Restricted Stock Good Alternative to Stock Options — Employee Ownership (a series)

Providing employees an opportunity to have ownership in your company can be a great tool to get alignment with the employees.  Restricted stock is one other tool to reach the Holy Grail of having employees who think like owners [December 9, 2012].  As I wrote before in this series, each type of “incentive plan” (or maybe we should call them “alignment plans”) has different characteristics that make them better used in certain situations than in others.  Stock options was the focus of this post and the situations where they are the best tool.

restricted stock

Restricted stock is often a better tool than stock options.

Another option that business owners may consider is restricted stock.  This is stock that is sold (at a discounted price, sometimes deeply discounted) or granted (taxable event) to employees along a vesting schedule that has time and performance vesting (thus the restriction).  If the time and performance vesting is not achieved, the company can buy-back the stock at the original price paid by the employee.  So, a person who just became CEO of the company with no prior ownership could be sold restricted stock that represents 5% of the company and 2.5% vests over 5 years and 2.5% vests if the company attains certain financial or operational results.  Thus, restricted stock has fewer all-or-nothing characteristics than stock options and may be better suited for more established companies where the goal is to increase value steadily, but not aim everyone toward a moon shot exit event at some point.

Below is a review of how restricted stock can influence behavior if it is implemented in a company.  Does restricted stock  . . . . .

  • Incent an exit?  Restricted stock does not incent an exit as strongly as stock options, but they do not work against an exit either.  While stock options only really become valuable on an exit, restricted stock is different.  Restricted stock gives employees access to dividends from earnings which means they are getting value along the way.  In my opinion, having the employee participate in both parts of the return to owners, dividends/distributions and capital gains, provides the employee with a more balanced view of the company and provides good alignment with the other owners.
  • Incent near-term profitability?  Yes.  This is totally different than stock options.  Because these employees would benefit from near-term profits through dividends or distributions, they care a lot more about aiming toward near-term profitability rather than a big exit.  Stock options are not ownership until exercised so even if the company made a profit, the employee would not have a claim on that profit through her stock options (other than through a secondary effect of company reinvesting the profit for greater long-term value).
  • Incent long-term employment?  In my opinion, yes.  Restricted stock is more steady value accretion which incents long-term employment rather than stock options which is basically a gamble where you win big or go home — either way the employee is leaving in only a few years.
  • Incent meritocracy?  In my opinion, yes.  Restricted stock is usually granted to a more select group than stock options because it is real ownership which isn’t given lightly in closely-held companies.  So yes, I think it is a way for star performers that have a large impact on the organization to participate in the value creation at the company and rewards merit.  Stock options can be very unfair when they are given broadly because the value received by the employee can be very different than the value created by the employee.

If you have a good, solid, profitable and growing company where you want a handful of top executives to be aligned for the long-term (and not focused on a quick exit), restricted stock is a far better tool than stock options.

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Art of Balance — the Key to Business & Management Success

Balance is key to success, particularly for business owners and leaders who think about an entire organization.  This means: a) the ability to decide where and when to focus on multiple continuums, b) the ability to execute those decisions, and c) the ability to know when to reassess (a minute or years later).

Art of Business Balance

Balance is a key skill for business owners and leaders.

This skill is not taught in a class.  This skill is not being a jack of all trades — it is the skill to know which trade is needed when and how much.  This is not the all-in entrepeneur or academic who knows one thing.  This is not the one strategy that worked for one organization one time being applied broadly to future circumstances.  This is the real life skill needed to lead and manage.

Below are some key balance continuums for all organizations and businesses.  For today, are you and your organization at the optimal point on each continuum?  What other continuums are you facing?  Make an active assessment of where you want to be.

  • External vs. Internal.
  • Focus vs. General.
  • Sales/Marketing vs. Production.
  • Revenue vs. Expenses.
  • Strategy vs. Execution.
  • Differentiation vs. Best Practices.
  • Short-term vs. Long-term.
  • Problems vs. Opportunities.
  • Innovation/disruption vs. stability/existing systems.
  • Work vs. family vs. friends.
  • Mental vs. Physical.
  • Top down vs. Bottom-up.
  • Balance sheet (stock/snapshot) vs. Income Statement (flow).
  • Finance vs. Operations.
  • Equity vs. Debt.
  • Sell vs. Hold.
  • Fast growth vs. slow growth.
  • Delegating vs. Doing.
  • All-in vs. small bets.
  • Your needs vs those of your organization.

You have a choice of where your organization can be on each continuum.  Decide what is best.  Go execute.  Reassess.

