Paul Giannamore: If I owned Rollins’ stock, no one is calling me from Atlanta saying, “Paul, you slept in on Sunday morning. You need to get rid of a few shares.” That's not how life works.
Patrick Baldwin: Uncle Paul, surprise.
Paul Giannamore: Morning, Fat Pat.
Patrick Baldwin: Speaking of Fat Pat, I got some on tap first and it comes at you as a little surprise.
Paul Giannamore: I always do. What do we got?
Patrick Baldwin: You've seen where partnerships can blow up in the end or even in the middle. I thought, what if you and I walk through Fat Pats again? That was episode 96 where this whole Fat Pat Pest was born. What if we get it right from the get-go? What are things that we can put in place to make sure that you and I are on the same page?
We've got Fat Pat and Uncle Paul. We're going to start Fat Pat's Pest somewhere outside of my non-compete to keep all that simple. Between the two of us, we bring time, capital, and skills. How do we structure this in a way to protect our business relationship, maybe even, hopefully, protect our friendship, and stay on the same page along the way? Uncle Paul, I need your help but we're going to do this.
Paul Giannamore: Fat Pat, that's a good question because as you well know, we deal with that all the time in this industry. It seems to be particularly acute amongst the door-to-door community and that's a function of the fact that these guys are constantly forming new entities. They're using a lot of different partners. It's common for a sales partner to partner up with an operating partner and one guy goes out and does the selling and the other guy goes out and runs the operations.
What inevitably happens, and we see this a lot, is in the early years, the guy who's recruiting the sales teams is extremely valuable to the organization because it doesn't exist. As it ramps up over time, he becomes less and less important to the operation and then the operating partner, 5 or 6 years into it, says, “I'm here toiling in the pest control vineyards every day. My partner, who was the sales guy and recruiter, is not doing anything.”
Going into this with the end in mind is important and that can mean a lot of different things. Before we even talk about that, we should frame up the distinction between ownership versus a position in a business. This comes into play in a family business as well. You and I can both be owners of a business, it doesn't necessarily give us the right to work at the business. Likewise, our compensation for working in the business.
Let's say we run Fat Pat’s, what do I do? I brought capital. I bring a little bit of know-how. I maybe take a board position. I'm involved in some strategy. You're out there in the Waco fields battling the day-to-day. You and I are doing different things. I probably don't get a salary. My returns from the business come in two forms, capital appreciation, and dividends. Yours come in three forms, cap appreciation, dividends, and then, of course, a market salary. One way of setting this thing up right from the get-go is making sure that the compensation each partner is getting is tied to market for what they're doing.
Patrick Baldwin: Is there a trick to do that to figure that out?
Paul Giannamore: Zero trick. You can benchmark things. You've got a pest control business doing $2 million per year in revenue. It's not difficult to determine a comp structure for that GM or president would look like. Frankly, you could look at branch managers for Orkin and Rentokil in the neighborhood and see what they're getting paid. I'm not getting a salary. In my capacity, other than providing capital, I'm probably in the early years on calls every day.
In later years, I'm probably involved in monthly calls and maybe quarterly board meetings. You're going into the office every day and so you've signed up for a job in conjunction with ownership and I've signed up for ownership and not a job. Going into this, one of the things we always have to think about too is, “What's the end goal?”
The end can always change. People die, they get sick, they get divorced, and they move on. There are a lot of things that can happen in life. At the end of the day, you have to determine, “What are we doing with this business? Is this a five-year and out?” Are we building a long-term sustainable asset that we may never exit? Maybe it gets passed down to children. Maybe it gets sold 25 years in the future. Either way, if one of us decides to go, how will that happen? That's one thing.
The other thing we have to think about is we have to think about corporate governance and control of the organization and who controls the board of directors. Are you and I going to be 50/50? Are you going to own a majority? Am I going to own a majority? Who makes that decision? The common knowledge out there is there should always be a controlled shareholder. Everyone understands that. In practice, it's difficult.
More times than not, I don't see that and it's always like, “We both started this business. Why should one of us own more than the other?” That's real. You can handle that in some synthetic ways. You could have a tiebreaker vote and do a shareholder agreement. That could be some independent third party that you both trust. It could be an advisor, a church elder, or an attorney. It could be anyone that understands the business. Both partners would make appropriate and just decisions.
Patrick Baldwin: What kind of decisions? Is this on expenses, on buying vehicles, on exiting? Is that consent rights? On those consent rights, what decisions are involved?
