Identifying and retaining key employees will grow your company and solidify your own exit strategy.

By Dyanne Ross-Hanson

Experts and laymen 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 business owner. They think like you and they act like you. 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, they are also a key component to the business owner’s successful exit strategy.

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 amount you’ll receive 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.

One of the many factors involved in creating, motivating and keeping key employees is the creation of a properly designed incentive plan for key employees. Successful plans share four basic elements:

First, the plan is specific. Employees know, in advance and in writing, what standards need to be met to receive the incentive. These performance standards need to be measurable, i.e. company net income or revenue levels. The key employee earns the incentive bonus based on this performance standard, which 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 (either 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 he or she is “fully vested,” he or she forfeits at least part of the deferred benefit.

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 best to present the plan face-to-face, with advisors present to answer any questions.

Having identified the elements that make up a successful incentive plan, you (as an owner) and your advisors must determine whether a stock-based plan or cash-based plan (or some combination thereof) will best motivate your key employees and cause them to stay with your company.

Equity-Based Plans
Providing the opportunity for stock ownership is one of the most powerful motivating and retaining factors 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 also enjoy the right to access company books and records, the right to be informed about the financial condition of the company (including your 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.

Cash-Based Plans
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.

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 a NQDC are not taxable until received. It is often advantageous to structure the payout over a multiple-year timeframe. This reduces the employee’s tax obligation and prevents giving a vested employee “seed money” to start a competing business.

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 employees’ account. The value of the phantom stock increases as the true stock value increases. When the employee terminates employment, the company pays him or her the per share equivalent value for each of the vested Phantom shares in his or her 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 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 the 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.

Dyanne Ross-Hanson is the founder of Minnesota-based Exit Planning Strategies, LLC. Her company helps business owners achieve their financial and exit planning goals by making more informed, more strategic, and more tax-efficient choices. She can be reached at drh@exitplanstrategies.com.