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Founder & VC Misalignment More Often Than Thought

The misalignment between vc’s and founders is painfully obvious from the quotes below from the IPO S-1 filing of Applied Medical Corp. (Dan Primack of Fortune did the reporting and should get the credit).  First is the company stating why they are going public (bold emphasis mine).  Second is the venture capital firm’s response.Founders need to make sure they are aligned with their investors.

“Institutional Venture Partners IV, L.P. is compelling us to register the shares of Class A common stock offered hereby by exercising demand registration rights. While we intend to comply with our obligations under the Master Rights Agreement, our board of directors and executive officers believe that filing the registration statement of which this prospectus is a part and effecting an initial public offering of our Class A common stock are not in the best interests of Applied.”

Response from vc Institutional Venture Partners (a very good venture capital firm):  “We invested in Applied Medical Corporation twenty-four years ago, when it was a start-up enterprise, and we led the follow-on financing twenty years ago. . . . . . . The problem we have is that IVP IV was supposed to be a ten-year fund, which is standard in the venture capital industry, so twenty-four years is a long time to try to keep maintaining a fund that was supposed to last for ten years.”

This example perfectly states one potential misalignment between venture capitalists and founders — the time scale of their involvement in the company.  By definition, most professional investment funds  have 10-year funds (my investment fund Greybull Stewardship is a clear exception) and this drives all their thinking about when to invest, how fast to grow, and when to exit.  This is perfect for certain types of high-growth companies that require relatively little capital and have their strategy tuned up.  However, most companies do not fit the formula and would be much better off trying to not fit into the box.  This can actually be harmful to the company if the successful strategy of the company pre-investment did not have perfect 20% per year growth rates, expanding EBITDA margins, and clocklike predictability.  If that does not describe your company, you should consider different options.

Other Dimensions of Potential Founder VC Misalignment

There are some other dimensions where venture capitalists and traditional private equity are not necessarily aligned with most companies in America.  Some other dimensions are:

  • How Much to Gamble: For a vc, they want to swing for home runs and it does not affect them or their fund much if your company is the one that strikes out (they hope the other investments in their fund make up for it).  For the founder, it is completely different.  You would clearly be better off with a double or triple rather than a strike-out so a strategy that swings for the fences with your company is not the best strategy for you.
  • Differences (strategy, product, etc.) are Good, But:  Every investor claims to like differentiation.  At the first sign of trouble, however, investors run for the perceived safety of something they think is working better (like what your competition is doing), particularly when an investment time horizon is short.  There is no extra time to risk a misstep with a unique strategy — better get back the industry best practice, and fast.  Differentiation, when it is done well, seems to me to take twists and turns over a long period of time through hundreds and thousands of little decisions.  It is not built best under pressure of  a short time horizon.
  • Balance of Near-Term and Long-Term Profits:  For founders, taking some cash out along the way in the form of dividends or recapitalizations is smart.  VC’s and private equity firms usually prefer to not distribute profit (tax-inefficient for their C corporations) along the way and bet on a bit exit — once again usually gambling all or nothing.
  • Non-Financial Factors in Decision-Making: In the businesses I admire, profit and financial decisions are important but not the only thing.  If you are in the business for the long-term, there are many decisions that are good for customers or employees or vendors that are not good financial decisions in the short run.  Any non-financially driven decision is much harder for vc’s and private equity firms to support.

My goal is for company founders and owners to know there are options to traditional venture capital and private equity.  I recommend they find the financing source that fits their strategy rather than make their strategy fit a financing source.

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Golden Age of Productivity Tools for Business — a Good Investment

Productivity tools are expanding at an incredible pace all around us.  These tools are particularly relevant for smaller business owners to understand and a good investment of time and money.  This struck me while being told a story a few months ago by the proprietor of Borsheim’s jewelry store that is owned by Warren Buffett’s Berkshire Hathaway and is said to have more sales than every jewelry store in America except for Tiffany’s in New York.

At last year’s Berkshire Hathaway annual meeting, some visitors came to Borsheim’s that only spoke Chinese and various sales people and managers were not communicating effectively with them.  This went through several rounds of people trying to help them to no avail.  Finally, the proprietor decided to attempt to help them and was no more effective.  He was about to bid them goodbye sadly, as it was apparent the potential customers were ready to buy.  It was then that he remembered the Google Translate app on his phone and started using it to communicate.  The eyes of the potential customers lit up and after a few minutes of communication, they settled on a purchase of several hundred thousand dollars.  As the proprietor told me, “That sale would never have happened without that app.”

