Many entrepreneurs understand that, in order to maximize the value of their businesses, they will have to become nearly expendable. But even if they are able to build an organization that thrives without their constant attention, they may not appreciate that their work must continue until every employee is as unimportant and interchangeable as possible. Some owners may even exacerbate the problem by transferring their own responsibilities to only a few key employees in the name of succession planning.
When we evaluate a business, we try to determine how much of its value is “institutionalized.” Much of the analysis is calculating how much a few key employees contribute to the company’s overall performance. But a secondary analysis evolves around how well the company has systematized its activities and how well it records and accesses information. In other words, we evaluate the extent to which the company’s processes and systems will help a new hire get up to speed and replicate a departed employee’s performance.
Similarly, one of the ways we improve our portfolio companies is to institutionalize their value by, for instance, developing processes, fostering collaboration and, when possible, adding redundant expertise. We lower the risk that the company could become dependent on the so-called “tribal knowledge” of a small number of indispensable employees and increase the likelihood that we can replace even our highest performing people.
Addressing the Problem
We routinely find businesses with one sales person who delivers a grossly outsized share of the revenue or a key engineer who is the only person capable of designing client solutions or driving the new product development efforts. In small companies, this key employee risk may be unavoidable, as it can require unattainable scale and resources to address properly.
In these cases, there are a handful of ways that owners can mitigate the risk and begin institutionalizing the value of their companies. Some tactics lower the risk that key employees will leave, while others reduce the impact in the event that they do so anyway.
The best way to keep the key employees is to increase their incentives to stay. Common approaches include (i) having the employee purchase equity – either directly or in exchange for a reduction in cash compensation or (ii) making an equity or deferred compensation grant that vests over several years.
Combining equity ownership with relatively punitive repurchase rights if, for instance, an employee departs prematurely can provide a powerful incentive for an employee to stay, as well as a mitigating increase in value per share for the remaining equity holders, if the incentive is not powerful enough.
Bootstrap Capital can work with owners to share the risk associated with employee retention and other issues that result from a failure to institutionalize their company’s value. If you have clients who would like to sell their businesses but are worried about how a buyer will view their own importance or that of a few key employees, please consider introducing them to Bootstrap Capital. We are willing to be creative in structuring a transaction that could allow them ultimately to get more for their companies.