Looking to give shares away in your company? Beware the pitfalls.

Confidence can be a fragile trait in many business owners.

I know that as a business owner you have confidence in bucket loads. It may have been recently or many years ago but at some point you took the decision to say “Enough is enough I can do this job better myself or I need to make this happen”. You set up a business! One of the most risky decisions you are going to make.

Several months or more goes by. You build the business up. You battle through those tough early months. Things are difficult and you might take on your first employee but things are getting better. You start building momentum, a number of small wins with more customers, your business’ reputation is starting to grow and then something happens. Perhaps a friend says they would like to come in with you, or you are working closely with another individual who has a few skills you value and who also wants to come in with you, or maybe you find an employee who is really good and who drops the odd hint that they would like in or they will leave. All of a sudden your confidence waivers. You now have a hundred reasons why this person is key to the future growth of your business and you decide you need to give away part of your company.

Sounds familiar? Maybe not, but be assured I have seen this hundreds of time. Your business is like light to a moth particularly if you are successful or have stacks of potential.

So do you give shares away or sell them and if so what are the implications?

The first thing you must do is to stop and assess your position and ask questions.

The right person

Do I know this person? If they are a friend I don’t mean do you know them,  I mean do you really know them? Have they ever been in business before? You know what they can do skill wise, but how are they going to react when there are tough times? Are they risk takers or cautious? Do they truly share your vision or do they have their own? If they are not just an investor are they going to put the hours in that are necessary to grow the business or believe like some employees that being the boss means you can take time off and do what you want? Have they got a supportive family behind them? Do you really think they are the kind of person who will be there in the trenches with you when the going gets tough?

One of my first clients set up a company (let’s say it was building widgets to keep this anonymous) many years ago. He set the business up from a room in his house, developed the product and started winning clients. One day he came to me and said that he was looking to give shares to the husband of his wife’s best friend. I asked why him and the response was he was great at the financials, the administration and negotiating with businesses and that he himself was terrible at all these things and it was vital for the business that this person came on board. I tried to structure a deal which would result in ownership being given based on future performance, but my client in his own mind was desperate. The new person wasn’t prepared to come in on the basis I had suggested. He wanted a 50:50 set up. My client’s confidence had gone. He believed that this person was now key to his business’ success so he gave away shares. A 50:50 company was set up.

Several years passed, the company grew but I could see the frustration and resentment building up in my client. Then one day I had the call. My client had had enough. His every move was being blocked, the person was an administrator and overly cautious. The business partner had no vision and no business acumen, with potential business deals being lost.

My client was adamant the relationship was over. If necessary he would close the company down. By this time the business was turning over almost £1m, was making good profits and had so much potential. After a couple of months the business partner was gone but a lot richer with a deal set up to buy him out spread over several years.

My client’s business then thrived. Freed from the shackles, the business grew and is on course to become hugely successful. An expensive but valuable lesson learnt the hard way!

This is one example of many I have come across. This one has a happy ending. Most don’t!

My advice is think carefully about whether you need a business partner or not and if you do make sure you choose carefully.

Assess their attributes. Skillsets can be bought but character cannot.

A great tool to use in deciding whether to take on a partner is to sketch a circle and going around in a clockwise movement write at least 20 attributes your ideal partner would have, for example:

• Integrity
• A risk taker
• A rainmaker
• Tenacity
• Great communicator.
• Highly organised.
• High level of analytical skills
• Creative
• And so on….

Don’t stop until you hit at least 20. Then from all the attributes written down consider which are the three key attributes you are looking for in a business partner. Once you have circled those ask yourself honestly how much would you score your new partner on these attributes. If they don’t score well then they are not the right person for you.

This same tool can be used for every key position in your business, not just for new team members but to assess whether your key players are performing the way you want them to.

How many shares?

Once you have made the decision to pass shares to your new business partner or investor the next step is to decide how many.

The answer is always less than 50%! Whatever you do keep control, even if your partner is your life partner (51%: 49% works beautifully!). This is your company and your vision. One of my newest clients is an extremely intelligent lady who has quickly built a business generating six figure profits and will within a couple of years be  generating a seven figure profit. She and her husband work in the company but it is her vision and her drive which is making this business a success. She has control of the business with a 67% holding.