It is a new world with an abundance of productivity tools.  While it takes an investment of time and money to find tools that work well for you, it pays off big time when you find good tools.  Also, at my investment fund Greybull Stewardship, we are investing in productivity tools and looking for more.  In particular, these two investments are helping businesses be more efficient

  • Our investment in Appointment Plus, the leader in scheduling software, helps any organization or anyone enable their customers to make, change, cancel appointments easily.  The software is used by thousands of organizations and has been used to book over 100 million appointments.
  • Our investment in ABC Registrations helps camp administrators register and manage the back office of managing a camp.  The company began with a focus on college baseball camp registration where it is the strong leader and has now expanded into all sorts of other camp registration and administration.

Kissing a Lot of Frogs: Smaller Companies Must Work to Find Investment Financing

Competitive advantages can both increase and decrease as a business gets larger.  One thing that gets easier for larger companies is attracting business investment and financing.  The chart below from John Paglia at the Pepperdine Business School demonstrates the shortage in capital and investment sources he found for companies with less than $5 million in EBITDA and a dramatic shortfall for companies with less than $1 million in EBITDA.

Business Investment Shortage for Smaller Companies

Source: Pepperdine Private Capital Access Index

If your company fits within this size range looking for financing, here are some observations I have found to increase your changes of finding an investment partner.

  1. Write a compelling one-page description of your company and its competitive advantages.  Potential investors needs a simple, short description of your company so they can quickly decide (for your benefit and theirs) whether you both want to spend more time exploring a relationship.  Even if you never show it to someone, this exercise can help focus your thoughts and ideas about your business.
  2. Invest (sometimes only a little is needed) in the most accurate accounting you can.  It is painful to spend money on overhead, but it pays off when trying to attract financing.  Your numbers need to inspire confidence and investors do not want to waste time on a situation where they cannot understand the numbers or they are not compiled using Generally Accepted Accounting Principles.
  3. Kiss a lot of frogs.  Finding an investment partner is more about finding someone that is the best fit for your company than convincing the world that your business is great.  If a potential partner is not a good fit for your business (according to either you or them), move on quickly.  Do not waste your time trying to convince someone that is not predisposed to like your company.  Thus, you will probably need to talk to 50 or 100 potential investors to find the 3-5 that may be a good fit.  Treat a “no” as a positive thing — you no longer have to spend time on that person.  If your business is a good candidate for financing, do not worry about the people that are not a good fit and focus your energy on those that are.

My investment fund, Greybull Stewardship, was founded to focus on exactly these companies with less than $3 million in EBITDA.  My perfect situations are companies where the current management has a good track record with the business and wants to stick with the business, and the management wants to hold a lot of equity post transaction.  For those companies, there is no better long-term co-owner than Greybull Stewardship.  Greybull’s structure is unique in that we can allow each company to continue to pursue its unique strategy without being forced into a formula of being sold in a certain number of years or being forced to grow at a rate that is imperfect for the business.

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Quest for the Holy Grail of Employees Who Think Like Owners — Employee Ownership (a series)

When a company owner says an employee “thinks like an owner”, the phrase is conveying an extremely high sense of appreciation and gratitude.  Employees like that are the Holy Grail for owners.   Not that all thinking by owners is holy, far from it :), it is just a way of the owner saying that they feel aligned with the employee.  They feel the employee is making judgments and decisions that balance all the things an owner must balance (long-term vs short-term, certain stakeholders vs other stakeholders, investment vs harvesting, etc.).  It is a relief to owners when they feel that someone is aligned with them.  It is one of Warren Buffett’s favorite sayings that he invests in business managers who “think like owners” — to him, there is no higher appreciation.

Holy Grail for Business Owners is Aligned Employees

Alignment between employees and owners is the Holy Grail for business owners.

If employees who think like owners are the holy grail, how does a business owner find and develop more of them?  It seems obvious that enabling employees to become owners would do that.  Stock options spring to mind because Silicon Valley legends have spread around the world with tales of stock option millionaires.  The Google massage therapist and chef who both made millions.  The artist who painted a mural at Facebook and made a hundred million.

Stock options are only one tool that is available to business owners.  Like most tools, it is great in certain circumstances and counter productive in other situations.  Restricted stock [post on January 17, 2013].  Employee Stock Ownership Plan (ESOP, not the Employee Stock Option Plan variety).  Phantom or Virtual Stock.  Profit-sharing.