Paul Giannamore: A consent right is an instance where nobody controls the board. It's in a minority shareholder position. Let's say that you and I started Fat Pat’s and you own 55% of the business and I own 45% of it. You have numerical control, meaning you can vote on key decisions. I might say, “Fat Pat, you control the board. In this shareholder agreement, I want a variety of consent rights,” meaning you have to come to me, the minority shareholder and I have veto rights on certain things.
If you think about consent rights, if there's an instance where the company wants to make a large capital expenditure above $100,00, let's make up the number, you have to come to me. If the company wants to issue stock, if the company wants to do a material acquisition, if the company wants to dispose of the business, there's a variety of things that you have to come to me. You can't make that decision. I have a right. I have a say in it.
Ultimately, it can be set up where I have veto rights to it ir it could be set up where we would invoke some tiebreaker. A tiebreaker is not like, “Do we use pest packs or pest routes?” Those can be real arguments. They could revert to that and then you can invoke a tiebreaker vote on anything. In my experience, one that I've seen before is you and I are partners, you're outrunning the business, and I am a relatively silent partner, which is how you like me. You're going on a lot of trips and blowing a lot of money. When you go out to Pest World, a lot of people are standing in the courtyard but you're staying at the Ritz Carlton, fine dining. A Pest World trip for you is $15,000 whereas it should have been $2,000.
Patrick Baldwin: Don't judge me. I like to eat.
Paul Giannamore: That becomes a real issue and you say to me, “Paul, you're not doing anything. I'm the one who's toiling here in the vineyards. I want to be able to enjoy when I take these trips.” I say, “We blew $15,000 when we should have spent $2,000.” Those things are the little small grinding problems between partners. We should think about ways to solve those because those ultimately bloom into much larger issues down the road.
First off, many people have never owned a business before that do this. Second off, they don't have experience working with equity partners so they can't anticipate a lot of these problems. It's like a body of law, you can't anticipate every way a criminal is going to do something. You need catchall provisions within the law. In the same way, you have to think about that from a shareholder agreement perspective.
Patrick Baldwin: Building in and operating agreement now or partnership agreement now. How important is it to go ahead and figure out the timing of an exit? I think about proximate objectives, and that was episode 11. We were thinking that we're building this for 5 years out, 10 years out, maybe an exit number, maybe it's a succession plan to the kids, and all that. In addition to that, are we looking at building into our operating agreement if there's any valuation component if we need to buy the other out? Also from, an exit perspective, even if I'm 55 and you're 45, how important is it that one of us has the decision on when it's time to pull the trigger on exiting?
Paul Giannamore: From an exit perspective, first, you have these voluntary exits. A voluntary exit is, “Patrick, I'm out. Buy me out.” Let's push that aside for a second and first think about the involuntary exits. The plane goes down, what happens?
Patrick Baldwin: I thought it was always a bus.
Paul Giannamore: I spend more time on a plane so we're going to go with the plane. My plane goes down, PB, or as the Mexican would say, “Paul, your plane falls.” My plane goes down, my estate will likely not be your partner. You don't want an equity partner who's dead. You want to clean up the cap table. The best way to handle that is to have a life insurance policy that's tied to valuation. Maybe it gets updated every year and it doesn't have to be a professional formal valuation, it can be more back in the napkin and we'll discuss that.
You've got a life insurance policy that funds one of those such events like a partner dies. All of a sudden, life insurance kicks in and pays out the estate, it effectively buys the equity of that partner from that partner's estate using life insurance proceeds. Of course, the company has paid those premiums for all equity holders in the business. That's an involuntary exit, it's one that's triggered by provisions in a shareholder agreement when it comes down to valuation. We know where the money is coming from, it's coming from Insurance, and we know why it's happening because it was triggered by a death. The question is at what value? Let's talk about that. What do you think?
Patrick Baldwin: Appraisal can get tricky if we trigger an appraisal for that. I think about how you do preliminary valuations. Is that the mechanism, having that reviewed once a year to get an update? Is it finding out where multiples are and applying that to our business? You have minority discounts. There are many variables. I don't know. It's always my answer though.
Paul Giannamore: It's a complicated area. You have to say, collectively as shareholders, “What is the standard of value that we are using?” In a little recap, because I know we've discussed this on The Buzz before, you have what's called fair market value. That's a hypothetical construct. What I mean by that is the US Department of the Treasury came out with revenue ruling many moons ago, revenue ruling 59-60, and said, “The value of a business in a hypothetical transaction where neither buyer nor seller is under compulsion to act. There are no synergies created by the deal.”
