Private Equity's Ownership Advantage: Uniting Teams and Value

[00:00:00] Lloyd Metz: Get ready to peer behind the curtain of the private equity universe with each episode of best, but never final. Hi, I'm Lloyd Metz joined by Doug McCormick and Sean Mooney. Together, we'll navigate the quarters of private equity, revealing the uncommon knowledge, challenges, successes, and lessons that drive the world of private equity and business forward.

Let's go.

[00:00:37] Sean Mooney: It is great to be back with. Doug and Lloyd. Doug and Lloyd, how you doing?

[00:00:41] Lloyd Metz: Good. Hey, Doug. Hey, Sean. Good to see you guys.

[00:00:44] Doug McCormick: Yeah, you too.

[00:00:45] Sean Mooney: The three amigos are back. We're ready to roll. Let's jump in. Today, I think we have an interesting episode. We're going to be talking about something that's been in the news a lot, and specifically relates to private equity.

It's been something that's pretty much always been a thing, but now it's getting attention It's almost thought of as like this new thing, but it is a kind of a common topic in private equity. And this is the idea of granting equity ownership to the employees of the portfolio companies. And one of the big pieces of news, which I think was really nicely done, is how KKR has benefited from this.

And then there's a bunch of other private equity firms that are starting to kind of say, by the way, we do this too. And really what we're going to talk about today is, it is common practice in private equity and has been probably for as long as any of us has been in the industry. Is that a good sense for it?

[00:01:32] Lloyd Metz: Yeah, that's fair. It's been around for a while. It's not totally new. So yeah, let's jump in.

[00:01:38] Sean Mooney: So what we're talking about here is granting equity to employees for a whole variety of reasons that we'll talk about. in doing so through a variety of structures. To set the foundation here, why do private equity firms grant equity ownership to their teams in the first place?

[00:01:58] Doug McCormick: Before we get into like the specific why we grant equity ownership, I think it's just interesting to comment on the overall power of the private equity model is premised on alignment of incentives. At the end of the day, there's a whole bunch of reasons on why private equity can outperform other asset classes.

There's an illiquidity premium. In many cases, it's lower middle market where some inefficiencies exist, but it's also this powerful alignment between investor and managers. It's the ability to attract exceptional talent because they see this alignment, they see the wealth creation opportunity. So I think it's important just to set that framework before we get into the gory details.

[00:02:38] Sean Mooney: Yeah, I think that's an excellent framing. It's kind of first principles. This is what it all starts as you're building in this alignment. With that said, then why does that alignment come down to, we're going to actually give you equity upside versus just here's your salary, here's your bonus, be a hired person for that role.

[00:02:56] Lloyd Metz: You can take a couple of different approaches. One is just basic alignment with the leadership team, and we've talked about that a little bit in previous episodes. You don't want to set up a us versus them sort of dynamic where the private equity firm captures all the upside for the value creation that the management team, the leadership, the employees are doing every day, right?

So you want to have them think and behave as much like owners, as much like the private equity firm as you can. So that when they are making a decision on the plant floor or in the office or some strategic planning session They're thinking along the same lines that we would be thinking that they gain as much or perhaps more than we would gain I don't know if you guys ever read anything by professor Mike Jensen who just passed away earlier this year in April But he was talking about agency problems, right where Corporate organizations, people will act differently because they don't own the business, right?

So they make suboptimal decisions or wasteful decisions or what have you because it doesn't really impact them directly. So, big part of the private equity philosophy is trying to reduce that agency. Having the leadership team, the managers, the supervisors, it depends on the business, depends on the organizational structure in terms of how far you want to align those equity incentives and grant those equity incentives, but you're trying to reduce that agency problem.

[00:04:31] Doug McCormick: Really well said Lloyd. For me, I think that the equity ownership has to be thought of in the context of a broad compensation philosophy. We look at it, we say, okay, we're going to pay people a base salary. We're going to pay them some kind of incentive comp that usually revolves around an annual basis.

