An effective tool for owners of private companies, to attract and retain talented employees, is to offer them an ownership interest in the company.
While there are many benefits to employee share ownership including motivating key employees, aligning the interests of the owner and key employees, and increasing the likelihood of retaining these employees, it is important to properly communicate and document the details of the arrangement in order to minimize the risk of disputes should the business relationship end.
Unfortunately, we have seen many cases where disputes over the nature and value of employee-owned shares has resulted in costly and lengthy litigation. The number of disputes of this type seems to be increasing as employee share ownership becomes more common. This article discusses common areas where valuation-related disputes can arise and offers suggestions to mitigate the risk of these disputes occurring.
A few of the areas where disputes can arise when employees acquire shares are as follows:
1) What is the ownership interest which is actually being acquired;
2) What is the fair market value of the shares when they are issued;
3) How will the shares be paid for;
4) How should redundant assets or liabilities be dealt with when valuing the shares; and
5) How will the shares be valued on termination of the business arrangement?
While these valuation issues may seem straightforward, we have seen many situations where disputes over these issues arise, so upfront consideration may “pay dividends” in the future.
1) What is the ownership interest being acquired?
At the outset, it is necessary to specify the ownership interest being acquired, which may include:
a) Common shares acquired from existing shareholders;
b) Newly issued common shares from treasury;
c) Common shares acquired following a corporate reorganization which allocates some or all of the existing value of the company to newly issued preferred shares. In this situation, only the future growth will be shared by the new common shareholders based on their ownership interests; or
d) Options to acquire common shares in the future.
It is important to specify to the employees the type of shares that are being issued to them and, as will be discussed below, how the value of those shares will be calculated at the time they are issued and the time they are sold or redeemed.
For example, if the owner of a company issued common shares to employees after completing an estate freeze, the common shares would have little or no value when issued. This should be properly documented and communicated to the employees so that they understand the initial value of these shares as it may not always be apparent from the employee’s perspective. It may also be helpful to explain the rights and privileges of the different classes of shares and how this may affect the employee. In another example, an employee may believe he or she owns equity in the form of shares of his or her employer’s company while the company may have merely issued the employee options to own shares, subject to certain vesting terms.
2) What is the fair market value of the shares when they are issued?
If the shares are issued at fair market value, it is necessary to determine and document the fair market value of the company at the time of issuance and the nature of the equity interest being acquired. The valuation should be completed using accepted valuation methodologies and, ideally, be done by an independent expert in valuing private companies. Each party may want to obtain independent advice with respect to the transaction and agree on the valuation that is being relied on. Practically, the number of experts retained is often driven by the value of the shares being issued.
For example, if the owner of a company completes a corporate reorganization and sets the value of the preferred shares too high or too low without the support of a formal valuation, the common shares issued to the employees will either have too little or too much value, respectively, when they are issued. There may be income tax implications to issuing shares to an employee at no cost or at a value that is less than fair market value, and tax experts should always be consulted.
3) How will the shares be paid for?
It is necessary to determine how the shares will be paid for, which may include:
a) Paying for the shares upfront, using the employee’s personal resources;
b) Paying for the shares upfront using funds borrowed from the company (with or without interest). There may be income tax implications to providing a loan with little or no interest;
c) Paying for the shares over time using income generated through the ownership interest; or
d) Gifting the shares to employees. There may be income tax implications to gifting shares.
How should redundant assets or liabilities be dealt with when valuing the shares?
If there are redundant assets or liabilities such as excess cash that can otherwise be distributed to shareholders, or related party loans outstanding when the shares are issued to employees, it is important to specify how these non-operating assets or liabilities will (or will not) be factored into the value of the company and the underlying equity interests. This would typically be addressed in a formal valuation report. For example, it may be necessary to specify that all cash over a certain dollar amount will be separately added to the value of the company. Alternatively, it may be necessary to specify that shareholder loans will be deducted from the value of the company.
4) How will the shares be valued on termination of the business arrangement
Upon termination of a business or employment arrangement, a shareholders’ agreement will typically specify that the shares will be redeemed or purchased by the company at the fair market value, as determined by an independent business valuator.
It is important to establish a valuation process that is fair and equitable to both parties. In our view, the valuation process should include provisions to allow for the findings of the valuator to be reviewed and challenged if issues are identified by either party. While this may result in an increase in costs, if the findings are challenged, this will provide some protection to both parties if there are significant issues identified in the valuation prepared.
It may also be necessary to specify if the departing employee is allowed to retain the shares, or if they are required to sell the shares. This may depend on the reason the employee is leaving such as voluntary separation, retirement, or termination for cause.
Issuing shares to employees provides many benefits to both the owner of the company and the employees. With careful planning, clear communication, and thoughtful drafting of employment and shareholders’ agreements, these arrangements can provide great benefits to both parties. In the unfortunate situation where the business relationship ends, advance planning will allow for the valuation issues to be settled in a clear and transparent manner, while minimizing potential disputes and costs.