can be. If it’s done well, it can be a superpower. If it’s not done well, it can be like disasters. Like,
yeah, we’ve seen, we’ve so many stories on just bad partnerships, bad business dealings going south and like,
yeah, if you’re gonna do it, spend the money.
Speaker 1 – 37:51
To have like talk with an advisor to get your philosophy down and make sure every, you uncover every thought,
every downside, every upside. Make sure the upsides are worth the downside and the time involved. Because one
thing I will say is, you know that your company’s become so much more valuable the more that you become
irrelevant to the company. You know, working, helping clients with private equity deals and sales, you know, the
biggest risk to an acquirer is if something happens to you as the owner. It is that are you going to lose customers?
Are you going to lose, are you going to lose accounts? If the answer is yes, your business is only valuable if you’re
healthy and you’re operating in it.
Speaker 1 – 38:32
So doing this framework of the equity forces you to start thinking as a business owner, delegating, empowering
your team members and really making yourself irrelevant. If you make yourself irrelevant, then you should be able
to spend time on what actually drives your business to the next level. Because if you’re at a 20 or 50 or $100
million valuation. Like you being in a face to face, one one with a client as a percentage of what that’s helping the
company. It’s really irrelevant at that point. So your time should really be focusing on the strategy, the key
relationships, the empowerment, the training, the culture of the business and just making sure everything’s aligned.
Speaker 2 – 39:12
And if you go to sell and your business depends solely on you as 100% owner and you’re 60 years old, the buyer’s
gonna be like, well, okay, we’re limited on how long you’re gonna be here and you wanna get out. That’s why you’re
selling. Like this can be a built in, almost like a built in succession plan of like, hey, like there’s all these, there’s
other people involved that have ownership that are capable of doing things that I’m not 100% dependent on. And
that’s much more attractive to a buyer. And it’s going to, you know, increase the valuation of your company
immediately, no question.
Speaker 1 – 39:48
Well, thanks for joining us everybody. Look forward to catching next week.