Monday, January 23, 2012

Equity Not Required -- 5 Alternatives to Equity for Key Employees

"I want him to have a piece of the action." "I want him to have some skin in the game." "He wants equity in the company." In this case "him" is a key manager or valuable employee, male or female. If you're a business owner, you've probably said or heard one of these things. They come up all the time in meetings of Chief Executive Boards International.

There are two sets of assumptions in these statements, both usually mistaken. The employee assumes that he'll become richer if he has a piece of ownership in the company, and that the owner would be inclined to gift that to him. The owner assumes the employee understands the risks and rewards of business ownership, and is willing to take them, including putting some money at risk.

What the employee is usually saying is, "I want to make more money, and I want to be recognized and rewarded for my contribution to the company's success." What the owner usually wants is a way to motivate the employee to better performance, to think more like an owner, and to have some "bronze handcuffs" that would disincentivize him from leaving.

So, business owners spend an inordinate amount of mental energy, consulting fees and legal fees to put plans in place to accommodate additional owners (partners). You need buy-sell agreements, valuation plans, stock restriction agreements, non-competes, employment contracts and a variety of other suspenders and belts to make this work. And then?

"You want me to PAY for that?", the formerly-interested would-be partner exclaims. That's when the business owner gets offended. He can't believe, after all that begging and what he's spent to set the company up for multiple owners, the employee thinks he's somehow entitled to the gift of equity. I've actually seen long-time great relationships between owners and key employees spoiled by this misalignment of expectations.

So, what are the options? First, when the topic of equity comes up, make your position clear -- you're not giving it away and you're not buying into the idea of "sweat equity" (a euphemism for giving equity away). One CEBI member suggested the best response to "I want some equity" is, "How much is your house worth?", meaning "How much money could you come up with to buy into the company?"

That's usually the end of the equity conversation -- when the employee realizes he's going to have to actually put something at risk. So, what are some alternatives to meet both the objectives of both the employee and yourself?
  1. A well-defined current-year incentive compensation plan that pays out annually. Then give the employee the option of diverting a large portion, if not all, of that payout into a qualified retirement plan (SEP, SIMPLE or 401(k)).
  2. A long-term incentive compensation plan that accumulates performance over, say, 3 years and then pays out similar to #1 above.
  3. A deferred compensation plan. This is usually calculated on the same basis as options 1 or 2 above, except that the payout isn't immediate -- it is deferred into the future, thereby incentivizing the employee to stay and quantifying the "leave behind" in case of termination. These types of plans usually "vest" some number (3-5) years after the incentive is earned and then pay out upon reaching an age, say, 60 or 65 or in the case of change of control (you sell the company).
  4. A phantom or shadow stock plan. These plans are not "real" stock. The employee is neither an investor nor shareholder. It's essentially a promise of the company to pay in the future some compensation that emulates the outcome of stock actually owned. Shadow stock would be awarded as part of a well-defined incentive compensation plan.  The shadow stock would emulate the value of real stock, thereby providing the key employee with an "owner-like" benefit without having actually invested in the company.
  5. A "change of control" agreement. You agree with a key employee that if he stays on until you cash out of the business, he gets a piece of that deal. Can be a fixed amount, an amount based on the transaction value, and may increase over the years. This "bronze handcuff" costs the employee nothing, and you owe him nothing if he doesn't stick with you.
These are just a few of the ways to recognize, retain and reward key performers. None of them tangle you up with a partner or change your relationship. You're still the owner and they're still the employee. They just have a more clearly defined reason to pitch in and to stay around.

If you've come up with a creative long-term compensation or retention plan, please click "Comments" below and share it with others.

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Terry Weaver

Chief Executive Boards International
Chief Executive Boards International: Freedom for business owners & CEOs -- Less Work, More Money, More Freedom to enjoy it

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