Professionals working in the independent financial services industry tend to organize their business the same way as other professional service providers. Whether a dentist, lawyer, or wealth advisor, chances are that the firm owner is both a full-time employee and an active manager of the business as well as a shareholder. We are often asked in our consulting work about this dual role; shareholder and employee, and the interplay between them, particularly as it relates to compensation strategies. For example, should employees be rewarded with stock, or the opportunity to buy stock for achieving certain targets? Or, now that I am an owner, shouldn’t I get a raise?
There are no simple answers to these questions, but context should help to understand the thought process required to make informed decisions when these issues inevitably arise.
Salary vs. Profit Share
At a first level, ownership and pay are distinct concepts with unique rules, purposes, benefits and risks. These concepts represent the division between the return an investor receives on the capital put at risk and the reward received by an employee for the work that is performed. This division should be simple, self-evident and unbending, but the reality in a small business is often far different. The smaller the company, the harder it is to maintain a distinction between ownership returns and compensation. In the most basic model, a one owner company, the black and white lines dividing a return on investment and wages for work often disappear completely.
One challenge with smaller organizations is the multiple hats owners wear. Whether a sole proprietor even draws a salary, or instead only receives “profits” may only matter to the IRS. Once the bills are paid the company’s cash flow ends up in the owner’s pockets either way. The choice between placing cash into the salary pocket or the profits pocket may make a small difference on the owner’s tax bill, but it all ends up in the same pair of pants regardless of the name any particular dollar is given. This is true whether taxed as a sole proprietorship, partnership, or under subchapter S.
As soon as we move to a two or more-owner company, how the profit and loss statement divides wages and profits becomes critical. Properly allocating the cash flow between wages and profits over time is a critical driver of investability, particularly for a next-generation internal ownership candidate. Investability means that the company has a clear set of rules for its owners through an appropriate shareholder or members agreement, predictable profit distributions, and a plan for growth. In other words, an attractive place for a next-generation owner to invest.
Making profits predictable requires that wages paid to owners be set at an economically reasonable level for the work performed, and that wages be relatively stable over time. Because the wages paid to owners are frequently one of the biggest expenses on the financial statement, if not the largest expense, setting and maintaining appropriate wages, especially those paid to owners, matters. Wage and expense control in a growing business should provide a consistently expanding pool of funds for distribution to owners as profits–a predictable and growing return on investment.
Profits are a major driver of value; particularly for an internal buyer of stock in a professional services practice with no short-term runway to full ownership and control. An internal buyer or succession candidate should not be expected to pay the same price for a firm with low profits as one that generates consistently high profits.
Another difference in a small company is that a single individual’s work performance can significantly impact (positively and negatively) the return achieved by all investors in the company. This leads to the question of employment incentives, and where equity fits into the equation. Sometimes advisory owners will set personal performance targets for employees which, if achieved, allow the employee to buy additional shares, or even receive a grant of stock from the company. This may be done through various synthetic equity alternatives such as stock options, phantom stock, or stock appreciation rights along with a vesting schedule. Other long-term incentive plans can be created to align the interests of employees with the company. These plans are designed to retain employees for the long term so that the investment made into their development is reaped by the company, and the employee is appropriately compensated–a win-win strategy.
It is important keep in mind that equity is limited in ways where cash compensation is not. Equity must come from one of two places; either another shareholder who has made the decision to sell, or from the company, which dilutes the ownership of all other owners. Compensation is only limited by the cash flow available and is subject to the other competing demands for cash, including profit distributions to owners.
Leveraging equity as a reward for achieving performance targets can be a costly mistake if mismanaged. For one, employees already receive cash compensation for the work that they are asked to perform, and often a bonus as well for meeting individual or organizational targets. Receipt of stock in addition should not pay the employee twice for the same activity.
Proper Equity Distribution
Equity should be reserved for special occasions, not everyday occurrences. To appropriately utilize equity, first, the stock must be available. Next, equity should only go to those individuals who will make a good long-term business partner and fit the company’s long-term strategic plan. Lastly, the buyer needs to pay for it. Even if received through a stock grant there can be significant tax bills due as a result. Essentially, the recipient will end up paying whether the stock is granted or purchased from another owner or the business. The difference is that there are additional benefits to the business that come with the responsibility of purchasing equity.
Equity is a powerful compensation tool to attract, retain, and reward employees. It is also a tool that must be used with measured precision, flexibility, and accuracy to achieve appropriate long-term results. Structuring proper equity compensation is an important strategy for advisors who are building an enduring business that aligns the interests of owners, employees, and clients together.