That could be a bonus. It could be commission. And then there's this equity component. And I think the equity component does three things that are really elegant. The first is it's the truest payer per performance measurement you can create, right? So many cases, like when we talk about bonuses. The bonuses are a proxy designed to kind of mimic the value you're contributing to the company.

The ultimate test of that value is like, how does terminal value change over time? It's, you know, kind of the ultimate measurement of are we collectively winning or losing? I think the other thing the equity does is it aligns duration between investor and employee. In all cases, investors should be thinking about how am I maximizing the terminal value or the actual value.

And all the other comp components, base and bonus, are generally measured around relatively short term metrics. And so you're aligning that duration. The last, as I mentioned kind of earlier, is the implications for terminal value. In many cases, businesses are making investments that could be depressing earnings, not creating value today, but they're doing so for the promise of value creation in the future.

And so I think it illuminates those choices in a way that the Managers and employees can kind of participate in that alignment as well.

[00:06:09] Lloyd Metz: Exactly, Doug. Because keeping it real simple, your bonuses are generally going to be tied to your annual budget. So what are your goals for this year? And if you hit it, you get your bonus, and if you exceed it, you get more.

If you miss it, you get less. But exactly to Doug's point, particularly in the private equity model. There's going to be projects that you're working on in year one or year two that don't bear fruit until years three or four or five, and you need to incent and reward that effort as well. Right? So that duration argument that Doug, you're making, I think is important.

[00:06:49] Sean Mooney: Those are really good points. And what I heard consistently from you is alignment and sharing of upside. And if you think about maybe even all of us, and I'll certainly personalize it as I was coming up in private equity, when you're relatively younger. You're paid well, but you don't have the equity value upside, which is called carried interest.

It's essentially the options or the sharing of the equity once you rise to a certain level In private equity, and I still worked really, really hard, but there was just only so many hours in a day, and you always knew you're kind of capped by what you can make and a salary and a bonus by what the company can do in a given year.

When I graduated to carried interest, which is like the equity upside of the options, kind of in some ways analogous. In private equity, you realize that now you get this kind of like amplifier. You're benefiting in the long term value creation within the portfolio companies, and then suddenly you start thinking like an owner.

And like, I cared a lot, because I wanted to be in that position where you, Lloyd and Doug are. And I was working really hard to get there, but once I finally got into that carry, I was like, Whoa! Now every little thing mattered to me because I was thinking and acting not like just a salary and bonus person, but like an owner.

Down to like little things. Like Should we try to get the more expensive flight or the cheaper flight? Should I get back earlier and leave later? Because every little thing had this ripple effect on this trampoline of value that occurred after a business is sold, this amplifier. And it's the same way within a company.

If you get it, you're in the C suite of a business, you're a mid level or whoever's getting these things, suddenly you know that you're getting a multiple on the value when this thing is successfully sold. And all these little things that probably you would just kind of walk by, even if you're just a really, really good person, you still, like, wouldn't do anything about it.

Suddenly the little things matter, and all those little things add up, and then the big things start adding up, and then when you sell that business, you're getting a piece of the multiple of the sale of the business. Versus a share of the proceeds every given year in terms of what a company can give you on a salary and a bonuses.

Does that resonate with you all as well?

[00:08:58] Lloyd Metz: Absolutely. And we've seen it in action, seen it happen.

[00:09:02] Doug McCormick: Said like an owner. I think I would just highlight here as we get into the details, the whole conversation we had could also be framed in the same context is when you think about reinvestment with entrepreneurs, it gets back to this alignment and duration concept.

And the other thing I'd say that I think is an important attribute here is these equity incentives are generally more tax efficient too, and at the end of the day, wealth creation is influenced by not what you take home, but what you take home after tax, and so that's really important. That's another important aspect here.

[00:09:37] Lloyd Metz: We can get into that as well, sort of the tax nuances. But the one thing I would raise, we're talking about equity, just like you were talking about carried interest in the context of everything working out great. Everything is increasing in value, going up and up and up. It also works the other way, right?