Stock Options and Employee Ownership

Each type of “incentive plan” (or maybe we should call them “alignment plans”) has different characteristics that make them better used in certain situations than in others.  Below is a review of how stock options influence behavior if they are implemented in a company.  Do stock options . . . . .

  • Incent an exit?  Absolutely.  This is the greatest strength of stock options.  In fact, stock options are best at encouraging moonshot investments — aiming everyone toward a moonshot exit event that is extremely difficult to line-up.  There is virtually no way to cash in options unless there is an exit by the company (IPO being considered an ‘exit’ in this context even though a pet peeve of mine is that IPO’s should be financing events and not exits).  I pity the founder who doesn’t want to sell his company when all the outside money investors and all the employees want to exit — the decision becomes fait accompli.
  • Incent near-term profitability?  Not at all.  Options are not ownership so even if the company made a profit, the employee would not have a claim on that profit through her stock options (other than through a secondary effect of company reinvesting the profit for greater long-term value).
  • Incent long-term employment?  In my opinion, no.  If the company reaches the exit, the employee also exits.  If the company doesn’t gain traction, the employee also exits in search of stock options that could lead to an exit.
  • Incent meritocracy?  In my opinion, no.  Because stock option programs are usually broadly shared and the measurement is the stock price, it is not tied to individual performance at all.  So, there can be broad distortion whereby the people who created the value are not necessarily the ones who capture the value and vice versa.  Compensation that is broadly measured is not necessarily a bad thing, the pros and cons just need to be understood.

If you want to aim everyone toward a moonshot exit in 3-5 years, you want to ignore near-term profitability, you want employees who can create value quickly in 3-5 years and then move one, and you want to foster legends of crazy upsides so there are armies of people ready to join start-ups, there is no better tool dreamed up by venture capitalists than stock options.

If you are a normal company, on the other hand, you may want to consider other methods.  In future posts in this series, I will explore the similar pros and cons of other forms of employee ownership, some of which were mentioned above.

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You Are What You Eat (or Where You Get Your Investment)

“Tell me what you eat, and I will tell you what you are,” said French lawyer and epicure Jean Anthelme Brillat-Savarin.  Similarly, tell me where you got the investment for your business and I will tell you what is in store for your business.

Business Investment and Thanksgiving

In business, you are where you get your investment financing.

Each type of capital investment has pros and cons.  Each type is perfect for certain circumstances.  The key is for business owners to understand the differences and find the investment financing that is best aligned with your strategy and what is best for your business. Some people may feel that finding investment financing is difficult enough, let alone finding the perfect investor.  Counter-intuitively, I believe your best opportunity for finding financing is to find the investors who are best for you.  Every minute spent defining the type of investment that you need will save you many hours of lost time and energy down the road.

The three most common sources of financing are venture capitalists, private equity firms, and strategic investors.  Venture capitalists want amazingly rapid growth toward serving huge markets and exit in three to five years.  Private equity firms want to use debt to buy companies, pay down the debt, and sell in five years.  Strategic investors and buyers want to change your company to fit into theirs.

My investment fund, Greybull Stewardship, is built to serve a business owner that wants to raise capital for growth or to take some chips off the table, wants to retain significant ownership (majority or minority), and is not yet sure whether to sell the rest of his company in one year or five years or never.  Best of all, we love unique businesses with unique strategies.  An investment from Greybull Stewardship allows you to continue to maintain your uniqueness and even further develop it rather than pursue worn-out strategies pursued by everyone else.

In life, you are what you eat.  In business, you are where you get your financing.

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Great Business Leader I Know — Roger Williams At A Non-Profit

A story well told.  An organization well led.  For me, these are two of the most inspirational things in life.  I found a wonderful leader in an organization I never would have expected to find such a person, a national accrediting agency for vocational and training schools that has over 650,000 students in the schools he accredits for the US Department of Education.  He is a better business leader than many CEO’s of public companies and other large businesses or organizations that I know.

Great Business Leader - Roger Williams

Roger Williams was an excellent leader of ACCET over 25 years.

