Farrell: Getting creative with incentive compensation plans

The importance of attracting and retaining high-performing employees is a not a new concept for businesses. Still, in an ever-increasing mobile world, the ease for an employee to move from one job to the next has made the concept even more vital than it was in the past.

When faced with the familiar dilemma of trying to hold onto top talent, employers typically choose between increased compensation, other financial perks (e.g. a company car, matching health care contributions), and non-financial benefits such as additional autonomy or involvement in interesting projects. While all of these things can increase an employee’s job satisfaction, none foster the same type of loyalty that a well-structured incentive compensation plan can offer.

The idea behind incentive compensation is fairly straightforward. You are aligning the success of the employee with the success of the business. Theoretically at least, if an employee can see that doing whatever is best for the growth of the business will also benefit the employee individually, that employee will do more to achieve that desired outcome. The implementation of a plan can be appropriate when initially organizing the entity, particularly as a way to provide someone helping with the start-up through their services, for planning for business succession, or more generally to motivate and retain key employees.

Of course, while the concept may be simple, the implementation of an incentive compensation plan is more complicated. Several different options exist and each carry with it different positives and negatives. As one would expect, there is no perfect solution. While not an exhaustive list, businesses may choose between profit-sharing bonuses based on some combination of the performance of the individual, business unit, or overall company; stock or restricted stock; stock options; phantom stock; and stock appreciation rights.

Annual bonuses paid to employees have the benefit of immediacy. That is, the connection between the employee’s performance and the benefit derived from that performance is fairly obvious. If the bonuses are paid annually, however, the downside here is that the company has to use cash resources now in order to fulfill that obligation. Depending upon the size of the organization, that might prove difficult. Another downside is that unless the bonus money is separately held and not paid during the year, it does not necessarily motivate the recipient to stay with the company long term. Conversely, if the bonus money is not paid out immediately, but rather is held in a separate account which the employee cannot access unless certain triggers occur, it has the effect of making the employee think twice about leaving for another opportunity when their interest in those separated funds has not yet fully vested.

Stock options more directly tie the employee’s incentives to the overall worth of the company. Depending on the structure, stock options can also be advantageous for both employer and employee from a tax perspective. Generally, stock options are an option given to an employee to purchase company stock at a set price. If exercised, the employee would then have a partial ownership interest in the company. While it doesn’t offer the immediacy of the annual bonus, it allows an employee to participate in the decision making process and view information that an owner would be entitled to, but an employee may not otherwise be able to access. Often most importantly, upon the sale of the business, the employee-shareholder would participate in and receive the benefit of the proceeds of the sale. Many small businesses, however, do not favor stock options because they are unwilling to cede any control or access of records over to employees.

A creative way for small businesses to achieve the financial alignment that occurs with a stock option, but without the loss of control that makes owners uncomfortable, is to implement phantom stock or stock appreciation rights. These are similar vehicles, where the employee receives the same or similar rights that a shareholder would, but does not receive the voting rights. The main differences are that with phantom stock, the owner receives the underlying value of the stock when it vests and receives dividends commensurate with other shareholders. Stock appreciation rights, on the other hand, only provide the owner with the benefit of receiving the difference between what the share is worth at the time of payout over the value of that share at the date of issue.

As businesses, especially small businesses, continue to look for ways to keep their top talent while not hindering the cash need to grow, the use of incentive agreements will remain attractive. There are many factors to consider in terms of upfront capital, tax matters, control, and overall financial ramifications, but to ignore an investment in top employees is likely the costliest option of all.

• Ryan Farrell is an attorney with Zukowski, Rogers, Flood & McArdle.