It's not guaranteed. If performance doesn't line up the way you expect, then that equity isn't worth what we're hoping it to be. Just like carried interest can be zero or in some cases negative, right? There's some adjustments to it, flawbacks. But in the context of portfolio company equity, that's a reality.

Now, the hope is, because the downside is also shared, your leadership team, the managers, the supervisors, or whomever you've given equity to, will also be cognizant of the risks in the business. Or if there are any weaknesses in the business, they'll be quicker to point those out, quicker to act on shoring those up, and bringing the board's attention, things that need to be addressed, they present risks to the firm and therefore their equity as well.

So that's the hope. So, it's not only upside sharing, but it's also downside awareness and downside protection that you hope to get out of that arrangement.

[00:10:58] Sean Mooney: I think that's a great point and kind of an extension as well. It's the ultimate team aligner and motivator when things aren't going well or you've got a weak link in the team.

Like you're quick because everyone does well together or everyone fails together when you're thinking about the equity. So, if you have a weakness in your team Everyone's like, we're either going to help that person be as successful as they can because it affects everyone, or we're going to swap someone out and bring it so we can have as many A's as possible, so the whole tide is benefiting everyone.

But when that tide goes out, it hurts everyone equally as well, and that's a huge motivator.

[00:11:33] Lloyd Metz: Yeah, sometimes the knives come out. That's a whole other conversation we should have.

[00:11:39] Sean Mooney: And hopefully it's everyone helping each other. That's a first move. But eventually, you know, you got to get the right people on the bus.

[00:11:47] Lloyd Metz: That's right. Sean, human nature being what it is when things aren't going well and the tide goes out, everybody's like, let's help each other. A lot of times they're finger pointing and you got to manage that too.

[00:11:58] Sean Mooney: Maybe one other question on this. Does it really make that big of a difference in outcomes?

The private equity industry, your job is to buy a company, make it more valuable and then sell it and then give. money back to your investors, pension funds, university endowments, et cetera. Why don't you just keep it all? Does it make that big of a difference?

[00:12:22] Doug McCormick: I would say this is just like any other investment.

When we think about the equity incentives or allowing other folks to participate, we will look at that as an investment where we're investing in a person, a human capital asset that is going to have a high ROI, I would argue at least for senior leaders in organizations. I don't think we ever hire somebody into the C suite that we're not putting together some kind of program that has a meaningful equity incentive component.

[00:12:51] Lloyd Metz: It definitely matters. It definitely works. And again, you have to remember context. Oftentimes, we're the Both Doug and our firms were the first institutional capital and to a business, so previously the family or the founder owned 100 percent of the equity. And you notice in the conversations and the attitudes of the people who are the direct reports, the leadership team, where they feel like they're, Strictly employees, and we're all working to make family X or founder rich.

When you open it up and share the equity with that leadership team. Now they are literally part of the ownership of the business and you can see how they act, walk, talk different. The energy level of those folks is just turned up, not quite to 10 sometimes, but it's higher than it was when you found it.

And to. Your point, Sean, it's the little things that are day to day, week to week, month to month that we, sitting on the board as a private equity firm, we never see. Like, we're not management, but that compounding benefit of all the extra miles that each individual now goes to, the extra lengths, the extra thinking.

In the shower every morning, that turns into better decisions, better product decisions, better sales decisions, better operational decisions, better whatever decisions. We just can't dictate and orchestrate.

[00:14:24] Sean Mooney: I think those are both well said in terms of one, you're making an investment, a reciprocal investment in your people.

Secondarily, you're trying to give them this incentive, this upside that makes them think and act and behave differently. And with both of those in mind, in this kind of like karma school of business, that has this ripple effect, and it's the flywheel moving. I forget who told me this saying one time, but I think it was a great saying.