That effectively takes away strategic deals. Rollins is coming in and buying your company. They get synergies. By definition, fair market value tends to be lower, at least in the most recent quantitative easing, lower than investment value or strategic value. I use those two terms interchangeably. An investment value would be ultimately what a strategic acquire or what a PestCo, Rentokil, or Rollins, you name it, would ultimately pay for the business.
When we live in a world where a $10 million business on a fair market value basis might be worth $10 million or $11 million and that same business might be worth $50 million in a highly competitive controlled auction process, there's a massive delta between fair market value and investment value. We have to think about that as partners and we have to think about if my plane goes down and we are in August of 2021 and our business on a fair market value basis is worth $5 million but we could have sold it for $27 million, is it fair and appropriate for you to be able to buy me out for $2.5 million?
Patrick Baldwin: Only because it was you and your plane. If it was my plane, it'd be different.
Paul Giannamore: It would not be fair. We have that conundrum to deal with. It's easier to do something under fair market value because it tends to be more static. It's a term that every appraiser, by definition, understands and it's relatively easy to reach. Investment value is much more complicated. Those are using actual real-time valuations in such a provision.
The other way to think about it is more static mechanisms. For example, it doesn't matter what the market is. Here is the calculation for what this business is worth. We are going to take the trailing 12 months of EBITDA and this is exactly how it will be calculated. This accounting firm, XYZ, will calculate this cashflow number, this EBITDA, and we will apply this specific multiple to it.
What I seek constantly is I get calls from a variety of attorneys, and this happens a lot at the beginning of the year, that we'll call up and say, “Paul, I am updating the shareholder agreement for my client. Every year, we update this. Can we talk for five minutes about where this market is at and what would be an appropriate multiple to use here?” That's one way to do it.
Patrick Baldwin: The EBITDA multiples are going to vary across the board based on geography and revenue. There are a lot of factors there.
Paul Giannamore: There are tons of factors. It's one of those things where there's not a prevailing multiple for this. If you take a wildlife business in Minnesota that's wildlife heavy and does a lot of one-time versus a highly recurring business in Tennessee, it's different. You understand the complications and all of that. One way to handle this though is to have an annual update. If you watched Bubble Trouble, we talked about how static the pest control industry was for 30 years, and then we've had this massive runup. We didn't have a lot of these discussions years ago because much of this didn't change and fair market value and strategic value were similar.
Now, there continues to be a huge delta between the two. One simple way to do it is to determine the mechanism that both sides agree on and try to get it as close to what you feel is fair. On that same example, we've got a $10 million fair market value and we've got a $50 million investment value in today's market. If the plane goes down tomorrow, are we okay with it being somewhere in the middle? Does that seem fair? If we're adjusting it every year, we'll always be in the middle of that.
Patrick Baldwin: Is there a right and wrong answer to that? It seems fair.
Paul Giannamore: Some of the complications that always arise in this is somebody did a shareholder agreement in the year 2004 and now it's 2019 and it needs to be executed upon, and it was at 0.9 times revenue and the business is doing $8 million. We know that's wildly off where it would've been trading at.
Now, the shareholder that wants to get paid out is extremely frustrated but that was already baked into the cake so that's the problem. As a matter of fact, I saw some notes in between an attorney and a pest control and a couple of partners where they asked me to take a quick peek at it and they were getting themselves in the exact opposite position.
Patrick Baldwin: How's that?
Paul Giannamore: The one that was done in 2003 and 2004 was inked, it was a fixed mechanism, and it was inked years ago. If you're using current statistics and you're inking something now, I have strong reason to believe that the same thing is going to happen maybe five years from now.
Patrick Baldwin: The inverse?
Paul Giannamore: Yes. It's three times EBITDA before. It's at 19 times EBITDA now. I don't know about that.
Patrick Baldwin: There's the bubble.
Paul Giannamore: To your point, you said appraisals are messy. I would avoid at all costs having a lot of these typical buys. All agreements will say, “On such and such a date.” Somebody passes away on June 1st, an appraisal is done of the business under a fair market value standard on June 1st, and then what ends up happening is you hire an appraiser, and then the estate of the other side looks at that and says, “That's BS.” They hire one and then now there's a disagreement. What ends up happening is it goes to the court and then you've got to litigate it and then the court brings expert witnesses. That's not good for anyone.
Patrick Baldwin: Is it even right if something happens, you could build into an operating agreement that, “We would take the business to market, run it through a process, and then not sell it,” to figure out what it would sell for.
