By Maurie Cashman
Stock bonus plans have many advantages over traditional employee incentive plans, which are designed to motivate employees to work smarter and harder.
Last week we discussed how retaining ownership of a business while backing away from the daily management is a question we often get from owners. They wonder if, rather than exiting, they can back away from their company.
Stock-based employee incentive plans can achieve this and a number of additional purposes.
- Retain employees through an ownership transition;
- Motivate employees to increase company value to provide the departing owner with financial security;
- Reward employees for performing at a superior level.
- Facilitate the transfer of ownership in anticipation of an owner’s exit.
- Awarding ownership provides an owner the opportunity to observe how ownership changes the behavior of an individual before committing to sell more significant ownership.
- Future distributions from the bonused stock can be used to partially pay for future sales of stock to that same individual.
The Case of Fictional Owner Adam Norton
Adam Norton was the sole owner of Norton Glass, a manufacturer of commercial greenhouses. Adam decided at age 54 that he did not want to die owning the business. He had assembled a talented management team that could run the operation. Adam did not believe he could sell to a third party-given the lack of M&A activity in his industry and really preferred to pass the company to his long-timed employees. Adam felt that his employees were receptive to the idea so he wanted to know what to do next.
We tested two of Adam’s key assumptions:
- Were Adam’s key employees capable of running the operation? With the exception of accounting, Adam’s key employees could carry on without him.
- Did Adam’s employees want to buy the company? Four of Adam’s key people had expressed interest in purchasing ownership if Adam were ever to offer it.
At this point, we felt comfortable talking to Adam about a Stock Bonus Plan.
Features of a Stock Bonus Plan
Types of Stock Awards. The stock can be unrestricted or subject to a substantial risk of forfeiture. Forfeiture is an important design feature and means that if an employee leaves before a certain date, he forfeits all or a portion of a previously awarded stock bonus. We design forfeiture provisions to support the owner’s transition objectives. For example, if an owner plans to leave her business in five years, the forfeiture period lasts at least five years and typically beyond that date, unless other incentives, such as buying the rest of the company, are in place. By encouraging key employees to stay beyond the owner’s departure, it helps to ensure that the business continues with minimal disruption caused by the owner’s exit. This is important in protecting the value of the business when selling to either insiders or outside third parties.
Determination of Bonus. Like any other bonus, owners can base a Stock Bonus on a performance standard: If business makes $X or does “X,” 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 transition goals, advisors can design:
- the amount of ownership to be awarded periodically;
- the performance threshold required before a bonus is earned; and
- the forfeiture provisions of the plan.
Adam and Peace of Mind
Designing a performance threshold combined with forfeiture provisions gave Adam some peace of mind. After all, he was in effect giving part of the business away and he wanted assurance that the result would be motivated key employees who were committed to the business, and were motivated to increase value and cash flow for the business and ultimately for themselves.
The Performance Threshold. Under the Stock Bonus plan, Adam’s two key employees were bonused 3 percent of the ownership annually over five years, provided the business attained a pre-determined annual cash flow threshold. That performance threshold increased annually. The increases were calculated so that if the covered employees met them, Adam’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 forfeited that bonus.
By embedding a substantial risk of forfeiture, the design achieved two goals.
- Adam was not giving stock to employees who could walk out the door and cash out their stock.
- The key employees were “handcuffed” to the business (the “golden handcuffs”). This was important in preserving the most valuable assets of the business – the key employees.
- There was no cash flow from the business until the forfeiture period had passed.
- In order for the employees to receive the bonus they must take actions that increase the value of the business. As they acquire more stock this incentive becomes even stronger.
- By requiring the business to meet increasing performance levels, the plan can be designing to pay for itself through increases in the value of the business.
- The receiving employee incurred no income tax until the forfeitures lapse. A stock bonus, like a cash bonus, is compensation and taxed accordingly if not subject to a substantial risk of forfeiture.
Before designing such a plan, it is critical that owners determine all of their exit goals and assess the gap between the goals and resources available to meet those goals. Only then can tools such as stock bonus plans be designed for maximum impact.
Next time we will discuss additional stock bonus plan considerations.