Rights and Obligations of Equity Ownership

As more wealth management businesses look to internal succession, more new owners are being created. As a next generation advisor, you should consider whether ownership is the right path for you, and it is important to understand what ownership entails. Owners of a privately-held business, even with a minority position, enjoy several rights and privileges in exchange for their investment in the company, but they are also responsible for meeting certain obligations.

The following rights and responsibilities apply to all owners whether the business is a corporation governed by bylaws or a limited liability company with an operating agreement.*

1. A VOICE: All owners can and should attend shareholder meetings and vote on major business decisions such as incurring substantial debt, merging with another business, electing Directors, or selling company assets. The percentage of ownership will determine each owner’s voting power. Commonly, each share has one vote. With increasing ownership comes increasing responsibility for business decisions.

2. PROTECTIONS: If a majority owner sells their stake in the company, the minority owner will have the right to join the transaction and sell their stake in the business on the same terms at the same time (if the company’s bylaws or buy/sell agreement create that right.) This protects the minority owner from owning shares in a business that is now owned by someone they may not know. When making decisions for the business, majority owners must also act in a fiduciary manner to protect all levels of ownership interests.

3. TRANSPARENCY: Any shareholder has the right to inspect the company’s list of shareholders and the most fundamental of its books and records. Sharing all of the financial information might be a challenge for a senior owner who is bringing in new owners for the first time. It is, however, a necessary and even useful step in creating a well-run, sustainable business–ultimately improving the cohesion of the leadership team.

4. SHARE OF PROFITS: Profits should be distributed in proportion to shares of ownership. As an example, a G2 owner who has taken out a loan to purchase 5% of the business should receive a full 5% of the distributed profits. New owners do not have to wait until the purchase price is fully paid, their right to the profit distributions accrues right away.

5. SHARE APPRECIATION: As the business grows, so should the value of its shares. Equity should build over time, so, assuming business growth, the seller should receive the appreciated value rather than the amount originally paid for the shares.

6. TAX TREATMENT: As stock goes up in value over time, the appreciation is not taxed as it occurs. Rather, the appreciation is considered capital gains and is taxed only when the stock is sold. If the stock is held for at least a year, the gain should be taxed as long-term capital gains, a more favorable rate than the tax on ordinary income.

Along with these rights, there are obligations for new owners to consider:

1. BOTTOM-LINE FOCUS: Owners do need to pay careful attention to the bottom line—the total profit or loss of the business–which is a responsibility shared by all owners whether they are a majority or minority owner. Equity ownership requires a focus on generating revenue in an efficient and scalable manner, and the reward is greater shareholder value. By embracing this focus, new owners often bring new ideas to the table and try to improve business operations in key areas such as: management of staff, technology, marketing, and client facing issues in order to improve profitability.

2. CONSENSUS & CONSIDERATION: For sole proprietors, all the decisions about how to run the business fall to a single person. Once other owners are part of the mix, however, founding owners are no longer making decisions that only suit his or her interests. Each owner should consider the voices and opinions of the other owners for all business decisions, including (but certainly not limited to) making adjustments to the marketing plan, deciding how to recruit and reward new talent, or investing in new technology.

3. TIME COMMITMENT: The obligations of owners may, and usually do, extend beyond an 8-hour day. Because owners are working on the business as well as in it, the responsibilities of managing the business are added to day-to-day operational responsibilities. This doesn’t mean owners will always work 16-hour days, but it may mean an additional evening or weekend in the office every so often­–whatever it takes to grow the business and get the job done.

4. FINANCIAL RISK: Along with the right to receive the profits and the stock appreciation, an owner is also taking a risk. The value of the business could go down due to market changes, loss of clients, increased expenses, or the loss of a key employee. Keen management is needed to handle such challenges and to regain the business’s profitability as quickly as possible. 

Though these rights and obligations apply to owners of privately-held corporations and LLCs alike, it is important to understand that the entity type (LLC, S-Corp, Partnership, etc.) will govern the specifics. Certain entities have a Board of Directors, others are run by Managers or Members. The Bylaws/Shareholders Agreement (or Operating Agreement/Members’ Agreement in an LLC) will outline many of the rights and obligations listed above. These documents should be prepared by an attorney who is familiar with industry rules and regulations and based on the correct application of valuation standards and approaches.

An offer of ownership in a financial services firm can be a rewarding opportunity for the right person. You’ll have the freedom to create your own work environment, client experience, and financial rewards. You may face challenges that all small business owners face, but by having all of the pertinent information about the purchase, you’ll be ready to determine if this is the right step for you.

*For ease of reference, we’ve used corporate terms in this piece though the concepts apply to both corporations and LLC’s.