April 14, 2022
We regularly get approached to provide valuation reports and advice to law firms and other businesses on offering equity stakes to members of staff or junior partners or salaried partners.
Here is our guide on how not to offer equity.
Decide your practice is worth considerably more than it is, and indicate a figure based on your assumptions rather than reality
This is very common and we see it time and again – owners of firms think their practice is worth considerably more than it is because they have either had an accountancy valuation based on a formula, or they have decided themselves what they think their practice is worth based on things they may have read on the internet, and therefore pitch their offer for equity at a level they think is reasonable, but the rest of the world probably thinks is utterly insane. Always base your offers of equity on reality and not on figures you would like to see.
Tell the junior partner how lucky they are that you are offering them equity
This is a similar mistake that partners make, because they have been partners themselves taking equity for many years, they see the benefits and they see how generous they are being to a potential new partner to come in to the partnership. Simply offering somebody equity is considered to be a huge benefit.
Unfortunately, members of staff and salaried partners do not see this in quite the same way. Firstly, they are suspicious as to why you are thinking about offering them equity in the first place – are you running out of money, and are you in need of new investment? Secondly, they are wondering why they would want to take an equity stake with your firm when they will then become liable for all the costs and errors of the business.
A substantial proportion of staff do not under any circumstances want to take equity, because they are absolutely terrified at the thought of what could happen if something goes badly wrong in the practice.
There are indeed lots of horror stories about junior partners being hauled up before the SDT because of something the more senior partners have done that has absolutely nothing to do with the junior partners, but because they have taken equity or taken a stake they are similarly liable for the mistakes made. You need to approach this whole thing that the person taking equity is probably doing you the favour rather than vice versa.
Tell the junior member of staff of all the extra things you are going to give them to do when they become an equity partner
Again, this is very common and easily done because you are thinking down the wrong route. In your mind, you think you are doing the person a favour by offering them equity, and in their mind they think they are doing you a favour by taking equity. If you then add to this by saying you are going to give them lots of extra work to do and lots of extra responsibilities, then you can perhaps forgive them for being slightly hesitant about taking on the role.
After all, someone taking equity is likely to be foregoing some remuneration in return for future increased remuneration, and they are probably thinking what is in it for them. They probably also see you working incredibly long hours to deal with all the administration work, and if you start indicating there are going to be lots of extra duties they will then be wondering if these lots of extra duties will require them to work lots of longer hours and very little reward. Think very carefully about instantly offloading all the things you don’t want to do onto the new equity partner.
Refuse to show your junior partner all the accounts when asked
Believe it or not, this does actually happen and I have come across it in practice. Firms think that because they are doing the junior member of staff a favour, the junior member of staff should take their word for it that the practice is in a good financial state, and when the junior member of staff asks them to provide full information and disclosure on accounts and further details about the firm, they immediately get very defensive and refuse to provide it.
This is a very bad idea, and you need to be appreciative that someone buying equity in your firm is going to want their own independent adviser to come in and look at the books.
NB: if you are a junior member of staff looking to buy into a practice, you need to bear this in mind and think very carefully about appointing an accountant and potentially a business adviser to come in and take a look at the firm to form a judgement as to its present state.
This is something we can assist with by the way, and if you do require our help, please get in touch.
Make sure, if you are the partners providing the junior member of staff with equity, that you give them everything they ask for and also make everything easy for their professional advisers to obtain the information they ask you for. Do not be defensive at all, and if there are any discrepancies or issues in the accounts, highlight them and explain them so you are not on the backfoot when they arise.
Fail to appreciate the word ‘risk’
Quite a few firms completely fail to understand the risk that a new investor is taking when it comes to acquiring an equitable stake. You must factor in the potential risk to any prices you indicate for purchasing the equity. It is no use just valuing a practice at say £500,000 and then offering a 20% stake for £100,000 without actually appreciating that the person taking the 20% stake is going to be also taking a risk in putting that money into your firm. The risk has to be factored into the price, and failing to do so is going to make it difficult to secure the partner.
Not looking at the end game
The difficulty with finding new partners to join your business or to invest in it, is very underestimated. We come across so many businesses where the owners have failed to find younger and more junior members of staff to come in and take the practice or business over, and they end up in desperate situations, closing down the business or simply handing it over to someone else in order to get out. If they had started looking a long time before and been appreciative of the benefits of having a more junior member of staff invested in the business, then it would have meant a lot more chance of continuity going forward and achieving a value when they come to exit.
If you do not appreciate how hard it is to find someone willing to invest in your business, then you are probably going about this in the wrong way. Whilst you think your business is a wonderful asset that anyone should be grateful to come along and take a percentage stake of, it is not the view of someone who is looking to put money into a business. It is more likely that someone looking to put money into the business will be considering the favour that they are doing you, because they know that in the future you are going to want to either downsize your time in the business or sell up and move on, which will leave them with the business. Indeed, we get telephone calls for example from junior partners of law firms, where they are very worried that in five years’ time most of the partners will have retired and they will be left with the practice without any way out, and a need to pay the runoff cover.
It is really important to look after the potential equity partners of your business, and to appreciate them, as this will be the future of your company and will in all likelihood offer you a good way out in future if you choose to reduce your hours working in the business or simply to retire and sell it.
Summary
In summary, finding investors to buy into your business is always difficult, particularly if you are well-established and they cannot see a huge demand for future growth, rather than just a consistent business, and it is really important to go about offering equity stakes in a generous way so as to ensure success.
We are very happy to assist with any queries, valuation reports, structure of deals, suggested prices for equity stakes, suggested future plans for a partnership where one of the partners is looking to retire, and any other assistance we can provide via our services. For full details, please get in touch with us via our website.
https://jonathanfagan.co.uk