50:50 companies or partnerships can be nightmares. Someone has to have the final say otherwise a business can be paralysed. The chances are that if you set up the business that you are a risk taker and every business needs clear vision, strong leadership and action. A 50:50 business can quickly generate into two people’s visions, weak leadership and no actions agreed, particularly if your new business partner is risk adverse.

The next questions to ask are how much will be paid for the shares? What is the price for the shares? Does the business have value?

If you transfer shares from one person to another or issue new shares that reduce the value you hold in the company then there is a transaction taking place for capital gains tax purposes.

If the business if worth £100,000 and you want to transfer 50% of your company then this is £50,000 in value transferred. If no cash is involved then potentially you could be assessed for a £50K capital gain. Additionally if the shares are going to an employee then you need to be aware of Employment Related Securities legislation as the employee would normally have the shares treated as earnings (the difference between the market value of the shares and anything they pay for them).

It is vital when looking at transferring shares that we assess the valuation of those shares, the amounts to be received and the tax implications.

If the business is in its early days then the value in your business is probably low and arguable and there may not be major problems. If the company however has value then there are many ways to structure a deal to get around the issues including holding gains over, creating and issuing new shares or new classes of shares such as freezer shares, share incentive schemes, group restructuring and so on. Each situation needs to be considered in detail.

A simple example would be for an investor. A business might be worth say £200K. A friend wants to invest in your business but doesn’t want to be involved in the day to day running of the business. You are desperate for cash and they are prepared to invest £50K in your business. If they paid the cash into the company the value of the company would now be £250K and you could issue shares equivalent to 20% of the total company share capital with no capital gains tax implications. If you need investors don’t forget about the SEIS and EIS schemes which can be used by companies to attract investors and lead to great tax savings for the investors.

What else is there to think about?

One major issue you really need to think about when giving away shares is dividends.

Each share usually has a right to dividends. If you issue ordinary voting shares to an investor who now holds 20% of the company, then when you come to paying a dividend to yourself then for every £100 you want you have to pay £25 to the investor.

This could be a big additional cost to the company and can have a significant impact on the planning on how to extract your income from your company.

The classic way a director-owner of a small to medium size company extracts the profits from the company is via a small salary and dividends. With another shareholder on board you have to pay them dividends as well if you have the same class of shares. You can get around this problem by creating different classes of shares with separate entitlement to dividends but you will need to amend the company’s articles and memorandum of association.

Get this wrong and you will have to pay dividends to your new business partner or alternatively increase your salary, leading to increased employer and employee national insurance costs.

A second (and often overlooked) consideration is a shareholders’ or partnership agreement. I will write a longer article on this subject but if there is one investment you should make when attracting any other shareholder to the company it is to get an agreement set up to cover most eventualities, for example:

1. What happens to the other party’s shares if they die or become incapacitated?
2. What happens if they bring your company into disrepute?
3. What happens if they are employees and they resign or you have to dismiss them?
4. How do you get the shares back and how much do you pay?
5. What key issues are they entitled to a say in? What things can be simply left to you to get on with?
6. If you sell your shares can you force them to sell theirs?

The list isn’t exhaustive but gives a flavour of many of the key issues to consider when preparing a shareholders’ or partnership agreement.

Unfortunately the shareholders’ agreement is one expense many business owners won’t pay for and live to regret. We believe it is better to get this sorted before the shares are transferred when everyone is on talking terms! When things go wrong they normally go badly wrong, leading to long and protracted arguments and huge expense in both time and finances to get matters resolved.

Conclusion

Our advice is clear:

• Don’t give away shares unless you really have to.
• Make sure you know who you are going into business with.
• Give away less than 50% of the company – never give up control.
• Think about the impact on your income package from the company by the issue of shares and the tax implications on the share issue. Make sure you structure the deal in the most tax efficient and financially efficient for both you and your business.
• Get a shareholders’ or partnership agreement in place.

The key is to take advice and be prepared to spend money now to get the best deal for you long term. No one wants to spend money where they don’t have to but here is one area where it invariably pays to do so.

If you need advice please contact Mark Friend or Andrew Grant.

The content in this blog is correct as at 21/08/2020. See terms and conditions.