They said, in business, there's a lot of things that motivate people and drive what you do is. Selfish altruism. It was wonderful because it won. There's altruism what you're doing in the first part and that you're investing in people and you're going to let others kind of also benefit from the value that's creating and that's in itself good.

But there's also selfishness to it in that. By doing that, you're also going to help yourself, and they're going to work harder, they're going to think like owners, they're going to create more value, because they're also seeing that they're going to benefit, which in turn will benefit you, and it gets this whole karma wheel of business and life spinning faster and faster, and everyone wins in this rare kind of win win way, or everyone fails if we don't do our jobs.

And so, I think that's a great way to think about it, and certainly my experience is that When I was in your shoes and certainly my experience now is the economic curves change in a way that makes everyone better And you're gonna be much more better than if you just had kept everything for yourself.

[00:15:50] Doug McCormick: I think there's one comment I'd highlight here We often talk about how these incentives change the behavior between the family owned business and the institutionally owned But I would argue the game is fundamentally changed when that transition happens from family owned to institutional And that the equity programs in a family owned business are actually, in many cases, not appropriate.

And to think about it, like a family, in many cases, has no plan to sell. It may run the business in perpetuity as a family owned business. And in many cases, they're not trying to maximize terminal value and they're certainly not trying to maximize earnings on a year to year basis. And so, like the value of equity in a family business with no plan to sell is very different than a I now have an institutional partner with a clear plan on how to create value and then how to get liquidity on that value.

And I'm aligned with them. So. I think this is an important tool in that environment.

[00:16:43] Sean Mooney: And I

[00:16:44] Doug McCormick: think

[00:16:44] Sean Mooney: that's well said. These tools don't work in every situation for good reason.

[00:16:51] Lloyd Metz: This episode is brought to you by HCI Equity Partners, a lower middle market private equity firm focused on partnering with family and founder owned manufacturing service and distribution company.

ICV Partners. An innovative private equity firm supporting management teams of leading companies at the lower end of the middle market. And BluWave, the business builders network connecting the most proactive business builders in the world with the best of the best service providers for critical, variable, on point and on time due diligence and value creation needs.

Now back to the episode.

[00:17:34] Sean Mooney: As a segue there, let's talk about what some of these Approaches are to getting and giving equity in the right situations And i'll preface this very clearly up front that none of us are financial advisors. None of us are attorneys So these worlds change very quickly. So anything that we talk about in this episode consult your financial and or legal advisors Accordingly because this is a world that's very dynamic So, caveat aside, let's talk about what are some of the approaches that investment firms will use to kind of create this win win motivation.

[00:18:10] Lloyd Metz: Starting off with the basic incentive equity, if you have a C corporation legal structure, those are called stock options. If you have an LLC corporate structure, those are going to be profits interests, but basically that is granting someone a equity economic stake. That increases in value as the value of the business from the date that you grant it increases.

The simplest example that most people are familiar with is a stock option and it'll have a strike price and that's the value of the business at the day that you grant it and you have time to exercise that option. And to the extent the business increases in value from that strike price into the future, you participate.

in the appreciation of the business. That's sort of like a basic starting point when you talk about incentive equity.

[00:19:07] Sean Mooney: That makes a lot of sense. What's another approach?

[00:19:09] Lloyd Metz: With the LLC structure, those are profits interests and they act similarly. There's a little bit of a tax nuance difference between the two.

It's the same concept. The business increases in value from the point of value that business had when those units are granted and When you get to the liquidation event, you liquidate the firm, you sell those equity interests to the next private equity firm. There's a profit, there's a gain for those equity units, and the incentive equity units participate in that and get cash in that event.

In both ways, the intention is when the private equity firm gets liquidity and sells their stake, turns it to the private equity firm's investors, and The leadership team, the supervisors, the managers, whomever holds those incentive equity units at the company, they also get cash too, right? So it's a payday for everyone, is the intention.

