I am the president of a family business and we recently received an offer to buy our company for $8 million plus an earn out. I own 20 percent of the shares and my brothers and sisters (who do not work in the company) own the rest of the shares. The buyer has asked me to stay on as president and thinks my earn out could be worth as much as $18 million over three years. How do I treat the earn out? I don’t think it is fair to share the earn out with my siblings when I am the one who is responsible for achieving it. Any advice?
When you start a business, you take on two roles: the CEO of your start-up and its primary shareholder. Even though those roles can feel like one and the same; the sooner you separate them in your mind, the better.
I was reminded of the difference between being a shareholder and a CEO recently when I received this letter.
It sounds to me like Paul is confusing his job as CEO with his role as a shareholder. My suggestion would be to treat them separately and have the buyer draw up both an offer to buy the business and a separate employment contract for Paul as the CEO.
The shareholders should share equally (commensurate with their equity stake) in the proceeds of the sale and that would likely include both an upfront sum and some sort of payment down the road if the company achieves the goals of the merger (i.e., an earn out).
Given his key role of running the merged businesses, Paul should also negotiate a lucrative employment contract to lead the business through the earn out period.
If the company hits the earn out in the future, the shareholders—Paul and his siblings—need to share in the proceeds in proportion to their equity position. On top of that, Paul would presumably win twice, as his employment contract would likely have bonuses paid for achieving the goals of the earn out. Since his siblings don’t work in the business, they would have no rights to Paul’s bonus payments, but every right to be treated like any other shareholder when it comes to dividing the proceeds of an earn out.
This can work the other way too. If Paul gets fired as the CEO during the earn out period, he may lose his salary and rights to future bonuses, but he shouldn’t lose his claim to an earn out payment if the business meets the targets in the share purchase agreement under new leadership.
Here are four reasons to separate your role of shareholder and CEO:
1. Increase the value of your business
When running your company, it can be easy to slip into a tactical focus on your immediate revenue or profitability goals for the month. At the same time, it’s worth taking one day each quarter out of the office to wear your shareholder hat and think about what will increase the value of your company.
Profits will help you become more valuable, but it could be even more important to invest in the development of a promising new product or hiring a salesperson to replace yourself as your company’s Chief Revenue Officer. Focusing on what drives the value of your company may actually make you less profitable in the very short term but ultimately much more valuable. If you never take a day to separate your role as CEO from that of shareholder, you may create a profitable company at the expense of a valuable one.
2. To keep more money after tax
As the CEO you may keep your salary modest because it is taxed at the highest marginal rate, but as a shareholder you may want to pay yourself a dividend at the end of the year to buy that boat you’ve been eyeing.
3. To take a vacation
If you have partners, it’s smart to have a very clear line between your role as an employee vs. your role as a shareholder. Let’s say you want to take a three-month sabbatical and your partner is fine with her two weeks' vacation. If you have done a good job separating your roles as employees and shareholders, the situation should be easy to deal with: you can go on sabbatical and give up your salary while you’re away and your partner can continue to draw her salary as normal. At the end of the year, if there are dividends to be paid, you should both be treated equally as shareholders.
4. To protect yourself
When you bring on a shareholder (angel investor, venture capitalist or private equity investor), it’s critical to draw a hard line between your role as a CEO and that of a shareholder. The job of the CEO is to maximize the value of the company for the shareholders. If the shareholders ever feel like the CEO is underperforming, then a new CEO should be brought in. That means you lose your job as CEO, but if you’ve done a good job separating your role as an employee vs. your role as a shareholder, you should continue to be entitled to the proceeds of the sale of the company as a shareholder, even though you’re not the CEO.
Obsessing over the different roles and rights of an employee vs. those of a shareholder may sound like semantics in the early days of company building, but the earlier you start to think of them as separate, the better.