Interest Free Loans for Equity
Q. I own a small business with about $7 million in revenue. I am hiring a very senior person and want to give her an equity stake in the business as a part of her compensation package. However, if I award stock to her, I’ll be giving away a portion of the existing business and she had nothing to do with creating that value. Is there a way for me to reward her only for future value that she will have a hand in creating?
A. Yes, you can accomplish this. The first thing you will need to do is establish a mechanism for valuing your existing business. If you are comfortable doing this yourself, great. If not, you will want to reach out for some professional help. We prefer valuation methods that consider the profitability of your business, but for simplicity sake, let’s say that you decide to value your business at one times revenue. Obviously, that would make your business worth $7 million.
If, for example, you were to give your new employee 10 percent of the outstanding stock of your company, you would be giving her $700,000 for coming on board—that’s quite a signing bonus, not to mention the tax effect. One way to avoid this is to allow her to purchase the stock. In this case, she would pay $700,000 for 10 percent of the outstanding stock, which is its fair value. You wouldn’t be giving away anything and she would have the equity stake you want her to own, having paid what it is currently worth.
Unfortunately, many talented employees don’t have $700,000 to invest in their new employer’s stock. Even if they do have the funds, they may not be willing to make such an investment. To address this issue, we have successfully structured deals where the company issued an interest free loan to the employee to enable him/her to purchase the stock.
No cash need change hands. In our example, the employee would sign a $700,000 note from your company and the company would issue stock to the employee equal to 10 percent of the outstanding shares. The terms of the interest free loan would require that it be repaid when the stock is sold. If you did this, it would enable your new employee to purchase the stock without putting any of her own money into the deal.
When the stock is sold, the loan is repaid with proceeds from the sale. The employee is rewarded only for growth that has happened since she joined the company. Returning to our example, let’s say that after five years, the company has grown to $20 million in revenue. Using our formula, it would now be worth $20 million. Therefore, the 10 percent stake would be worth $2 million.
If the employee with the 10 percent stake were to sell her shares back to the company, she would receive $2 million for the sale. She would repay the $700,000 loan and net $1.3 million. Your employee would be compensated for the $13 million of growth that the company experienced after she joined, but would receive no value for what the business had attained prior to her arrival.
Obviously, you could accomplish this in other ways. For example, you could use options. However, interest free loans are a simple way of enabling your employees to purchase stock without rewarding them for value they did not help create and without requiring them to put their own money into the deal.