Paul Giannamore: Let's say that you and I have Fat Pat’s Pets Control which does $5 million in revenue. We don't even have to talk about this publicly but you sold Bugs.com a few moons ago. You're well aware of what the transaction multiples were on that business. Let's take a $5 million business and let's apply those multiples in your mind.
I die and we've put that in the shareholder agreement that we're going to run some sort of a process. We run a process. The numbers end up where you think they are based on what you know. What position does that put you in now as the surviving partner to buy out my estate? You can't do that. You wouldn't have the money. You would be saddled with debt. You can't create any synergies. It would be a train wreck. That's the problem with investment value for these things. Under fair market value, it's a hypothetical transaction whereby there are no synergies and no one is under any compulsion to act.
The purpose of that whole thing in the actual regulations is that if there were synergies, it wouldn't work for an internal bio transaction because there aren't any in fact. That's the problem that you would have. I'm sure my estate would love to get paid out of investment value. In a nutshell, there are some simple things for people to do. One is to avoid appraisals at all costs. You might end up getting there, unfortunately, but you shouldn't be the guy who writes a shareholder agreement that says, “If something goes down, we're going to get an appraisal.” You don't want to do that.
You also don't want to write anything in stone. If you're going to be sophisticated about it, you should educate yourself, as a business owner, on how these businesses are valued. You need to stay close to the market. At the end of the day, you're building a business, you're investing in this thing, and you're trying to build a capital asset.
You need to act a little bit like the CEO of a publicly traded company and pay attention to how the market values the asset that you're creating and how that changes over time. If you do that and your partners are all on the same page, then every January or every December, you should update the mechanism in your buy-sell agreement. It could be fair market value. Fair market value is a safe methodology to use. You can determine exactly how you want it done from a calculation perspective and put it in there.
Patrick Baldwin: It's important what you said about having an attorney involved in updating the operating agreement on an annual basis but also that attorney represents the entity, Fat Pat's Pest, not Fat Pat, and not Uncle Paul. That ability to give maybe an insight, there's value there. By not representing either of us, he can go in fair and balanced if you will. There might be issues where I need to have a conversation with the attorney. He needs to be thinking about things and updating an upward agreement. You might have things going on. You need to let him know, “This is what's going on.” Isn't part of the update, not just the evaluation component?
Paul Giannamore: Correct.
Patrick Baldwin: What issues might he be needing to ask us on an annual basis to be like, “How's life?”
Paul Giannamore: A lot of times people take these shareholder agreements, they get written. First off, when you start a business, you don't know what goes in there because you haven't experienced any problems. For that reason, most people don't have them. You don't wish you had one until you have a problem and then it's too late.
Patrick Baldwin: Overconfident, like, “We're fine. We're besties.”
Paul Giannamore: It is common to not have one. If you're out there and you don't have one, do not feel bad. That's the standard. However, if you are serious about this business and you want to retain a friendship and a relationship with your partner, you will do your absolute best to try to anticipate all the issues that you could potentially run into. Of course, the exit is a big one. Who is controlling things? Who has consent rights? Those sorts of things.
My recommendation to everyone is once you get one of these things established, you do have a brief conversation every year with the attorney who's drafting these under the laws of the jurisdiction in which the company operates. As you said, Patrick, the attorney is not an advocate for you or not an advocate for me. In a perfect world, let's make this up, every January, we sit down and we have a quick catch-up chat. The attorney might have a quick call with you, “Patrick, what's going on? Any issues? Anything you think we might need to address?”
The same thing for me. I might say, “Attorney, I got some bad news. I was diagnosed with cancer. It's not looking very good. I haven't talked to Fat Pat about it. I haven't talked to anyone about it.” A lot of business owners are like that, as a matter of fact. My old man passed away from cancer. Of course, the family knew about it. I remember being at his funeral and people were like, “I didn't even know he was sick.” He didn't tell anyone. A lot of business owners are like this. I have seen this over the years.
Having that one-on-one conversation with the attorney, I might trust the attorney and say, “Here's what's going on. Here's what we need to anticipate.” Of course, that will raise the adrenaline there in the attorney to look at the things that might be affected should I meet my demise sooner than later and focus on getting those things addressed. A conversation with the attorney is warranted. Oftentimes, there are ways to handle things that partners fight about and they don't realize that there's an actual solution to this. Having a third party come in and look at that might be helpful.
