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.

Part one, like the first program, is based on annual profits. But the goals are more realistic. If the company achieves a minimum pretax profit level of 10%, each manager receives 1% of the total amount in cash. As the company's pretax margins rise -- and the Lovejoys are restricted in how much they can pay themselves in salary and perks -- individuals can receive larger shares: from 12% to 15% they get 2% of the profits; more than 15%, they get 3% of the profits. For example, if the company earns $450,000 on $3 million in sales (which Lovejoy thinks it can within the next couple of years), the individuals will receive a cash bonus of $13,500.

The juicier part, however, is what Lovejoy's lawyer has long-windedly dubbed the "equity equivalent participation rights agreement." It has a lot of the features of equity -- like the opportunity for capital appreciation -- without some of the legal strings. Lovejoy considered making his managers conventional shareholders, but he worried about the possibility of interference if for any reason the business had to be sold. Under the system he came up with, he and Lorie hold 100% of the stock, but two key managers (Franklin and Clifton) get to share in the increase in the book value of the business between the end of 1988 and the time they cash out. The way the plan is written, each has 2%, and they can get their money whenever Lovejoy Medical is sold or when they leave -- even if they're fired. If they quit or are fired, the company can take up to 18 months to come up with the cash.

So how do people feel about this? Has it made any difference in the way the managers approach their jobs? Well, it's a little early to tell -- the plan is less than a year old -- but Clifton and Franklin are pleased. "It gives me reason to hustle a little more," says Clifton. "As the company grows, I stand to make a nice chunk of change."

Setting up a program like Lovejoy's has its risks. One is that you'll alienate employees who aren't included. And as the value of the participation rights increase, there's the danger that you could be creating an incentive for key people to leave.

Lovejoy believes the first risk is unavoidable. "As an owner, you have to make choices." Although he has no specific plans, he says, there's no reason why he can't add new people or give current participants larger shares. The longer-term risk, that the program might encourage people to leave, he considers both speculative and amusing. "If the company does well over the next several years, it's a bridge I might have to cross." As it is, the 18-month payout is designed to discourage people from leaving on a whim.

While Lovejoy admits that there may be some unanswered questions, nothing has dampened his enthusiasm for his program. At many companies, he offers, even the most critical people have very little upside. "They see it simply as a job. I'm lucky to have people who know the business inside and out. They contribute to our success, and they'll share in it. I think they'll think twice before leaving for something else."


The anatomy of a nonstock deal

The idea of sharing actual ownership with employees gives a lot of business owners pause. Even when minority owners hold a small number of shares, the fear is that one day they'll exercise -- or try to exercise -- a bigger voice. A nonequity solution mollifies that worry. You hold the stock; employees get some of the benefits. Here are some questions Matthew Lovejoy of Lovejoy Medical Ltd. answered when designing his "participation rights" program:

* Who participates? Lovejoy has a number of extremely dedicated employees at his 27-person business. But only 2 were employees he depended on to carry the ball. "They were part of the fabric of the business," he says. "I would entrust the business with them if I were disabled or unable to be there for other reasons. If they left, my business life would be miserable."

* What's the value tied to? Rather than relying on outside appraisals, the participation rights are tied to the growth in the company's book value (assets minus liabilities) over a base level that was set when the program began; in the event the business is sold, the value is tied to the sale price (minus the base book value). If Matthew Lovejoy or cofounder Lorie Lovejoy take compensation or perks greater than agreed-upon levels, the amount is added back in when profit is calculated. Participants get to see monthly financials.

* How big are the shares that people get? To some degree, Lovejoy concedes, the 2% shares he offered each of his managers was purely arbitrary. "Your gut tells you what is fair." Over time he may include other people in the program or offer bigger shares to the current participants.

* When can they cash out? Lovejoy's lawyer wanted to limit the opportunities in which individuals could become liquid to the sale of the company or a participant's disability, retirement, or death. Lovejoy rejected his advice. "I decided I would pay them regardless of the circumstance of their departure -- even if I fired them." In his view, the value is built up over time, so it would be unfair to deny people rights to what they've earned. To reduce the incentive for quitting in order to raise cash, the company can take up to 18 months to buy out shares.