I was working with a business owner on ideas for retaining a key employee. The employee was threatening to leave for a higher paying job, declaring “I love working here, but if I’m going to stay, I want to have some skin in the game.” I started explaining to the owner why he should avoid offering the key employee stock as an incentive. He stopped me, and asked that I first give him an idea of some of his options. “I don’t even know where to start; what kinds of plans are there that can help an employee feel he or she has a financial stake in the company, and will be rewarded for contributing to our success?” Fair question. The challenge is too many options; not too few.
To get the process started, following is a checklist of possible “skin in the game” opportunities. A convenient way to sort through these opportunities is to consider: which plans share equity in the business, which share ownership of the business and which are for key personnel versus employees in general.
- Sharing Equity, not Ownership; Employees in General
- Bonus Pool: An employer can establish a regular pay schedule, and supplement it with a year-end bonus based on company performance. Typically, the employer would declare a bonus pool after year-end financials are completed and pay the funds out to eligible employees based on pre-set metrics or criteria. This is a form of profit sharing that is outside of qualified and nonqualified plan rules, and it is important that this compensation be paid shortly after it is earned.
- Qualified Profit Sharing Plan: A qualified profit sharing plan gives employees a feeling of ownership without distributing profits currently. These plans have tax advantages for both the employer and employee, but require adherence with qualified plan rules. The company decides what portion of the company profit will be shared and that amount is then contributed to the plan, allocated to employees’ accounts and tax-deducted. Because it is a qualified plan, there are restrictions as to when and how employees can withdraw these funds.
- Sharing Equity, not Ownership; Key Employees
- Variable Pay Performance Bonus: Procedurally, a performance bonus is similar to the bonus pool arrangement, but this bonus is targeted at key employees who are assigned specific and measurable company goals. Each key employee is given an individual goal at the beginning of the year; and, if achieved, is rewarded with a bonus at the end of the year. This arrangement is especially effective when the employee has significant control and involvement in the outcomes that determine the level of the bonus.
- Performance-Based Nonqualified Deferred Compensation: Employers who seek not only to reward key employees, but also retain them, will often use nonqualified deferred compensation arrangements. The plan can be designed so the employer’s contribution is based on the employee’s meeting of performance targets. Rather than paying the award in cash, however, it is credited to a deferred compensation account that will vest and be paid out in the future. Common designs of this plan include Phantom Stock and Stock Appreciation Rights. There are, however, a number of other ways to design these programs that use employee-targeted metrics (i.e. sales or profits goals) beyond just the value of the company’s stock.
- Sharing Ownership; Employees in General
- Employee Stock Ownership Plan (ESOP): An ESOP is a qualified plan that allows the employer to borrow money to fund the plan, and is designed to be primarily funded with the company’s stock. This plan offers significant tax incentives, both to the company and current stockholders, plus it creates significant motivation to employees. The employees aren’t direct stockholders, but they become owners through their participation in the company’s qualified plan.
- Employee Stock Purchase Plan (ESSP): ESPPs allow employees to purchase shares of their employers’ stock, typically at a discount, by using after-tax payroll deductions. They can be divided into two categories: qualified and nonqualified. Qualified ESPPs offer tax advantages, but must follow qualified plan rules, including offering to a broad base of employees.
- Stock Options: A stock option gives an employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years. Employees with stock options hope the share price will go up so they will be able to profit by purchasing the stock at the lower grant price, and then selling the stock at the current market price. There are both nonqualified and qualified (incentive stock options) plans. Although stock options are usually thought of as an incentive for top management, some industries offer broad-based stock option plans.
- Sharing Ownership; Key Employees
- Stock Options: A way for management and key employees to both profit from the company’s success and share in eventual ownership is through stock options. They are often used as a form of incentive compensation for the executive leadership in established or growing companies. Typically using nonqualified stock options, companies will grant options to select employees that are designed to vest in the future. Although there is no significant tax advantages involved, these plans give executives the motivation to work hard, have some control over timing of their profits and are a reason to stay with the company.
- Restricted Stock (RSU): These are typically granted with restrictions as to vesting or ability to sell. When used as a form of compensation, stock typically becomes transferrable or vested upon the satisfaction of certain conditions, such as continued employment for a period of time. And, sometimes the achievement of particular financial targets is required before vesting. The stock value is taxed to the executive when the risk of forfeiture no longer exists.
When a key employee demands to have skin in the game at the company, the natural assumption is that he or she wants to own company stock. In reality, the employee may not want to contribute capital when it’s needed, pledge personal assets to cover a loan or share in the burden of company taxes on undistributed profits. There are other ways to satisfy their needs which may be just as, if not more appealing. Consider all the options before you jump to the first thing that comes to mind.