Experiment 1: Grandfathered Equity with Buy-ins and Payouts going forward
In this case, we allow all current Partners to keep their 12.5 percent stake at no cost, but we place calculate a value for those shares and agree that, from this point forward, all equity that is awarded must be paid for and all equity that is surrendered back to the firm must be paid for.
Let’s say we made this choice and used annual revenue (let’s call it $2,000,000 to make things simple) with a low-end multiplier of 1x. That would make each percentage ownership share of KA worth $20,000. A new Partner buying an 8 percent ownership stake (1 percentage from each of the current 8 Partners), would have a buy-in of $160,000, and each current Partner would get a one-time payment of $20,000.
If one of the current Partners decided to leave the firm, they would have to be paid for all their remaining shares. If that happened before any new Partners were brought on board, that would mean KA would have to come up with $250,000 to buy out the departing Partner. That money could be raised by remaining Partners buying the shares now available themselves, or by having the business buy the shares and hold them for some future use.
My guess is that adding Partners would not cause a whole lot of friction among the original 8 Partners, but Partners leaving could cause stress and potentially conflict.
The big question, though, would be whether to retain the project-based, 1099 model for paying Partners. It would be easier to see the logic for saying that shares now have a monetary value because you are buying a percentage of annual profits, but moving in that direction would be difficult to imagine unless there was some sort of performance system in place to ensure that the money each Partner made via their ownership shares was appropriate given their contributions to firm profitability. If you did not give equity a larger role in determining annual pay, you would likely have fewer new sources or tension but you would also have done relatively little to actually change Partner’s economic incentives so that they supported increasing the value of ownership shares or overall firm profitability.
Option 2: Refounding the business with discounted buy-ins
An alternative to the above would be to say ok, from now on, equity has monetary. Ownership shares will have a big impact on individual’s annual earnings and will need to be purchased.
One way to do this would be for KA to pay all 8 current Partners $1 to reclaim their shares. You could then say that each current Partner will initially be given an opportunity to buy up to 12.5 percent of the business, with the proceeds going into the KA firm fund to support investments in growth. If some Partners choose not to buy all the shares available to them in the first round, Partners who wanted to buy more than 12.5 of the business could be given an option to do so.
So how much would you charge current Partners for their buy-ins? You could use a model like the one proposed above ($2M in revenue times 1x divided by 100 equals $20,000 per percentage of ownership). Or, we could say that the refounding is a one-time opportunity to buy discounted equity by setting the multiplier at .5x or even .25x.
If current Partners bought all of the available equity at 1x, KA would raise a total of $2,000,000 to support reinvestment and growth. But that money would have to come from us.
If current Partners bought all the available equity at .5x, KA would raise a total of $1,000,000 to support reinvestment and growth.
If the Current Partners bought all the available equity at .25x, the firm would raise a total of $500,000 to support reinvestment and grow.
Any of these options would dramatically reshape the firm’s economic incentives and, accordingly, operations.
It is likely that some current Partners would opt to buy less that 12.5 percent of the business (or perhaps no shares at all), and that some current Partners would opt to buy more than 12.5 percent. Partners who bought larger stakes would reasonably expect to have a larger say in firm governance, and they would have an incentive to maximize Firm profitability and the amount of money they could make each year through the ownership shares they had invested in. They would also have a strong incentive to use KA’s seed money to make investments that grew profitability over time, such as bringing on w-2 employees.