If the business eventually will be sold, a prospective buyer may pay more if he or she knows these key employees will stay and help manage the business. A stable, motivated management team is an attractive asset. It also may be the most logical buyer. In fact, in appropriate situations, an employee stock ownership plan, or ESOP, is an effective arrangement for facilitating a management buyout.
But if the business eventually will pass on to members of the owner's family, on the other hand, the succession plan may have a greater chance of success if these key employees stay and help the new managers of the business. Will they want to stay and train the new owners/managers or will they accept a competitor's offer?
I am discussing "key" employees, rather than just employees in key positions. Who are the people whose absence would cripple your efforts? Those are the ones you should motivate and retain if at all possible.
How can you retain and motivate these key employees? If your reward system consists of compensation and a year-end bonus that you alone determine, it may be appropriate to consider alternative systems.
Any reward system must include at least these elements:
• The plan must provide financially attractive rewards. It should have a potential bonus of at least 10 percent of the employee's compensation. Anything less than this amount will probably not be sufficient to motivate behavior.
• The plan must be specific. Make sure it has measurable performance expectations.
• The plan must increase the value of the business. The measurable performance standards, if achieved, will boost the company's profit, for example.
• The benefits must be vested, but can be deferred. The plan should be structured to encourage the employee to remain on the job to receive the reward, with the reward to be paid only a set number of years after it is earned.
• The plan must be fully communicated in writing. It must be thoroughly understood by the key employees. Opportunities must be presented for the employees to ask questions face to face with the business owner.
Should the reward be paid in cash or in stock? Many business owners may be overly generous with their key employees and award stock for superior performance. While those new owners may become more loyal and motivated, the grant of an ownership interest can also make other employees jealous and resentful.
Some minority shareholders may find themselves holding the tie-breaking shares if there were deadlocks among the majority owners. There may be no mechanism to buy back shares if there later were a parting of the ways.
A non-qualified deferred compensation plan avoids many of these problems. Because it is "non-qualified," the onerous requirements of the Internal Revenue Code applicable to tax-qualified plans do not need to be met, such as annual reporting, prohibited discrimination, minimum employee coverage and the like. With the exception of withholding for FICA taxes, the benefits are typically not taxable to the employee until paid or, if earlier, no longer subject to a substantial risk of forfeiture.
The plan may provide for a reward to the key employee determined by an incentive formula, to be paid to the employee at a future date. The plan should be structured so that it is funded only in years when the business is profitable. Determine the time(s) in the future when the reward is vested, so the employee is financially encouraged to stay with the business.
Provide for a forfeiture of the reward if the employee is terminated for cause or violates a covenant not to compete. Finally, care must be exercised to fund the company's liability under the incentive compensation plan without subjecting the employee to current income taxation.
Recall that the success of your business may depend in large part on the past and future efforts of these key employees. Take steps now to create incentive compensation plans to reward them for performance and to encourage them to remain as your management team.
Manterfield, a partner in the law firm Krieg DeVault LLP, assists family businesses with succession planning. The information in this column is not intended to be legal advice.