And to the extent the leadership team, the CEO, the founder, the direct reports, two levels down, whoever has the equity, decides to roll over their equity with the private equity firm, the next private equity firm. Those tend to be tax free rollovers. So you're rolling over pre tax dollar ownership with the next private equity owner, and that's a nice little benefit as well.

[00:20:41] Sean Mooney: And I think the good thing about these as well, as you think about options for the receiver or the grantee, is you typically don't have to put money up front, and you don't have to pay often taxes up front, but eventually you do. Oftentimes that's tied to when actually the company is sold, and so. The money from selling can actually be rolled into paying your strike prices and taxes.

You eventually have to pay both, but you don't have that upfront cost. What about another approach? Do people kind of just give you full shares? Is there certain companies that do that? I

[00:21:14] Lloyd Metz: mean, you can. We generally try to avoid it because current tax code, real simply, is if you give someone value today, that's a taxable event.

So if anyone were to grant you stock, that fair market value today. And you didn't necessarily pay for it. Certainly we're given value and now that's triggering a taxable event for the recipient. So they're going to have to pay taxes on that stock. And we generally try to avoid that because yes, you're giving someone value, but now you've just stuck them with a cash tax bill, right?

That they're going to have to pay at some point later that year. So generally speaking, I know we do it fairly often. I don't know about you, Doug, but we also invite. People to write a check and buy equity when we make our investment in our transaction. So they're literally buying the same security at the same price and the same terms that we are when we make our investment.

So we tend to open it up and offer that to however broad a group that we determine along with the CEO or the founder, how many people appreciate being in the equity ownership group, and we'll invite them to write a check. And on top of that, We'll often put in a matching loan to allow that person to own more equity.

So maybe it's one to one or two to one. So for a dollar that they decide to write a check for, the company will extend a loan for a dollar or extend a loan for two dollars. So now instead of owning one share, they own two or three shares. And that's a nice way to amplify ownership and the economic upside for the folks who participate.

For I don't know if Doug, you guys do anything like that. I think there's

[00:23:06] Doug McCormick: a whole variety of instruments that generally do the same thing around this terminal value alignment, if you will. So there's options, which we talked about, there are stock grants, which we talked about, there are stock appreciation rights or phantom equity, and then there are often purchase rights or employee purchase programs.

And in my mind, if you don't get lost in the details of the individual instruments, the primary differences are the slope of the payout curve, the risk of loss, and the tax treatment. As a private equity investor, I will say my bias is I want a really steep curve because I think that incents the most interesting behavior and I want to try to make it as tax efficient as possible.

For me, that ends up putting you in a situation where you're probably going to do something like an option because the payout curve on the option is relatively steep, i. e. before the investors get their money back, you get zero. And then you're only participating in the upside, but because you're only participating in the upside, the value of that can accrete dramatically as the outcome gets much better.

From a tax perspective, the problem with the options is often that it's not so tax efficient because it's treated as ordinary income because there is no risk of loss. And so I think, Lloyd, to your point, the way you can amplify the payout curve is through loan programs. And that creates a situation where Beneficiary actually owns the instrument.

It's more tax efficient because it's capital gains, but they get that steeper payout curve because they borrowed a lot of the capital.

[00:24:40] Sean Mooney: Those are all great points. And we'll talk maybe a little bit more about this, but the ownership thing is interesting as well because not only is the employee being given something like an option, but they're putting their own kind of money on the line.

And that kind of even amplifies further the incentive to do really, really well. And Doug, the other thing you touched on, I think is really important is there's also these things called stock appreciation rights, sometimes called phantom equity. And that's just another tool. Where sometimes you can give people the economic benefit, but not the legal kind of complexities or requirements of being something that's called an accredited investor.

And so there's other kind of tools that you can use to get the same outcome without having some of the complexities legally. And what I'd say for all these, just reiterating, talk to your attorneys, talk to your financial advisors, and they can give you much more on this. Hopefully this is going to be just a good kind of survey of the art of the possible here.

