Partnerships and Equity Shares

post # 18 — February 16, 2006 — a Strategy post

I received the following question about the economic structuring of a professional business: ‘Although legally a corporation, our firm is run as a partnership. Each year we pay out all outr profits to the partner/owners. Should we consider retaining our earnings and using an equity plan as part of our compensation plan?’

Equity plans are not traditional among large professional firms, although there is a growing interest in them. Like the professions of accounting and law, most consultants earn their reward from the income they derive while practicing, and not from capital appreciation. In most tax jurisdictions there is little attractiveness in retaining cash inside the firm unless there is a significant, real investment purpose.

There are at least six reasonsthat I have heard for considering an equity plan:

1) The LONG-TERM-THINKING reason. If principals can share in the increasing value of the firm, they may be led into more long-term thinking, and more willing to support long-term firmwide investments. I consider this to be the most powerful reason to have an equity plan.

2) The TAX reason – create a vehicle for firm principals to convert income to capital gains. Naturally, whether this is feasible depends on the jurisdiction in which you operate.

3) The RETENTION reason – create an incentive for valuable people to remain with the firm. Equity is is an effective means of structuring a deferred compensation plan, but it is not the only means to do so.

4) The TEAMWORK reason – create institutional behavior and teamwork. If all principals have a stake in the value of the overall firm, it can be argued that collaboration is more likely. It should be noted that the teamwork effect can be obtained without using equity by structuring a compensation system based on current income (e.g. by tying rewards less to individual results and more to collective firmwide results.)

5) The MOTIVATION FOR JUNIORS reason – by allowing for ownership, ‘partnership’ can be made more attractive. (I find this reason less than compelling: the more reliance is placed upon the equity value of the firm, the harder it will be for juniors to buy in. While the other reasons for an equity plan may be convincing, this one is not.)

6) The SUCCESSION reason- equity allows the current principals to capture the institutional value they create, without “giving it away” to newly admitted owners or partners. In principle, this should encourage the current principals to be more open in admitting new principals, thus promoting the growth and dynamism of the firm.

It is most common to find the use of equity in professional businesses with extensive investments in tools, methodologies, and systems, so that the value rendered to clients is not only the skills of the specific professionals on the job, but also the accumulated wisdom, experience and knowledge of the firm as a whole. This extra value creates a ‘surplus value’ in the firm above and beyond the contributions of individuals, and it is appropriate that this value be captured (and owned) through the use of equity. Therefore, owned firms (particularly those owned in whole or in part by outsiders) tend to offer the more procedural, mature services.

In firms practicing at the creative frontier, where each job is unique, there is less value in the firm itself, and it is hard for anyone to own the firm. Thus, it is most common to find that the elite firms in each profession do not use equity as a primary reward vehicle. If it is used at all, elite firms tend to have an ‘In-and-out-at-book-value’ equity system. New principals buy their shares at book value, and sell (when they depart) also at book-value. While this allows for some capital appreciation (it captures the value of firms investments) it rarely allows for the size of capital gains obtainable in the corporate sector.

Some well-known firms do have equity plans which differ from ‘In-and-out-at-book.’ One prominent firm prices its equity by having a valuation performed by an external valuation companye every year (!) However, it should be noted that valuing a consultiung company is more art than science. External valuation firms usually rely on ‘benchmarking’ value against equivalent firms to arrive at their valuations, but this is difficult in consulting since so few firms are either publicly traded or otherwise have their financials in the public domain.

I am suspicious about those equity plans I have seen which value equity at multiples of revenue (usually close to one times revenue). These create an incentive to grow the firm almost independent of profits, and lead to a diffusion of strategic identity. Even those plans which value equity at multiples of profit (or, more commonly, the average of profits in the latest three years) can lead to more short-term thinking as pressure builds to show short-term profit gains.

I am also nervous about valuations based on discounting future cash flow. The buyer of such stock would already be paying for projected earnings, and would see a return only if profits were to exceed that projected level. Personally, I would be nervous about buying such a stock, whether as an insider or outsider. Too many ownership transitions have been made at a premium of book and have left the remaining firm burdened with excessive debt. I like to say that the existing owners can either make a lot of money (value the stock at full discounted cash-flow value) or they can leave behind a viable institution. They can rarely do both.

For these reasons, I am most comfortable with an equity system which is ‘In-and-out-at-book.’ It allows for the concept of equity, and ensures that the value of firm investments are not lost to individuals but reflected in the stock price. It also makes it easier for new principals to be admitted at a reasonable cost to them without the existing principals having to ‘give away the shop.’ Such systems, in my view, maximize the ongoing viability of the firm.

I would make one final recommendation. Since there is always the chance that the firm will be bought by an outsider, I would include ‘recapture’ provisions in the partnership agreement or terms of incorporation. If a succeeding generation of principals who bought stock at book were to subsequently sell the firm for a market premium, then the past owners should have the right (for say, 5 to 10 years) to participate in that premium.