Patrick Baldwin: Paul, you mentioned monthly meetings and quarterly board meetings. I want to stay at the Ritz. You want me to eat at McDonald's. We talk about the shady attorney a long time ago, distributions versus reinvesting, and clip my coupon. Outside of the operating agreement, one-to-one here, how do we make sure that you and I are staying on the same page over time?
Paul Giannamore: It's a difficult one. You talk to any CEO of a publicly traded company, they spend roughly a third of their time dealing with shareholders, dealing with institutions that invest in their company. When you think about a variety of different shareholders out there, even look at a mutual fund, you've got mutual fund, you've got growth investors, and you've got a large cap, and a small cap, you've got defensive. You've got a lot of different flavors and personalities of shareholders.
Some shareholders want to invest in high-growth businesses that don't kick out a lot of dividends and they're focused on reinvesting all that money in the company. Other shareholders or other investors are more dividend-focused, they don't care about long-term or capital appreciation. They want to collect their coupon. Aligning shareholder goals and objectives in a public company with the strategy of the actual company itself is an important job of the CEO in the same way that happens on a small level in a privately held business you mentioned.
I might want to clip coupons. I might want to go to the mailbox every month and there's a dividend check from the business. I don't care about hyper-growth. I don't care about selling this ten years from now. I might not have a job and I might rely on those dividends. Whereas you might be ten years younger than me and saying, “I don’t want to blow the doors off this thing. I'm going to reinvest every single penny in this business so there shouldn't be dividends.”
Starting the business is a good time to have those shareholder-objective discussions where you can sit back. I've been involved in businesses before. One business I'm involved in is a financial investment and I'm on the board and I've said to my partner, “I don't care to get distributions for a decade. At the end of the day, I'm looking at capital appreciation here.” Of course, I won't take a salary, you will. You're involved in operations.
At some point, we will take a look at the dividend policy and we'll make a decision as to ultimately what we're going to do with the business. It’s having those discussions and we see that a lot when you have a younger partner who's the guy who's out operating the business. I can think of Daniel van Starrenburg, for example. He ran a company called SavATree, which now has been bought out for the third time by a private equity firm. He's grown it into a $200 million-plus green industry business up in the northeast.
I've done some work with these guys over the years, great people. His original partner when he was in college was maybe 25 or 30 years older than him. He was a guy that had money and Daniel was out working on lawns and said, “I need to buy some equipment. I can turn this into a business.” Daniel happened to be in college at the time and the guy was like, “Yeah.” They put a little bit of money behind this. They grew the business and he financed it and was a sounding board to Daniel.
Decades later, it's a multi-hundred million dollar business, which is all well and good. Those two shareholders had different objectives. Daniel, being young, didn't need the money, he wanted to roll it all back in and build up the business. His older partner though would've been more focused on dividends, probably earlier. At least having those discussions, like, “What are we going to do from a dividend policy and how are we going to allocate capital?”
As you said, our proximate objective, what are we going to do? Is it five years before we start distributing? What's the purpose of our business? Is this our job? Is this to fund our life? Is this an investment? Partnering with somebody who is using the business to support his family versus being an investment is a different consideration than what I would have, which I wouldn't need to fund or support my family so to speak. Those are important discussions to have upfront and those are important ongoing discussions to have as you think about how to allocate capital and dividend policies and what will be reinvested.
Patrick Baldwin: I do think about our roles in the situation of Fat Pat's Pest. Uncle Paul, you've put in capital and some strategy. I'm putting in time and skills. I'm an employee getting paid that way as well. We've had Mark Winters on the podcast, episode 106. I don't know if this is a visionary integrator relationship that you see or if this is, “I'm CEO and you're the president or chairman of the board.” What does that look like from a governance and how do we figure out what role we fulfill?
Paul Giannamore: In Fat Pat's Pest, for me, it's an investment. I certainly am not even going to be on the payroll. I guess what you're saying is let's say that I happen to live in Waco, God forbid.
Patrick Baldwin: We had an anniversary.
Paul Giannamore: I heard about that.
Patrick Baldwin: The Big 30.
Paul Giannamore: I'm in Waco and we're going to do this together, saying, “Who's going to be an operational control of the business?”
Patrick Baldwin: Are you saying that at that point, if you moved to Waco, you're going to be more involved?
Paul Giannamore: Let's say I was in Waco. Let's live in fantasy land here for a second. I'm in Waco and you and I are running Fat Pat’s Pest Control. I don't believe in the whole co-president-type situation. We see that in a lot of businesses across the industry and I don't think co-president necessarily is ideal. Somebody needs to be in charge.
