The benefits of employee incentive plans are to motivate employees to work harder and smarter. In Capturing Synergy in Acquisitions we discussed how companies capture the benefits they anticipate from an acquisition. A key to any transition of ownership is preserving the most important asset – the key employees. We often deploy several types of stock-based employee incentive plans to accomplish a number of purposes:
- Motivate employees to increase company value to provide the departing owner with financial security.
- Retain employees through an ownership transition.
- Reward employees for continuing to perform at a high level.
When transitioning to insiders, an additional purpose of a stock bonus can be to accelerate the transfer of ownership in anticipation of an owner’s exit. This accomplishes at least two objectives:
- Awarding ownership provides an owner the opportunity to observe how ownership changes the behavior of an employee before committing to sell more ownership;
- Distributions from the bonused stock can be used to partially pay for future purchases of stock to that same employee.
Earl Oriole was the sole owner of Oriole Grills, a manufacturer of wood grills. Earl decided that he did not want to die at the plant without enjoying the benefits of his labor in retirement. He’d assembled a talented management team that could run the operation. Given the lack of M&A activity in his industry, Earl didn’t believe he could sell to a third party, and he preferred to pass the company to his loyal employees. Earl felt that his employees were interested in the idea so he wanted to know what to do next.
We discussed Earl’s assumptions with him:
- Did Earl’s employees want to buy the company? At least four of Earl’s key people had expressed interest in purchasing if Earl were ever to sell it.
- Were Earl’s key employees capable of running the operation? We found that Earl’s key employees could carry on without him if a key sales function were added.
At this point we felt comfortable talking to Earl about a Stock Bonus Plan.
Features of A Stock Bonus Plan
Determination of Bonus. Like any other bonus, owners can base a Stock Bonus on performance: If the business makes $X or meets certain standards, the employee receives a predetermined amount of ownership. Alternatively, owners can simply assign whatever bonus amounts they feel are appropriate. Based on the owner’s exit objectives, we can design the amount of ownership to be awarded annually, the performance level required before a bonus is earned, and the forfeiture provisions of the plan.
Types of Stock Awards. The stock can be unrestricted or subject to a “substantial risk of forfeiture.” Forfeiture means that if an employee leaves before a certain date, he or she forfeits all or a portion of a previously awarded stock bonus. We design forfeiture provisions to support the transition objectives. For example, the forfeiture period typically lasts beyond the owners targeted exit date. This helps to ensure that the business continues with minimal disruption caused by the owner’s exit, enhancing transferable value.
Peace of Mind
Designing a stock bonus based on performance with forfeiture provisions can provide some peace of mind by giving some assurance that key employees are it in for the long and are motivated to increase value and cash flow for the business and themselves.
The Performance Threshold. Under the Stock Bonus plan, Earl’s two key employees were bonused 4 percent of the ownership annually over five years, provided the business attained a pre-determined level of annual cash flow. That performance level increased annually. The bonus plans was structured so that if the employees achieved their bonus, Earl’s financial security goals would be met as well.
Forfeiture. If a key employee left before five years from the date ownership was bonused, he or she forfeited that bonus.
By embedding a risk of forfeiture, the design achieved two goals.
- Earl wasn’t giving stock to employees who could walk out the door and cash out their stock;
- The receiving employee incurred no income tax until the forfeitures lapse. A stock bonus is compensation and taxed accordingly if not subject to a substantial risk of forfeiture.
Before designing a stock bonus plan, it is critical that you determine all of your exit goals and determine the gap between those goals and available resources. Stock bonus plans can then be designed for maximum benefits.
Next week we will discuss additional stock bonus plan design considerations and benefits.