Five Characteristics of a Well-Designed Employee Incentive Plan

The beauty of a well-designed employee incentive program is that as employees meet their physical and financial goals, you, as the owner, attain your goal of making your company more valuable and, perhaps, more marketable.If there was ever a case of “win-win” for both employer and employee, it is key employee incentive planning.

The first task in key employee incentive planning is to identify exactly who your key employees are. Most of your employees do not fit into the “key” category. Instead, they are attracted to your company and motivated by the usual items:  a pleasant work environment, a stimulating job, good wages and benefits and job security.

Key employees, on the other hand, act and think more like you do. They want more challenges and opportunities. They want to prosper and grow as the company does. In short, they behave like owners.  You may have key positions in your organizational chart. Make certain the persons filling those slots are key employees.

Keep in mind that people who are in key positions are not always key employees. If employees do not respond well to the incentive plans described below, it is questionable whether such employees truly are key.  With these guidelines in mind, let’s look at how to motivate this small, yet vitally important, group.

A well-crafted incentive plan is one that does more than make both owner and employee feel good. In fact, the following five criteria are present in a well-designed plan:

1. The plan provides substantial financial awards to key employees. A potential bonus equal to at least ten to thirty percent of annual compensation is necessary to motivate an employee to modify performance.
2. Performance standards are specific. There must be determinable performance standards such as certain company net income or revenue levels.
3. Performance standards are tied directly to increase in the company’s value. As the key employee achieves measurable objective standards, the net income of the company increases. Put another way, unless the company’s net income increases, the key employee does not receive a bonus.
4. Part of the bonus is deferred and subject to vesting. This characteristic of incentive plans is commonly referred to as “golden handcuffs.” If the employee severs his employment before he is “fully vested,” he forfeits at least part of the deferred compensation.
5. The plan is communicated in writing to key employees. In order to be successful, key employees must understand exactly how the plan works. The plan must be simple, easy to read, communicated face-to-face to employees with advisors present to answer any questions and contain a summary for easy reference.

Having identified the elements that make a successful plan, you (as an owner) and your advisors must determine whether a stock-based plan or a cash-based plan (or some combination thereof) will best motivate your employees and cause them to stay with your company.

Equity-Based Plans

Providing the opportunity for stock ownership is one of the most powerfully motivating and retaining factors a closely-held business can offer to a key employee.

Stock ownership motivates key employees for a number of reasons. The most common include:

• Stock ties key employees to the company by making them part of the company.
• The plan can require employees to pay for ownership, thus investing themselves, quite literally, in the company. Requiring employees to pay for stock demonstrates their dedication and commitment to the company.
• Stock ownership provides strong incentive for increasing the value of the company and therefore, increasing the key employee’s benefit.

These are great reasons to transfer stock. We would be remiss, however, if we left unmentioned some of the “not-so-great” reasons that motivate owners to give stock to employees.

It is not uncommon for owners to reward an employee with a small percentage of stock perhaps because the employee was instrumental in a start-up or is integral to one facet of the company. Unfortunately, these owners fail to appreciate that even the smallest percentage of stock carries with it significant rights.  Shareholders enjoy more than the right to a share of the growth of the company. They enjoy the right to access company books and records, the right to be informed about the financial condition of the company (including your salary and “perks”) and often, a right to be consulted and given the opportunity to vote on major company decisions. Keep in mind one possible “major corporate decision” is the future sale of the corporation. You should be fully aware of the voting percentage requirements imposed by law and by your company’s articles or bylaws before unwittingly tying your hands.

As ownership changes the outlook of the employee receiving the stock (usually for the better), it can also change the outlook of her co-workers, who now perceive her status as changed. Co-workers may demand ownership as well or may quit. In attempting to reward a key employee, you may inadvertently antagonize other competent, potentially key employees.

If you believe that stock is the appropriate incentive for your key employees, you then must determine if the time is right to make that award. A decision regarding timeliness is based on the presence of four conditions:

• Your key employee(s) has been with your company at least two years.
• The key employee(s) would be more motivated by stock than cash.
• You are prepared to award the employee(s) a meaningful amount of stock. (Should you be unprepared to commit a significant amount of stock ownership to an employee, a stock-based incentive is not appropriate.)
• You are willing to bring the employee into the company’s confidence, to provide that employee with access to all information regarding the company (including your total compensation) and to allow the employee to participate in major decisions concerning the company.

In addition to determining when to award stock, you and your advisors must consider the following:

• How does the incentive plan affect participants in other existing plans?
• Can non-participating employees participate in the future?
• What type of stock (voting or non-voting) will be awarded?
• What amount of stock will be awarded both at the outset and in the future?
• What valuation formula will you use when awarding and re-acquiring stock?
• When will payments be made?
• What agreement is in place to buy back the stock should the employee leave the company?

Cash-Based Plans

Most of the key employee incentive plans prepared are cash-based rather than ownership-based. While granting ownership is an excellent way to motivate performance, it carries an element of risk and most key employees prefer cash to stock, unless they have plans to own and run the company.  For those reasons, owners choose a non-stock incentive plan that provides cash or gives rights to appreciation in stock value rather than to the stock itself. The primary non-stock (or cash-based) incentive plans are:

• Non-qualified deferred compensation plans
• Stock appreciation (SAR) and “phantom stock” plans
• A blended plan combining current cash bonuses with deferred benefits

Properly designed, the non-qualified deferred compensation plan (NQDC) is often the simplest, most effective, and single best method of motivating and retaining your key employees. The NQDC plan is a promise to pay benefits in the future based on current or past services of a key employee (or group of employees).

In a phantom stock plan, owners give employees something that looks like stock, grows in value like stock and can be turned in for cash just like stock, but it’s not stock.  As the employee strives to make the company more valuable, he makes his interest in the phantom stock plan more valuable.

A stock appreciation rights (SAR) plan is similar to the phantom stock plan in that the value of benefits in the SAR plan is tied to the value of the corporation’s stock.  Unlike phantom stock, however, the employee under a SAR plan is only entitled to receive appreciation on a certain percentage of SAR units valued against the corporation’s stock, not the entire principal value of the stock.

If you have not yet installed a key employee incentive plan designed to motivate your employees to increase the value of your company, now is a great time to meet with our advisors. If you have installed a plan but find that it is not meeting your objectives, sit down with your advisory team, adjust your plans where necessary, and prepare to see the value of your company take off.

Construction Business Owner, February 2007