[00:25:37] Doug McCormick: One comment to add. As I use the analogy that it's related to the slope of payout, I think you could also overlay employee profile type on that slope of payout. So I generally see the more senior folks are, the steeper the slope, the greater the risk of loss, the more focused on tax efficiency. And when you think about getting the entire company aligned, I often see employee stock purchase programs, and that may not have a very steep curve, but everybody's participating in the ownership at some level.

So they do feel affiliation with a company's good performance or bad performance.

[00:26:16] Sean Mooney: That's really well said. Maybe with that in mind, and What are some of the approaches in terms of kind of the depth and breadth of grants generally across kind of the landscape of private equity and maybe start like what most family companies do and then what are the kind of different flavors in terms of depth and breadth that private equity firms will consider in different situations?

[00:26:39] Doug McCormick: As I mentioned earlier, I think in many cases, family businesses, they don't do grants for some of the reasons I mentioned about they don't have a plan to sell. They're not worth as much to the employees. And I think the company business model, the employee profile, and the firm culture has a lot to do with like what the appropriate allocation is.

I've seen models where this equity incentive is very concentrated amongst the senior leadership team or the C suite. I've seen organizations where the key players that are going to drive the impact of the business is more spread throughout the organization. And so it could be C suite at mid level. And then in some cases, you've seen organizations adopt ESOP programs or have an employee base that is so critical to the business that they push the ownership or the incentive way down.

I don't think there's a right answer. I think it's more a product of the business model, the employee profile, and the company culture. Our bias is, if you get back to, I said, these equity incentives are considered an investment. So whenever I'm allocating them. I'm asking people to make the case on how these allocations are investments that I should expect to see in ROI.

And for me that generally means it's helping me attract the right employee profile. Or it's allocated to folks that can have a positive impact on the investment outcome.

[00:28:05] Sean Mooney: I think that's well said. What are some of the pitfalls that you think through or the things you certainly have to really think about in consideration?

And some of that, I think you kind of touched on a little bit there in terms of like, is it going to have the desired effect, et cetera. So what are some of the other things that you think about in terms of. How to use this opportunity to create more value.

[00:28:29] Lloyd Metz: Doug, you touch on something interesting, and that is, for an individual, we ought to think about, is that person sort of narrow in their scope in terms of how they work, how they affect the organization, or do they actually interact across the enterprise more broadly?

I think if the person is interacting, or should be interacting more broadly across the enterprise, to drive results, to drive improvements in the business. Those are usually better candidates for equity than the folks who are just working a particularly narrow or discrete function or role in the organization.

That's a way of thinking about it.

[00:29:12] Doug McCormick: Hey, Lloyd, and just on that point, I think it's exactly for the reason you highlighted about agency risk and lack of alignment, because if a person has a relatively narrow zone of impact, you can often develop bonus programs or something that are highly correlated with the quality of their work and their contribution.

And the more you have a role that touches all parts of the organization, the more the equity is aligned with your contribution, I think.

[00:29:37] Lloyd Metz: That's right. But to Sean's question in terms of pitfalls, it can be complicated. Just the legalities, the paperwork, whether it's stock options or profits interest or matching loans or stock appreciation rights or phantom equity, the paperwork, Particularly drafted by lawyers, it's complicated for most people to understand.

And so you kind of have to make an extra effort to explain it to people, walk them through it, give them time to understand it, ask questions. You definitely don't want to be in a situation where you put this out and sort of jam it down people's throats. It's not going to feel good. You have to take the time to explain.

[00:30:20] Sean Mooney: That's once again, spot on. The biggest thing that I always encounter and consider is that these things are pretty complicated. There's tax issues, there's legal agreements, there's a gauntlet of rules federally and state around accredited investors and all these other things that can make it just difficult to overlay.

The last thing I think about is like these grants, they're not liquid. And so They're usually tied to an exit event or a sale event that's going to happen three to five years later. And so all of those just need to be considered by anyone thinking about using these resources to supercharge kind of value creation.

