Commercial Insights

Retain Your Top Talent

Private companies often ask us what they can do to retain and reward a select group of executives or managers through some form of incentive compensation plan. The answer depends on a number of factors your company should consider:

• Is your company a start-up or a family-owned business?
• What are your board’s or owners’ short- and long-term goals?
• How many employees do you consider to be the “top” talent?
• Are you looking to commence succession planning?

Depending on your goals, the availability of cash, and the needs of the employees you are hoping to retain, some methods will align better than others for your needs. However, most companies would do well to consider these options:

1. Cash-bonus programs: a detailed cash-bonus program that rewards a company’s key employees for achieving various short- or long-term goals by providing additional cash compensation. The benefit of this method to the employer is that the additional payment is only triggered by additional profits (or achieving other goals). A potential disadvantage is that the bonuses paid can limit the amount of cash available to reinvest elsewhere in the business.
2. Stock-based programs: the benefit to the employer is that it allows the company to use current cash for other purposes.

Stock-based compensation programs can be very flexible, but can quickly grow complicated. There are generally two classes of them — involving “synthetic” equity and actual equity. The main landmarks to keep track of are outlined below.

Synthetic equities: are derivative instruments with the same risks and rewards as traditional equities except that the holder has no actual ownership. They include:

1. Stock Appreciation Rights (SARs) — the rights to be paid an amount equal to the difference between the value of a specified number of hypothetical shares of company stock on the date the SARs were granted and the value of the actual stock on the date the SARs are exercised.
2. Phantom stock — hypothetical shares of company stock in which the employee’s benefit is based on the hypothetical shares’ performance over a specified period of time. The benefit is typically an amount equal to the fair market value of the hypothetical shares on a specified date.

Pros and cons

SARs and phantom stock both allow your company to provide equity-based incentives without issuing additional stock — which can be attractive for closely held firms that are reluctant to issue stock to anyone other than the current owners.

Some companies favor SARs because they provide value only if the company stock gains value.

Phantom stock provides value even if the stock price declines. But they can make sense when you wish to recognize an employee’s past and future performance (because phantom stock has value on the day it is granted).

Your company might decide to set aside cash today to fund the benefit payments in the future, although there is no requirement to do so. Cash set aside is almost always considered a company asset and subject to claims of your company’s creditors. On the accounting side, because the participant can require the company to settle them in cash, SARs and phantom stock are typically classified as liabilities on the balance sheet based on their estimated fair value.

Actual equities: are additional shares of stock issued by a company for actual ownership by key employees. These include:

1. Stock grants — restricted* or unrestricted company stock awarded at low or no cost to reward employees for their performance.
2. Stock options — rights granted by the company to employees to purchase company stock at a specified point in the future for a specified price. Stock options include:

• Incentive Stock Options (ISOs) — rights granted by the company to    employees to purchase stock for a specified time period at a price fixed on the date of the grant. As long as various tax requirements are met, the employee reports no income when the option is exercised and, when the stock is sold, the gain is taxed as long-term capital gains.
• Nonqualified Stock Options (NSOs) — options that do not meet, or were not designed to meet, the requirements of an ISO. For employees, NSOs result in additional taxable income, but are frequently preferred by companies because the company is allowed to take a tax deduction equal to the amount the employee was required to report as income.

For accounting purposes, stock options usually need to be valued using an option pricing model, such as the Black Scholes model. Stock options are generally classified as equity on the balance sheet based on the estimated fair value of the options on the grant date. If the holder can settle in cash, the award should be classified as a liability.

Pros and cons

Some companies favor stock options over stock grants because — like SARs — options provide value only if the company stock gains value. Stock grants provide value even if the stock price declines.

Other equity-based programs

There are two other types of actual equity-based arrangements that you should add to the mix— Employee Stock Ownership Plans (ESOPs) and Employee Stock Purchase Plans (ESPPs). Both provide broad-based employee ownership opportunities — and can provide meaningful benefits if one of your company’s goals is to provide some form of equity to all employees rather than just a certain group or specific executives. Moving to an ESOP is a complex endeavor and you should know and weigh carefully the pros and cons before determining whether to take the plunge.

To learn more about how private companies likes yours can retain top talent, please contact Bill Enck , Roger Prince or your BerryDunn advisor.

_______________________________________________________
*Restricted stock grants are issued in the employees’ names but held by the company until certain conditions are met (e.g., the employee must continue in the company’s employ for a specified period of time). The employee typically has the right to vote the shares and receive dividends.