The Trade-Offs

There is a very important trade-off that we need to recognize in order to build a healthy firm—the more we value equity, the more we will “undervalue” contribution. And the more we reward those who are contributing, the less value we will drive to owners.

Here’s an extreme example: Law firms tend to allocate their income to those who created it—by being rainmakers and billing the most hours. But law firms have no equity value whatsoever.

The trade-offs have a very real financial dimension. If we pay contributors 40% of the revenue, the normal benchmark, we have a very good chance of providing equity owners with a 25% profit margin (another benchmark). If we increase the pay to contributors to 60% of the revenue, we will pay more to those who created the revenue through their efforts but we will reduce dramatically the income to the owners. Not only will the profit be lower, but a permanently reduced profit margin will also likely reduce the multiple of profits someone is willing to pay to buy the firm, since the risk to owners will be higher. It is not likely that someone will pay six to eight times EBITDA for an advisory firm with a 5% profit margin.

There is another important trade-off at play here. If the equity is very valuable, it may become unaffordable to the people working hard to create that value. What if our 30% contributor is offered a 30% share but she simply can’t afford to buy it? Founders sometimes ask, “Why do I need to discount my equity in order to sell it to my partners who can’t pay for it when I don’t want to sell any of it even at a higher price?” The answer is that, unfortunately, if our 30% contributor can’t afford to buy at least some of the equity of the firm she is building, she might leave and then our firm may have 30% less value, especially if we keep all the equity.

Sometimes, owners confuse this fairness issue with a legal issue. They think that if we “tie up” our 30% contributor with non-compete, non-solicit and non-complain agreements, we don’t need to worry about the loss of value. Realistically though, just look around. More than half of the firms in the industry were created by someone who had such agreements with a bank, wirehouse or accounting firm and still left them to start a new business. The departing advisor does not even need to “take” the clients; her absence as a professional and as a business developer alone will result in the deterioration of the business even if she takes no clients whatsoever.

Even if she stays, her disappointment might prompt her to stop pouring her heart and soul into the business, and I promise you that this will also damage its value.

In other words, in an industry where the best contributors get the opportunity to become owners, not selling equity to your top people will likely damage the quality of the talent you can attract and therefore the value of the equity you are holding on to.

Compensation

The friction can be significantly reduced by the proper use of compensation. If somehow, conceptually, everyone is paid very well for their work, they will have less of an issue with not being owners or not being bigger ones. On the other hand, if someone is undercompensated in the hopes of someday being an owner, they will be very eager for that “someday” to arrive soon.

It’s important to say what being paid “well” means:

• For one, it means a competitive base compensation—a salary or some other income that is competitive in the industry. No one is undercompensated for their position and skills, and there are no “promises” that supplant or supplement compensation.

• It also means compensation that is equitable internally. In other words, the top contributors earn the top compensation. This is where many if not most firms fail—the top contributors are often not the best compensated people in the firm.

• It means performance is rewarded. There is a well-functioning form of performance measurement that is tied to incentive compensation, and the top performers are rewarded for their achievements.

• It means growth is compensated. If you were to ask valuation experts what creates the most value in a professional services firm, the answer will undoubtedly be “growth.” It’s precious, and while it is not the only form of contribution, it should be rewarded because it is so scarce and because it makes everything else work.

Still, as one of our clients put it, “As long as the firm has value, there is no amount of income that will make me forgo the equity.” This is both a recognition of our tax code (the value of cap gains over ordinary income) as well as a recognition of behavior—we spend income, but we accumulate wealth through equity. In many ways, it is also part of the culture of the industry. Equity carries a prestige that income just doesn’t.

Am I Buying What I Am Building?

One of the most common questions of balance between ownership and contribution arises when younger professionals realize that every client they bring to the firm makes it a more expensive firm when it’s time for them to buy equity. They might ask: Am I not buying my own contribution?

Finding a good answer to that question is not easy, but if there’s a well-functioning compensation system, a firm can explain why an employee needs to buy what they create. The professional is well paid for what they do. By contract, everything that the employee does is owned by the firm and is work for hire. For example, if a builder constructs a house, he will likely not argue that he has equity in the house because he was paid for the construction. Michelangelo did not get any shares of the Sistine Chapel and Michael Jordan never got any shares of the Chicago Bulls.

“Sweat equity” by definition is the notion of ownership that was created through effort that was not compensated. If I am paid well for what I do, I can’t argue that I have sweat equity. You can’t have both. You can either take the pay or forgo the pay to build equity, which is what founders often do.