Let's say your CEO. From a governance perspective, the shareholder agreement boxes in the decisions that you can make and can't make and, ultimately, what you have to come to me for. I still have veto rights even if I'm the secretary and you’re the CEO. I don't know the mechanisms by which folks should determine that. I'm making the point that there should be some corporate hierarchy, I believe.
Patrick Baldwin: What's it going to take to get you to move to Waco, though? A real airport? Taxes?
Paul Giannamore: Moving my casket perhaps, that'll get me to move to Waco.
Patrick Baldwin: Done. Let's write that into the operating agreement. Not just staying on the same page but if we're friends going into it, how do we make sure that we are friends coming out of it? I know you've seen a lot of blowups over the years. If you almost reverse engineer a successful exit as best as possible, with that in mind, how do you get from start to exit without blowing this up?
Paul Giannamore: A lot of partnerships take place that should have never happened to begin with. I've always said you probably shouldn't partner with somebody that you can ultimately buy. You shouldn't be like, “He's good at digital marketing so he should be a partner because he's going to help us with digital marketing,” for example. You could hire somebody to do that. They don't need to be a partner. This is the whole intermixing of the job-related skills people bring to the table versus the actual company's capital structure, which is an entirely separate thing. Who's financing this business is the question.
You and I might be 50/50 partners and let's say we're starting a business and it's a $1 million startup. It doesn't have to be pest, it'll be whatever. It's $1 million. You and I agree we're going to be 50/50 partners. We're in this together. I'm the one who's going to come up with the majority of the capital. I might put in $900,000 and you put in $100,000 and we're 50/50 partners. How does that work?
Patrick Baldwin: I don't know. I like it. Keep going.
Paul Giannamore: You put in $100,00 and I put in $900,000. That becomes the equity capital of the business. I take the remaining $800,000 and I loan it to the business.
Patrick Baldwin: Now what?
Paul Giannamore: Now the business is capitalized. It's got $1 million. It's got $200,000 in equity. It's got $800,000 in debt on the balance sheet. It's a debt to a shareholder. It's a friendly creditor. Now we're off to the races and now we've preserved our 50/50 partnership. We've capitalized the business. Now that we've dealt with the capital structure but what you and I are doing for the business are two different things. Our ownership shouldn't be split up by, “Patrick knows more about bugs than I do so therefore should own more equity,” or you've had more experience. That's not how you should do this because these things always change over time and that's what ends up creating problems later on in the future.
If we know upfront that Paul is a capital source and he's on the board and he's going to provide us advice and he's going to help us build out the team and we're clear about what I'm going to do, what I do, and don't do. We've set up the cap table and we've made our financial investments. Patrick, if you've got to work overtime, you're the CEO, you get paid $150,000 for being the CEO. You'll take dividends at some point. If you've got a toil night and day, that's the job of being the CEO.
Patrick Baldwin: I'm up for it. I got this.
Paul Giannamore: Those things will change over time. I would say the most common thing I hear is, “Hi, Paul. My name is John. I got a partnership with Chris. In the beginning years, he worked super hard. Now I feel like I'm doing everything and he's not doing anything or his skillset is no longer relevant to the business. I'm the one growing it and he's not doing much.” Maybe his skillset was extremely valuable. Maybe he contributed that as part of his capital in the early years and now he's not required. You're mixing ownership with position within the company.
If you, as a shareholder, can separate those things upfront and say, “This is the ownership. It has nothing to do with what we contribute on the day-to-day.” “Patrick works nights and weekends so he should be a bigger shareholder.” “Paul doesn't so he shouldn't be a shareholder or he should own less of the business.” Those are two separate things. If I owned Rollins’ stock, no one's calling me from Atlanta saying, “Paul, you slept in on Sunday morning. You need to get rid of a few shares.” That's not how life works.
Shareholders enter into these relationships understanding how this works and how this should work and documenting that. Sometimes it's appropriate to put preambles in agreements. A preamble is effectively part of a contract that's not contractual, it doesn't find itself within the four corners of the contract but it's on the actual document. It's a recital of why we're doing what we're doing and the beliefs that we currently have as to why we're entering into this.
We might say something to the effect, “The shareholder agreement below was agreed upon on such and such a day in the presence of so and so and we've entered into this knowing that Paul will not be an active part of the management of the business. He is contributing X amount of dollars and here's what he will do going forward. Patrick will be contributing Y and this is what he's going to do going forward.”
