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This podcast is for small to medium business owners. You've got a lot to gain, a lot to lose, and business is tough; there's a lot at stake. Business acumen is what every business owner needs, it will make a profound difference to your business.
This podcast will cover marketing, positioning, branding, lead generation, selling, negotiating, customer service, managing staff, managing finances and accounts and much more.
https://www.businessveteran.com.au/
mark@businessveteran.com.au
Are you being offered shares in a small or medium business?
A new client of mine has an offer to buy 25% of a small business he has recently done some work for. He wanted my opinion and I though it a great topic for an episode. For this episode, I am going to assume the listener is relatively new to business, so I'll start with some basics - bear with me.
There are multiple roles that you can occupy in regard to a business. First there is shareholder. This means that you actually own a share of the business. The company issues shares, say 100 of them, and if you buy 50, then you have 50% of the business. Just because you are a shareholder, does not mean you are a director of the business, or an employee in the business. As a shareholder, all you get to do is vote for the directors.
One of the purposes of business is to make a profit, and those profits are distributed by way of a payment called a dividend in proportion to your shareholding. So if you have 25% of the shares then you receive 25% of the dividend. The directors decide whether or not to pay a dividend, and how much of the profits should be paid to shareholders, and how much to retain in the business.
To understand how the shareholder/director dynamic came about, imagine a large company with hundreds of shareholders. You can't have hundreds of people trying to direct a company, so they get together and elect a small committee called the "board of directors" to act on their behalf. Even in a small company of only one shareholder, you still have at least one director.
The directors collectively decide what the company will do, and not do. Collectively, they control and govern the business, but they don’t manage it, they give the employed managers the strategy to execute. By now you have figured out the role of director is important. A director is a legal position held within a company.
Now while it sounds all powerful, there are huge personal risks to being a director. If employees are not paid properly, this is called "wage theft" and directors could face criminal charges. If the company runs into financial trouble, is forced into administration or receivership, and the company is found to have been trading insolvent (which means can't pay their bills), the directors can be held personally liable. That means their houses are on the line. They could lose everything and be put into bankruptcy.
The risks don’t end there. If an employee of the company is badly injured and the company is found to have been negligent, directors can go to jail. So you really only want to be a director if you have to be and have plenty of control over the running of the company, or you are well paid, insured, and are on the board of a very professionally run company , and you can commit the time to asking for the right reports and reading them to verify that the company is compliant and well managed.
As I said before, directors don't actually manage the company, the managers do. The board of directors, in theory, only meet once per month and directly employ just one person, the CEO. In most small businesses, the CEO is also on the board and that role is called "managing director" (the director who also manages). The CEO or MD then employs everybody else. The managers and other staff of the business actually do the work of the business.
Now these three roles, shareholder, director and employee and completely independent and you can be all of them or any combination. Often in a small business, you might see two people, who each own 50% of the shares, both being a director, one is nominated managing director, and both work in the business as employees - typically known as working directors.
Right now let's consider my client's offer to own 25% of an existing business. Presumably he needs to buy his way in. So he wants to know what the company is worth. This is a very complex issue however a very rough rule of thumb is that an SME might sell for 3 times the average net profit of the past 3 years, plus the net value of the assets. So if you were buying 25%, you'd pay a quarter of that total value.
But who are you paying? Is the business issuing more shares and the company sells you the shares, so your money ends up in the company where it can be used to buy equipment, fund expansion etc, or is the owner of the existing shares selling down and the money goes into his pocket? I think you'd want to know that.
Next, a critical document is the shareholders' agreement. Too many companies don’t have one, but I consider it to be critical if there are multiple shareholders. It is an agreement between shareholders and sets out all sorts of important things such as valuing the company's shares if someone wants out, who they can sell their shares to, whether or not they get a seat on the board (of directors), how many votes they get, who else is on the board, and so on.
Now recall that the shareholders vote for the directors. Their vote is usually proportional to their shareholding, so if someone has more than 50% of the shares, they effectively control the company. If you are a minority shareholder, you ultimately don’t have much of a say. 25% is very much a minority shareholder.
In the event you are invited, or are entitled via the shareholders' agreement to a seat on the board, we come back to the risks associated with being a director. What is the financial state of the business? Has it always paid its debts to suppliers, staff, banks etc? Is it up to date with its tax and superannuation obligations? Once you become a director, you take on these obligations. Not being there when the debts were incurred is no excuse. Your personal assets including your house if you have one, are on the line.
You may be employed by the company, but in that role you are just an employee, you are told what to do and can be fired or made redundant any time. Just because you're a shareholder doesn't change that.
So by this point, you might gather than I'm not enamoured by the prospect of buying 25% of a business, at face value.
There are circumstances which might reduce the risk. For example:
• No one person dominating control by having more than 50% of the shares
• Having more than 2 shareholders so that decision making is less likely to be dead-locked
• Having a comprehensive and robust shareholders' agreement which spells out the process by which anyone sells out and exits the company, as well as who else, and for how much, others can buy in
○ Buy the way, on this point, I've seen shareholders leave and paid out for their shares, then set up business in competition taking clients with them. Yeah - Nah. A serious restraint of trade was needed here - and these restraints have big teeth when associated with a share sale - but back to reducing risk…
• You could buy more than 50% of the shares, that would effectively put you in control (beware complex issues such as different classes of shares with different voting rights)
• A quality company will have regular management reports giving insight into the company's performance - these should be read and understood. Look-out for these
• Talk to the biggest customers of the business and find out how it is viewed by them
• Get professional advice. Use accountants to examine the financials, and lawyers to examine the contracts. Worth the cost many times over
Finally, consider the human angle. You don’t really know someone until there is money involved, or they are under extreme stress. You can know someone for years and think you can trust them with your life, but then money gets involved and you're in for a nasty surprise. Hidden mental health issues, shockingly common, can surface after years. Death, disability and divorce also play a part. You might not end up being in business with the people you started with.
So how do you protect yourself from all of this? As a lawyer friend once said to me "if it's not in writing, it's not worth the paper its not written on". Protect yourself with the appropriate advice and comprehensive agreements which cover all the circumstances you hope will never happen. I've seen partnership splits turn very ugly even with the appropriate agreements in place. But with the law on your side, you have a huge advantage.
Speaking of partnerships, there is a form of business structure called a "partnership" which is different from a pty ltd company which law practices often use; but rarely SMEs. I'm using the word in the simple sense of people who co-own a company.
From the company selling the shares point-of-view, there are often good reasons to sell down. The owner might be wanting to retire in the near future and it's a way for, often an employee, to buy from the owner slowly by using the employees share of the dividend to buy more shares until they eventually own the company, and the original owner can retire taking away their equity in the business.
Another reason might be to attract and/or retain difficult-to-find employees. The question you need to ask in the case is: why is the owner struggling to retain people? The belief of the owner is that if the employees own shares, they'll work harder, stay longer etc. I have seldom seen this done successful and it's fraught with the risks mentioned above. An additional risk is that the employees with a small shareholding suddenly see themselves as bosses - confusing the roles. It can be done of course but with extreme care and caution.
On the positive side, I've seen plenty of successful partnerships. It's never easy as business is never easy, but there are real advantages to having complimentary skills. All business have to be good at three things, making a sale, delivering on that sale, and keeping score (finance etc). Almost no-one starts off good at all three, so go into business with someone who can fill in your gaps, or get a good coach to help you skill up!
As always, if you want to chat about any of this, make contact.
I'm Mark Jackson