In closely held businesses, company executives are often the founders, running the day-to-day operations while also owning or controlling most of the company’s equity. This unique dynamic makes the allocation of equity a crucial consideration for the long-term success and stability of the company.
It is essential for founders to understand that equity should be allocated to individuals who have earned it through their contributions, skills, and dedication to the company’s growth. While it may be tempting to simply split ownership equally, such as in a 50:50 arrangement, this approach can lead to significant problems down the line.
One of our clients shared their positive experience with a 50:50 ownership structure: “My business partner and I have been 50:50 owners for over a decade. It’s worked well for us because we have a strong foundation of trust and communication. We always make sure to discuss major decisions and find a compromise that benefits the company.”
However, not all 50:50 partnerships have such a favorable outcome. Another client of our firm warned, “I thought going 50:50 with my co-founder was a good idea, but when we had a falling out, it led to a lengthy and expensive legal battle. The litigation took a toll on our relationship and the company’s future. I wish I had been more strategic about equity allocation from the start.”
These contrasting experiences highlight the importance of developing a thoughtful and strategic approach to equity allocation. Founders should consider factors such as each partner’s role, experience, financial investment, and long-term commitment to the company. By allocating equity based on merit and contribution, founders can create a more equitable and stable ownership structure that rewards dedication and aligns incentives.
In perpetually small businesses, a 50:50 ownership structure may not pose immediate issues, as the partners are forced to collaborate and make major decisions together. This inherent need for consensus can help founders avoid conflict, as they understand that an impasse could lead to the dissolution of the company. Dissolution, in this context, refers to the legal process of winding up a company’s affairs, settling its debts, and distributing its assets among the owners before permanently closing the business.
The threat of dissolution can serve as a powerful motivator for founders to find common ground and avoid deadlocks. However, this approach is not without its drawbacks. If a serious dispute arises between the partners, the consequences can be disastrous. With equal ownership, neither partner has the authority to break the deadlock, which can paralyze decision-making and jeopardize the company’s future.
Moreover, a 50:50 ownership structure fails to account for the varying levels of contribution, expertise, and responsibility that each founder brings to the table. This can lead to resentment and a sense of unfairness, as the partner who puts in more effort or possesses critical skills may feel undervalued and unappreciated.
To mitigate these risks, founders should consider implementing governance mechanisms, such as shareholder agreements or voting rights, to prevent deadlocks and ensure smooth decision-making. These agreements can include provisions for dispute resolution, buy-sell arrangements, and clear guidelines for the transfer of ownership.
S0, equity allocation in closely held companies is a complex and critical issue that requires careful consideration. While a 50:50 ownership structure may work for some, it can also lead to significant problems and even the dissolution of the company. By allocating equity based on merit, contribution, and long-term commitment, and by implementing effective governance mechanisms, closely held companies can create a more stable, equitable, and successful ownership structure.
If you would like to discuss your company’s equity allocation strategy or need guidance on implementing governance mechanisms, please don’t hesitate to book a time by clicking on the link to the right or reach out to the author, Scott Levine, at slevine@aegislaw.com. Our experienced team at Aegis Law is here to help you navigate the complexities of equity allocation and ensure the long-term success of your closely held business.