I've seen people be colloquial with these things, saying, “It's going to be super hard on Patrick. It's going to be like long hours and all that jazz. At the end of the day, Patrick should always keep in mind that Paul was here in the beginning. He established this, he put in this capital, and so on and so forth.” The partnership works together to think about these capital allocation decisions and lay them out. What it is it's all the discussions that you and I are having and then ten years from now, you and I are going to remember those differently.
Patrick Baldwin: It helps our recall.
Paul Giannamore: It's not a contract, it's a preamble, or sometimes it might be even an ancillary agreement to a shareholder agreement. It's a memorandum written folksy, written in crayon, or however you want to do it. It's something we can point back to and say, “PB, I know you're frustrated because it appears that I don't do much. If you remember, I'm the reason we started this business because I put in $900,000 and you put in $100,00. We would've never done this without me. I told you from the get-go, it's going to be hard work. You're going to be the president. We're going to own this thing 50/50.” At some point in time, we're going to sell this. I'm okay with not taking dividends right now and I'll do that as long as I have to. You've got a family to support.
This, for me, is an investment. Don't come back to me ten years from now and be like, “Paul, you didn't do much. I'm the guy who's working all the time.” At the end of the day, you are getting paid to be a CEO and I am not. That's right. If we lay this out, it can very much help those future discussions when people forget that thing. This is always ever present in my mind because I hear it all the time. If I look here in our system, we've probably two dozen of these people that have called saying, “I'm having a partner dispute. I need evaluation,” or, “I need this,” or, “I need that.”
Patrick Baldwin: What about overtime? We put in $1 million and $2 million of that was for equity and $800,000 is debt. What if in the future we need to raise capital? Do we establish that now for future capital calls? Is that call for dilution? Do you do future debt? How do you structure the future that way?
Paul Giannamore: You would have a variety of different provisions in there for anti-dilution-type rights. Let's say that you've grown the business and now there's an acquisition opportunity and you need capital to make the deal. We need $1 million and we look around and you're going to put in $300,000 and I'm going to put in $700,000. Is that a loan to the company? If I put that money in there, am I diluting you out? You raise a good point. You should think about how that's going to happen.
Patrick Baldwin: Is there an answer?
Paul Giannamore: You can do a variety of different things. For most privately held businesses that are non-institutionally owned, the partners will try to revert to a loan to the business. Sometimes as you start to grow and you're taking on institutional financing, that loan is not going to be helpful, it's got to be equity. If I put in equity, am I buying equity at your expense and diluting you out? Probably.
Patrick Baldwin: Careful. Fat Pat got to eat.
Paul Giannamore: There are provisions that can be figured out. The good news is that in the world that I live when I see disputes among shareholders, I have yet to see that one as a real issue.
Patrick Baldwin: A lot of this scenario was you and me, two partners. Especially as you were talking early on the door-to-door that spin up these businesses, a lot of times, it's more than two partners involved, which has become more complex as you add a 3rd or 4th partner into a business.
Paul Giannamore: In some ways, it can almost even become easier. When you get more heads in there thinking about different potential issues when you're drafting these things, it could be helpful. I don't know if it gets more complex because I see the same issues with two partners that I do with guys with 3 or 4 partners.
Patrick Baldwin: Paul, I'm always looking for a common trait. This is a few years back but what makes these people successful? We talked to early Boardroom Buzz guests, episode 5, Tony Sfreddo, episode 10, Mike Rogers, and I was like, “What is it?” I was not expecting that you said there's a humility trait there that made these guys successful. Based on the conversation we've had, is there a trait on the flip side in which you see partnerships in these huge blowups? Is there a common trait or common theme there that you've noticed?
Paul Giannamore: Absolutely. Conflict avoidance. This is a deadly poison in businesses. We live in a world where if you're in a privately held business and because you're the owner, all of a sudden, now you're in charge of it, which doesn't make sense. There's a distinction between a manager and a shareholder. There's a distinction there at a public and traded company level and there should be at a private level but that's not how it works. I own the business and I'm in charge.
Whether you have partners or not, one of the worst places to work is to work for a company where the boss is a conflict-avoider because things happen over time. We were talking about you going out and blowing all this money at the Ritz-Carlton going to Pest World. Folks do things over time, the boss avoids conflict, doesn't address it, and then, of course, it builds up until one day he goes up into the clock tower with a rifle, and that's how it all explodes.
Patrick Baldwin: Another Texas reference. Thanks, Paul.
