Rewarding key employees when ownership is off the table

Turnover in key positions is disruptive to the business, costly and consumes time. Sometimes these valued employees want “a piece of the pie,” but some owners are not wiling give up any ownership. In those cases, how can owners structure compensation so that their talent will stay and so that incentives remain appropriate?

By Donald Goldman, Professor of Practice, Accountancy

I recently had lunch with Sara and Bob, co-owners of an electronic components distribution business. Their business operates in eight states and has 65 employees. In discussing the issues facing their business, they said their biggest concern was the inability to attract and retain key employees. They identified the employee positions crucial to the success of their business as the CFO, vice president of operations, vice president of sales and three regional sales managers.

Turnover in these positions is disruptive to the business, costly and requires a lot of Sara and Bob’s time. In exit interviews with departing employees, Sara and Bob consistently hear that they like the work environment, their responsibilities and the authority they have to make decisions. However, they want “a piece of the pie." Sara and Bob have made it clear that they have no intention of giving up any ownership in the business. Many public companies provide equity based compensation to key employees in the form of stock options or stock grants. If the stock price goes up, so does the value to the employee. This type of compensation typically “vests” over a period of years.

A typical vesting schedule is 20 percent a year for five years. If the employee leaves before the option or stock vests, they forfeit it. This equity based compensation helps align the employee’s interests with those of the shareholders. It also makes them think twice before leaving the company as they could be forfeiting a significant amount of value in the unvested options or stock. Sara and Bob don’t want to offer ownership to their employees. However, they could provide compensation that makes their key employees feel like owners. One alternative would be to institute a bonus program to provide each key employee with a bonus equal to a percentage of the net income of the company. These bonuses could vest, and be paid, 20 percent a year for five years.

If the employee left one year after earning a bonus, they would forfeit 80 percent of it, plus 60 percent of the bonus from two years ago, etc. The idea is to make the employees feel more like owners and less likely to leave. Another alternative is to provide the key employees with “phantom” stock each year.   Phantom stock is similar to actual stock in that its value is calculated as a percentage of the value of the company. However, it does not give the holder any actual ownership in the company. The purpose of phantom stock grant is to provide an economic benefit to the holder that is the same as if they held actual stock.

Again, there could be a five year vesting period for each year’s grant, with a payout as the grant vests. The value of the company each year could be based on a pre-determined formula, or a valuation firm could be engaged to determine the value. There are many variations of the above alternatives. Sara and Bob need to consult with professionals to help craft a plan that enhances their ability to attract and retain key employees, promotes behavior that is beneficial to the company’s short term and long term goals and complies with all applicable laws.

Donald Goldman is a professor of practice in the School of Accountancy at W. P. Carey. He is also a certified public accountant.