But just be mindful of that and make sure that you're well advised on these.

[00:31:04] Lloyd Metz: Absolutely. We make it super clear that don't put an investment here. With money that you absolutely, probably, likely, whatever are going to need, right, because it is illiquid and you guys are driving the bus, it's going to get tied up for 3, years pending, right?

So you got to make the proper decision for you and your family. So we try to make sure people understand that when it comes to writing a check and putting their cash in to the business.

[00:31:38] Doug McCormick: Yeah, I think you guys are making A really important point of, there are real costs associated with getting these programs in place, and once you've incurred those costs, if you're not committed to really investing and allowing the employees to understand the impact and the benefits, it's really not a good kind of ROI, candidly, because, like, you're getting all the costs, but you're not necessarily getting the benefits, and so, I think if you're going down this path, if the company's going down this path, you got to acknowledge the cost up front, but then you've got to be committed to articulating how this gets valued over time, what the benefits are to the employee base, so they really see the value and it changes the behavior.

I think the worst thing to do is go through all that work. And then the employees didn't really appreciate the value of what they got until after it happened. And then you really haven't changed behavior, you've not benefited from the investment you've made.

[00:32:29] Sean Mooney: It's another really important thing to consider and we talked about the pitfalls and I think you made a great point there.

Doug, on how do you make it successful? And so can you talk a little bit more about how should you teach beneficiaries of these programs about them so that they appreciate what they are, why it's important, and then what the expectation is as an owner now, as there's greater expectations as well.

[00:32:53] Doug McCormick: I share your concern around when you're communicating these programs, you always want to make sure that, like, the company can deliver on the promise that is implicit in security, and so you're hesitant to say your security will be worth this much at a future point in time, but I think it's fundamentally walking through how companies are valued, what the business is worth today, how much leverage the business has on it, if we accomplish the vision or the five year plan for the business, What we hope to return to our investors and you lay out that framework and then you can educate folks on how we're progressing along the way if we're doing M& A, how the M& A influences the prospects for value creation, if we're implementing M& A.

New growth initiatives that are organic, how those play in to that calculus. And so I think it's really just a commitment to broadening the discussion about the strategic roadmap in a way that people can see where the value is coming from and kind of track it over time, whether implicitly or explicitly, like not every company does a published annual valuation, but people can see.

Earnings are growing, growth rates accelerating, and those are indicators of better value ahead.

[00:34:03] Sean Mooney: That's one of the things that I think I found the most impactful that I never did previously per se. But at BluWave, we grant equity to team members. And during the first couple of years, we really didn't say what it was worth.

It's just, no, you should think about it. Here's what is great. And the reason why I think a lot of people are scared to say what it's worth, because then you think you're like making a commitment in any valuation, save like selling a company. It's just an estimate you're doing your best. You're triangling.

Here's what I think at work, but until you sell it, you don't really know. I think I certainly had a lot of insecurity about taking a position and saying, here's what I think it's worth. And here's how that changed from a year ago, when it was granted. And I finally got over it and I had to put like 50 different caveat footnotes in every one of these things.

So I was like, I'm still nervous, but I tell you, I was like, this is not going to happen. This won't happen. This is why I didn't do this. But if you do these 10 things, this is what I think it's worth. And so that's what the spreadsheet looks like. You have to have the integrity of the process. And it's your best guess, but once I did that, everyone's like, whoa, I didn't know it was worth that much.

It's like, this is doing ten times better than anything I have in the stock market. And like, it changed how everyone thought when we kind of said, here is what we thought it was worth last year, here's what we think it's worth now, and then let's look at how much that's grown. And here's how you played into that.

And then here's how what you're going to do this next year is going to play into making it grow X percent more even this next year. So that was kind of a hard earned lesson that I learned just being in the trenches that I think made it really even more successful. Then it was just by having people think and know that they're an owner.

Like what's something that you think as well, that would be a piece of advice to making these entire programs successful.