Paul Giannamore: It's the same thing with shareholder agreements. If you don't address the small conflicts, they turn into bigger problems in the future. I would say conflict avoidance is a trait that I can look at the wreckage that comes to me now and quickly say, “That was done by this individual and it is a result of decades of conflict avoidance. Here's how we've arrived here.”
Patrick Baldwin: That's fascinating. I was not expecting that answer so I appreciate it.
Paul Giannamore: This is timely because I had a YPO forum meeting and one of the things that we focused mainly on is fierce conversations.
Patrick Baldwin: I've not heard the term fierce conversations.
Paul Giannamore: I hadn't heard of the term till yesterday either. Having those direct discussions made me think quite a bit about communication within organizations sitting through and listening to that to breakthrough from conflict avoidance.
Patrick Baldwin: Are there some takeaways you can share for those that are conflict avoidance? We interviewed, back in Atlanta, Victoria Roos Olsson and Andreas Olsson came along because she needed a ride. They're great people. She co-authored Everyone Deserves a Great Manager. There was a chapter in there that hit me about leadership and conflict avoidance.
Paul Giannamore: I do remember having to chit-chat about that with her. It's been a while since I peruse that book and it's a relatively easy book to read.
Patrick Baldwin: It is an easy book to read. It's a good book.
Paul Giannamore: We went deep into how to clear the air so to speak and address things in a corporate setting. Maybe that's a great episode to do. If that's the case, I might know a few people to bring in for it. Shall we maybe punt this into a future episode?
Patrick Baldwin: Yeah, let's do that. That'd be awesome.
Paul Giannamore: We'll do that. To recap this, Patrick, most people don't have shareholder agreements. They're referred to as buy-sell agreements, operating agreements, and shareholder agreements. There's a variety of terms for these and are all the same thing. Most people don't have them. If you do not have one, you're not alone but it's never too late to do it. You can be in business with a partner for five years and not have anything on paper and you can sit down and say, “We need to get serious about our future. Let's document this. At a bare minimum, we should know what happens, if you die, if I die, if one of us gets sick, and all those things.”
If you sit down with an attorney, because this ultimately becomes a legal document, that has a lot of experience in drafting these things and he's representing the company, he can explain to you what you should be thinking about and the questions that you need to answer and then you can ultimately document it. If there's any backstory that wouldn't show up in the shareholder agreement, you can certainly document that in some recital or preamble so that you guys have that on paper.
The next part of this is you should think about the voluntary or the involuntary exit. What triggers an involuntary exit? How will you fund that if somebody needs to be bought out? If there are buyout provisions, have you gone out and gotten life insurance for the shareholders in case something happens? Have you tied that to the buyout provisions? That's something to think through. In order to do that, you're going to need to come up with a methodology for valuing that business.
It is more elegant and simple and easier in the event somebody dies for the estate to deal with clear formulas as to how to come up with value rather than go out and get a bunch of appraisals and then battle it through. We also talked about the fact that just because you and your partner own a business doesn't necessarily mean that you have to work for the business. Whoever's working for the business should be compensated based on our market structure. What else did we talk about, Patrick, in summary here?
Patrick Baldwin: Conflict avoidance is the one that sticks out. Deal with it. Come out and talk about it. Going into it, like, “Here's how we're going to talk about things.” Am I going to pick up the phone and call you as soon as it happens? Are we going to have a weekly call once a week and get all of our issues out to vent? Are we going to bring a third party in to have these conversations if it gets to that point? That's something that can help you in all aspects of life, dealing with stuff. It's my life lesson for the day.
Paul Giannamore: Mr. Fat Pat, that's it. I am back on the road.
Patrick Baldwin: I’m going to figure out a good place for your casket in Waco, Texas.
Paul Giannamore: I appreciate that. Hopefully, you can hold off for many moons.
Patrick Baldwin: I hope so. I don't want your plane to fall.
Paul Giannamore: Thank you.
Dylan Seals: Thank you so much as always for supporting us at The Boardroom Buzz. We know your time is valuable and the fact that you spend 45 minutes or an hour with us means the world. All the media that we put out from Potomac is meant to honor and celebrate you, the service industry owner. As Paul would say, “Yee who toil in the pest control vineyards.”
As part of giving back, we have this podcast, but more than that, Paul and I have been working our tails off over at POTOMAC TV. We've spent a tremendous amount of time, energy, and resources to build out that platform to bring you market updates, to bring you visual breakdowns of the merger acquisition process, and to tell stories and present information in ways that, frankly, it's not possible for us to do on The Boardroom Buzz.
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Everyone Deserves a Great Manager