Smart Incentive Plans Are Key to Successful Exit
MOST PEOPLE AGREE that one constant of successful companies is a loyal, motivated group of key employees.
Who are these key employees? They behave much like you, the owner. They typically ask for more challenges and opportunities. They want to prosper and grow as the company does.
These qualities not only contribute to corporate success, but they are also key to the business owner’s successful business exit.
You may be wondering what motivating your key employees has to do with exiting your business. Should you decide to sell your business to a third party, you’ll discover that potential buyers place significant value on the strength of your management team — if that management team can be expected to remain after you have left the business.
Similarly, if you contemplate selling the business to family (or to employees), the likelihood of being paid for the business after you’ve left is entirely dependent on the strength of your remaining management team.
In short, capable management remaining with the company is the key to getting top dollar for your business. So how do you keep them?
Tips:
Successful incentive plans share four basic elements. First, the plan is specific.
The incentive is substantial, up to 25 percent of annual compensation.
The plan handcuffs employees to the business.
The plan is communicated in writing, initially with advisers present.
First, the right incentives.
One of the many factors involved in motivating and keeping key employees is the creation of a properly designed incentive plan.
Successful incentive plans share four basic elements:
First, the plan is specific. Employees know in advance what standards need to be met to receive the incentive. These performance standards need to be measurable: for example, company net income or revenue levels. The key employee earns the incentive bonus based on this performance standard, that when attained, increases the value of the business. This element is critical in a properly designed incentive plan.
Second, the incentive is substantial. For many years, a bonus of at least 10 percent of annual compensation (in stock or cash) was the minimum necessary to motivate a key employee. But today, the minimum potential incentive has risen to 25 percent of annual compensation, and sometimes more.
Third, the plan handcuffs key employees to the business. Employees are motivated to stay with the company. If the employee severs employment before being “fully vested,” at least part of the deferred benefit is forfeited.
Fourth, the key employee plan needs to be communicated in writing. To be successful, key employees must understand exactly how the plan works. It is effective to present the plan face-to-face with advisers present to answer any questions.
Having identified the elements that make a successful incentive plan, you (as an owner) and your advisers must determine whether a stock-based plan or a cash-based plan (or some combination thereof) will best motivate your key employees
and cause them to stay with your company.
“In short, capable management remaining with the company is the key to getting top dollar for your business.”
— Dyanne Ross-Hanson, Exit Planning Strategies LLC
Give them equity
Stock ownership is one of the most powerful things a closely held business can offer to a key employee. It ties them to the company by making them part of it. It often requires them to pay for ownership. This demonstrates their dedication and commitment to the company.
Stock ownership also provides strong incentive for increasing the value of the company. These are all great reasons for transferring stock.
I would be remiss, however, if I didn’t mention the “not-so-great” aspects of transferring stock to employees. Even a minority position carries with it significant rights.
Shareholders enjoy more than the right to share in the growth of the company. They enjoy the right to access company books and records, the right to be informed about the financial condition of the company (including the majority owner’s salary and perks) and often, a right to be consulted and given the opportunity to vote on major company decisions including future sale of the business.
Or, give them cash
Most key employee incentive plans are cash-based rather than ownership-based. Or they take the form of rights to appreciation in stock value rather than stock itself. The primary cash-based incentive plans include Non-Qualified Deferred Compensation Plans (NQDC), phantom stock plans and Stock Appreciation Rights (SAR) plans.
Based incentive plans include Non-Qualified Deferred Compensation Plans (NQDC), phantom stock plans and Stock Appreciation Rights (SAR) plans.
The NQDC plan is a promise to pay benefits in the future. When contributions are based upon performance standards, funding the plan is often tied to profitability.
Contributions are flexible and carry no minimum or maximum limits unlike most
Qualified Retirement Plans. NQDC plans can be completely discriminatory. Owners can vest future benefits or make them totally contingent upon staying with the company for a designated period of time.
Forfeiture provisions are commonly part of the plan design. Benefits awarded to a key employee under an NQDC are not taxable until received.
It is often advantageous to structure the payout over a multiple-year timeframe to reduce tax obligation and to prevent supplying vested employees with “seed money” to compete with the company.
Phantom stock offers key employees something that looks like stock, grows in value like stock and can be turned in for cash just like stock, but is not stock.
Phantom shares corresponding to shares of stock are allocated to the participating employee’s account. The value of the phantom stock increases as the true stock value increases.
When the employee terminates employment, the company pays the per-share equivalent value for each of the vested phantom shares in the account.
A Stock Appreciation Rights (SAR) plan is similar to the phantom stock plan in that the value of benefits in the SAR plan is tied to the value of the corporation’s stock.
Unlike with phantom stock, the employee under a SAR plan is only entitled to receive the appreciation on a certain percentage of SAR units valued against the corporation’s stock, not the entire principal value of the stock.
In all of these cash-based incentive plans, success depends on careful design of vesting, forfeiture, payment schedules and funding devices.
Motivating key employees is critical to the overall success of your business.
Not only do they represent your greatest business asset, they likely will be sending you the checks to support your retirement years.
Contact
Dyanne Ross-Hanson operates Exit Planning Strategies LLC:
651.426.0848;
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