What’s the best way to assure the business’s survival? — A stable, motivated team. The future of the business depends on how securely the key employees are tied to it. Businesses use a variety of incentive packages designed for team retention. These plans are generally categorized as equity or non-equity based and share 5 common features: the benefits are substantial, measurable, aligned with the attainment of the business’ benchmarks and given according to a vesting schedule. These plans also have legal safeguards that help mitigate risks to the company and other equity holders.
Equity Based Incentive Plans
There are few better motivators for retention than making an employee an owner. Ownership immediately changes one’s perspective. The key employees/owners will be more loyal (“the company is I”), more committed for the long haul and more likely to see their financial and psychological goals as tied to the growth of the company.
Granting an ownership stake comes with certain corporate risks. Even minority shareholders have substantial legal rights, which include the right to be informed of and vote on decisions of the company, to have access to company books, and be informed of finances, including other owners’ salaries and perks.
Moreover, as in a marriage, taking on an owner/partner is easy to get into, and can be tough (read: costly) to get out of. Companies have been known to be held hostage by a disgruntled key employee/owner who wants out and now has the leverage to make demands, no matter how unreasonable.
Tip: There are legal safeguards that can reduce or even eliminate these risks. Two of the most important are the buy-back provisions for retrieval of the equity (in case things turn out badly) and fixing the value of the retrieved equity in the event of a repurchase at the outset (capping monetary risk).
Non-Equity Based Plans
Realizing that equity is not right for everyone, non-equity based incentive plans avoid some of the risks associated with granting ownership and are often used by small and mid-size companies where ownership structures are limited and closely held.
Cash bonus plans are offered when key employees meet measurable goals. Bonuses can be a flat sum, percentage of profits or based upon some other metric. Bonus plans motivate employees without the risks associated with equity plans. But, monetary rewards may not help retain key employees and require the company to make cash outlays at given intervals.
Nonqualified deferred compensation plans promise to pay monetary benefits in the future based on current or past services of a key employee. As “nonqualified” plans, they do not have to meet the formal reporting and discrimination testing requirements of qualified plans under certain federal statutes, including the Employee Retirement Income Security Act (ERISA). In addition, benefits awarded usually are not taxable until the date when they are paid to the employee. IRS aggressively regulates this taxation and businesses must be careful to not fall into common pitfalls (see the Internal Revenue Service 409A regulations for example). Forfeiture provisions offer an additional safety net, as owners can reclaim some or all of vested benefits if the employee leaves or violates an employment agreement (like a restrictive covenant).
Similar plans — known as phantom equity plans — are becoming increasingly popular tools to incentivize key employees. Perhaps because such plans offer the best of both worlds — they offer payouts mirroring the payouts of true equity holders but without the risks of true equity based plans because the equity is phantom, not actual true equity. These plans also require careful planning to make certain that federal regulations, such as the IRS 409A rules, are satisfied.
Retaining key employees is crucial to growing the value of a business and to the owner’s goal of one day converting that business to cash. A well designed key plan can be a highly effective retention tool if it is provided with forethought as to the proper recipients as well as to effective plan design and the implementation of necessary legal safeguards.
Such plans provide the measurable, specific and substantial incentives that induce key employees to cast their lot long term with the business and see their best future in terms of the business. Note: These plans are not “set it and forget it.” Review your annually to ensure they are “on track” with business realities and corporate goals.
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