By:  S. Eric Bass, J.D., M.B.A.

Many employers struggle to find and retain the best talent without paying an arm and a leg in salary and benefits. In today’s article, I’m going to discuss three of the most useful alternative incentive options that businesses can offer to key employees.

To do this, we’re going to look at my client Joe Fitnessbuff, who owns a chain of successful fitness centers.  Bob has worked for Joe many years and is important to the business.  Joe will even admit (in private) that his business would suffer greatly if Bob left, but Joe isn’t ready to offer Bob any ownership in the business.  Joe is also worried about Bob leaving to work for a larger competitor who could pay more in salary, or even starting his own competing gym.

Joe has asked me to draft a non-competition agreement for Bob.  Joe knows that he must offer Bob new consideration—some benefit to Bob that he didn’t have before— for Bob to sign and to make the agreement enforceable.  Joe also wants to reward Bob’s hard work and incentivize Bob for the future.  However, Joe doesn’t have much additional cash to spare right now for a traditional bonus, commission plan, or increased salary.  Plus, those alternatives may not provide real long-term incentives to Bob.

In today’s economic climate, business owners like Joe should look for alternative methods to provide incentives to key employees that do not immediately impact cash flow.  Fortunately, business owners do have alternative incentive methods to consider.  The right incentives can encourage key employees to think and act more like owners and grow the business while avoiding the burden of an immediate payout of cash. In today’s article, we’re going to discuss three of the most common and most useful alternative incentive structures:

  • Deferred compensation plans
  • Phantom stock plans
  • Stock appreciation rights plans

Deferred Compensation Plans

Deferred compensation plans award employees with cash payments at a later time—usually as a result of the employees meeting certain goals.  A smart, well-advised employer will be careful in setting these goals so that he or she encourages employees to grow the business.  These plans do not typically pay the employee until retirement or termination.  The cash payout may occur over a period of years or, in some cases, never at all.  For example, if Bob is terminated for certain bad acts, he may not collect deferred compensation.  These plans may also require the employees to work for a certain period of time before becoming eligible for compensation.

The main drawback regarding these plans is the lack of immediate gratification for the employee.  You should also be aware that deferred compensation plans are subject to complex tax regulations that can greatly affect their worth as incentives.  If you consider a deferred compensation plan, you should consult with an expert advisor to implement it properly.

Phantom Stock Plans

Phantom stock plans do not actually grant stock to employees. Instead, most phantom stock plans give employees the right to receive payment of the value of a specified number of shares.  For example, if Bob were provided with a phantom stock plan equivalent to one share of stock in Joe’s company, he would have the right to collect the fair market value of one share of company stock on a certain date.  If the share of stock was worth $1 on that date, he would be paid $1. This means that employees are incentivized to increase the value of the company’s stock.

As you can see, phantom stock plans are useful in providing long-term growth incentives to key employees without giving the employees the voting rights granted to actual owners.  Further, an employee granted actual stock would likely have to pay taxes on the initial grant while the proceeds of phantom stock plans are not taxable until paid.

Phantom stock plans do have some drawbacks.  These plans are usually long-term plans, thus providing little immediate incentive.  Employees may incur a windfall for growth of the company that they did not truly help create.  Lastly, the company will need to make sure that it has sufficient cash to pay the employees when the time comes for payment.

Stock Appreciation Rights Plans

Stock appreciation rights plans are similar to phantom stock plans in many ways.  However, these plans provide the employees only the right to the increase in the value of a number of shares over a certain period of time.  For example, if Bob were provided with stock appreciation rights equivalent to one share of stock, he would have a right to collect the difference between the fair market value of one share of the company on a certain date and the current fair market value of one share.  If the share of the company was worth $1 currently and worth $1.50 on the applicable date, Bob would earn $0.50.

Stock appreciation rights plans have similar positives and negatives as phantom stock plans, except these plans more accurately award employees for helping the company grow.  Unlike phantom stock plans, they do not provide employees with a windfall for the current value of the company shares.

Which Option is Right for You?

As you can see, these three most common incentive options come with an array of benefits and drawbacks.  In picking one, you need to consider a number of factors, including:

  • Your current and anticipated cash flows
  • How fast your business is growing
  • How long you expect the key employee to work at your business
  • The tax situation of your business and the key employee

And these are just a few of the options available to business owners that want to reward and properly incentivize key employees without using current cash reserves.  To learn more about the advantages and disadvantages of these plans, or to explore other options, contact us for a consultation.