[00:35:48] Lloyd Metz: It puts an onus on the private equity firm and the leadership team for sure. You should have a. At least once a year, state of the firm, how did we do financials, high level, what the equity account, what did it do, did it go up, did it go down, and by how much, what did we accomplish strategically, what did we have left on the table that we need to work on in the upcoming year, and I think in the context of those kind of annual discussions, that's where you share how the equity increased in value, or what have you, and arguably you can do it twice a year, Heck, you can do it quarterly if you want to, but I think at least once or twice a year is probably the best way to do it if you're going to do it right.

[00:36:34] Sean Mooney: I think this has hopefully been a good survey for everyone, not only in the private equity industry who've been using these, I really appreciate that the power of this tool is getting kind of broad exposure across. larger sets of media in a way it hasn't before. The good news is this tool's been used for a long time.

And I also think everyday business owners can use this in certain degrees. Even if you're a family owned business, there are tools like stock appreciation rights, where you can kind of give people not only short term incentives in terms of base and bonus, But also participation in the long term value creation, the things that you do today that won't impact value for two or three years later.

Hopefully the listeners, what they take away from this is, one, if you're already using it, here's a couple different approaches that they can think about. But two, if you're not, this is a powerful incentive that every business builder should be thinking about to align value creation, sharing of upside, selfish altruism.

And something that's going to be a powerful motivator of change in any of your organizations.

[00:37:36] Doug McCormick: Hard to argue with that logic. Not only is it a powerful motivator for creating value internally, but I think you probably got to acknowledge your competition is using this tool because it's pretty ubiquitous in most organizations at some level.

And so if you're not using it, what does that say about your competitive advantage?

[00:37:56] Lloyd Metz: Right. And to your point, Sean, family owned businesses do have their way of competing, as Doug described. So there's a whole other set of tools that they're able to use, deferred comp plans and long term incentive plans and the like that have equity like attributes.

So that over long periods of time, people participating in the value creation of that business, even though it is family owned and not going to be sold, They're not dummies, right? These family owned businesses, so they have their own set of tools that they can use. But it's the concept as you're broadening out your equity ownership base, even if you strip the governance aspect of equity, it's the economic aspects of equity that you want to share to drive better performance, to attract the better talent, etc.

[00:38:47] Sean Mooney: I think well said. So gentlemen, this has been another, I think, great cornerstone episode, pulling the curtain back on the private equity way and how you all do what you do and others can do the same. So I appreciate your candor and sharing kind of how this tool can be used across the economy as successfully as it has been within this broader industry that we all participate.

So Thank you. Thank you.

[00:39:10] Lloyd Metz: Good stuff, Sean. Thanks a lot, Sean.

[00:39:14] Doug McCormick: A special thanks to HCI Equity Partners, a lower middle market private equity firm focused on driving transformational growth through consolidation strategies by partnering with family and founder owned manufacturing services and distribution companies.

Learn more at hciequity. com. ICV Partners, an innovative lower middle market private equity firm supporting management teams of leading companies at the lower end of the middle market. Learn more about ICV at icvpartners. com. And finally, BluWave, the business builders network, connecting the most proactive business builders in the world with the best of the best service providers for critical, variable, on point and on time due diligence and value creation needs.

Learn more about BluWave at BluWave. com. For further information on HCI, ICV, and BluWave, and relevant topics discussed here in the episode, please see the episode notes for links.

[00:40:15] Sean Mooney: The views and opinions expressed in this program are those of the individuals presenting and do not necessarily reflect the views or positions of any other persons or entities, including those referenced herein.

No representations, warranties, financial, legal, tax, or other advice are made herein. Consult your advisors regarding any topics discussed during this episode.

Join Doug McCormick from Oridian Capital Partners, Lloyd Metz from ICV Partners, and Sean Mooney from BluWave as they explore timely private equity topics and offer their seasoned perspectives on crucial areas of focus within the industry. Gain valuable insights from these industry experts in this engaging podcast tailored for PE professionals.