Owner's Rights

CEO finds a non-equity solution to ESOPs.

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How to give key employees a stake in the company without giving up any control

Your business is humming along. After periods of toil and uncertainty, your key managers have finally found a groove. They understand the market. They know how to make the right decisions and how to care for your customers. At last, you have a team that can run the show when you're not there. So what do you do to encourage these players to stay around?

Clearly, there's no simple method to hold on to good employees. Capable people have options, including going to work for your competitors or starting their own companies. To keep key individuals interested, founders sometimes share equity with them. As owners, proponents argue, they'll be more focused on the challenges at hand and less tempted by greener pastures. But what happens if you're not willing to go this far? What if you don't want minority shareholders? There are other ways to approach this problem. Meet Matthew Lovejoy.

Lovejoy, 29, the founder and chief executive of $2.3-million Lovejoy Medical Ltd., has devised a plan that he believes does what conventional equity does -- only better. The premise of his "participation rights" program is that some managers are essential to the smooth functioning of the business. Lovejoy is convinced they make daily decisions that influence the company's value. But giving them actual stock, he feared, would raise too many questions about control and shareholder liquidity. It took a while, but Lovejoy found an alternative.

When Lovejoy and his wife, Lorie, started the Lexington, Ky.-based business at the end of 1983 with the idea of providing medical equipment to home-based patients, sharing success with key employees was already in the back of their minds. Several people, including Lovejoy's father, the CEO of a much larger business in Chicago, had advised them to use it as a way to build commitment. But concerns about cash flow dominated everything else, Lovejoy recalls.

By the fall of 1985 Lovejoy Medical's revenues were around $600,000. The business was finally profitable and generating cash. Matthew spent most of his time on sales; Lorie handled finance and administration. They had a couple of dedicated employees helping them out -- Beth Franklin, who ran the office, and James Clifton, who was in charge of operations. Both were in their mid-twenties and had been with the company since the first months of business. "We could relax a little since they knew their jobs inside and out," Matthew says.

Unfortunately, the relaxed atmosphere didn't last long. Franklin, who handled billing, among other things, soon quit to take a job in Florida. It wasn't until the Lovejoys tried to replace her that they realized the extent of the loss. For the next several months, Lorie struggled to teach new employees how to handle the paperwork required by the scores of insurance companies they dealt with. Eventually she had to take care of it herself along with everything else she was doing. In the midst of this bedlam, accounts receivable stretched from 50 to 100 days and the company was forced to borrow money. It was almost a year before the billing system was in order.

In retrospect, Matthew doubts he was prepared to offer any kind of ownership or incentives to Franklin -- or anyone else -- before she left. "I was reluctant to do anything until I felt I had the right people." He was still a bit leery about moving too fast, but he and Lorie knew that to grow the company they had to make it attractive for people to stay.

The longer they waited, the more pressing it became. Early in 1986 Lovejoy had opened a second location and was planning a third; he was also contemplating the purchase of a larger medical-supply business. How would he and Lorie manage the new operations? They were already working 80-hour weeks. Lovejoy knew he couldn't run the company without help. The time had come to put together a management team.

By the end of 1987 Lovejoy had a lot of talent and experience in the company's 20 employees. Beth Franklin, the former administrative whiz, had just returned from Florida to rejoin the company on a special project; she was promoted to director of finance. James Clifton, who'd been in charge of operations, became general manager. A third employee, who had managed one of Lovejoy Medical's new locations, became sales manager. In addition to the new titles, Lovejoy set up a new incentive plan especially for them.

The original incentive program, which took effect at the beginning of 1988, was based entirely on profits. Each manager would get a share of the pretax profits based on the dollar amount by which that year's profits exceeded the previous year's. Pretax profits had to be at least 17% for the program to kick in. The details were put in writing, and the managers were delighted.

But the incentive program turned out to be a dud. As it happened, the company missed its profit target. Not because people weren't working their darndest, says Lovejoy, but because of the changes in the way the federal government and insurance companies reimbursed costs. "Our projections turned out to be way off." Needless to say, the people who had expected bonuses were disappointed. Lovejoy, however, used the occasion to review the plan and to figure out ways to make it better. What he ultimately came up with was a more elaborate reward system that's divided into two parts.

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