Here is what makes Roger Williams of ACCET (Accrediting Council of Continuing Education and Training) a great leader:

  1. Integrity.  I would trust this guy with my life’s savings.  He oozes good judgement, stability, thoughtfulness, and pragmatic decisions.  Over 25 years, his accrediting agency is the only one to maintain a high bar for quality and integrity on many standards from unannounced visits to schools, requiring a 90% attendance by students at ACCET schools, particularly rigorous methodologies to measure completion and placement rates, and willingness to close down schools and call out schools for doing things that should be improved.
  2. Tells you what he believes.  Roger is no wishy, washy regulator afraid to take a stance and keep you guessing on how to interpret regulations.  He tells you exactly what he thinks, most importantly when it is something that you do not want to hear.  He knows that “the truth is rarely comfortable” and he doesn’t try and make it comfortable when it is something someone needs to hear.
  3. Manages the fiscal health of his organization very well.  Roger managed this non-profit organization from the brink of bankruptcy in 1990 to one with a healthy reserve, ownership of a building, and a stable, bright future in 2012.
  4. Great communicator with eloquent use of language.  He doesn’t say that the commission “discussed” an issue when saying they “anguished” over an issue is more accurate.  He doesn’t say we need to “think about the idea a bit more” when he could say “that idea needs a bit more beechwood aging”.
  5. Smart and Thoughtful.  When he articulates something, it is well thought out and on point.  I take what he says seriously because I know he has thought about it wisely.
  6. Focus on Quality, Inspiring People to Do Better.  Roger is always pushing schools to improve their quality, to improve outcomes for the students, and pushing schools to do better.  When I am facing a big decision for my school, it is Roger’s voice that I hear in my head.
  7. Appreciates the entrepreneurial spirit.  For me, it is so refreshing to hear a regulator encourage the entrepreneurial spirit among the schools he regulators.  He understands the enterprising spirit and realizes that it is a source of great innovation and improvement among schools.  It is something to be fostered, not squashed, as some regulators would prefer.
  8. Appreciates the importance of culture to an organization.  ACCET has a culture among its staff, members, and commission that is serious.  As Roger said, “Without a serious purpose in life, we are just wasting our time.  We have a purpose.”

I had tears in my eyes this week when I heard Roger speak at the ACCET conference for the last time about what schools mean to him and his journey at ACCET.  He has taken something that could be a mundane job and made it profound.  He has built an organization with a unique, strong culture and deep dedication to its task.  He has taken a job inherently difficult — an organization formed to self-regulate its members — and managed it with integrity.  He has proven that great leadership makes a great difference.  I am grateful for being able to see Roger in action and being able to learn from him.

Rich vs King? Spoils Go To Business Owners Who Delegate & Share

As is often said around Silicon Valley, “Would you rather be rich or be king?”  I think the rich vs king question is too crass and is aimed narrowly at convincing a founder to bring in senior management to manage a growing enterprise.

Rich vs King.  Choice for business owners.

Rich versus King. Business owners who share control do better financially.

However, I think there is a lesson if the question is framed a bit more broadly such as, “What is the optimal way to manage a growing enterprise with big potential?”  The things high on my list would be:

  1. Get the right people in the right roles.  A growing enterprise needs to spread the work over a team and a business owner should put good people in roles to complement himself or herself as soon as possible.  A team working together is very powerful.  So, the ability to attract good people and put them in places where they can bring their maximum capability to bear is most helpful.
  2. Share control to harness the power of others.  It helps to have as many forces working for success as possible through a good board, good investors, and others aligned for the company’s success.  Bringing in investors, board members, and others who are working for the success of the company can really help the company make the most of the opportunity.  Like some sort of zen saying, improve success by sharing control.
  3. Think carefully about the CEO role.  This is a key role that the business owner may choose to delegate or not.  There is no one right answer and this role is particularly difficult to fill, but it is one lever that a business owner should always remember is in his or her toolkit of options.

The chart above and research done by Noam Wasserman of Harvard Business School and presented in his book The Founder’s Dilemmas shows the various financial results obtained by business owners or founders who shared various amounts of control in their enterprise.  Because there are such advantages to be gained by building out your board, bringing on investors, or hiring someone for the CEO role, these are questions that every founder or business owner should consider.

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Business Management So You Can Surf

Business ManagementI love the story that the founder of Patagonia, Yvon Choinard, built Patagonia in a way that he could leave at any moment to surf.  He said that surfing was the best thing that ever happened to him because it motivated him to create systems that did not require his constant presence.

Systems are key to optimal business management, particularly for business owners.  We need time and space for many reasons, including dealing with the occasional emergencies, working on long-term growth ideas, working on those important but not urgent priorities, and able to do something thoughtful for a customer, employee, or partner.  Plus, it creates more long-term value and competitive advantage to build systems to operate your business rather than rely on heroic effort from yourself and others.

It is an art to develop good systems.  There is a balance between process efficiencies and overly rigid processes.  I believe anything you can do to improve your skill in building systems is good for your business management, good for creating long-term value in your business, and good for your ability to go surfing on a moment’s notice.