Give Me Your Stock and Nobody Gets Hurt

by

Joan M. Gruber Ridley, CFP™

Sometimes key employees do demand to have a piece of the action, but are they really asking for a share of ownership, or do they just want a significant share of the profits and some recognition. Looking at the situation from our business-owner clients’ viewpoint, they often want to “reward” key employees. To a business owner, “ownership” is the ultimate reward, so he (or she) often concludes that transferring stock is an appropriate solution. But for a key employee, sharing in company growth is usually reward enough. Before you start giving or selling away part of your company, take a look at exactly what that means and then explore other strategies that are available to you. More importantly, find out what both you and your key people are trying to accomplish before offering to give or sell stock to them.

Downside of Transferring Stock

There are several reasons why sharing ownership might not be the best way to go. Ask yourself if the amount of shares you would transfer to your employee would be meaningful, and, do you really want or need another shareholder. That shareholder is entitled to know everything about the company such as everyone’s compensation and perq’s, including yours. Would you want your shareholder employee to know about company dollars that are spent on your cars, boats, planes, vacation homes, travel, and compensation paid to your family members? Worse yet, he will have a say about everything that goes on and company strategy.

If he leaves the company, retires, dies, or becomes incapacitated, he or his estate, or his heir, still retains ownership. That problem can be solved with a buy-sell agreement, meaning that the remaining shareholders or the company would repurchase the stock. If you transfer stock to him, the value placed on the stock would need to be supported by a business valuation prepared by a qualified business valuation professional. It would also need to be defensible in the event of a challenge by the IRS. When re-purchasing the stock from a departed shareholder, you would need to come up with the cash to complete the purchase. Life insurance or disability buy-out insurance is the ideal funding strategy if the shareholder dies or becomes incapacitated, but if the reason for separation is not one of those events, such as his retirement, then you will need to raise cash by borrowing against, or selling, an asset. For instance, you could borrow against the cash value of the insurance contract, if you or the company owns the contract. The stock that was once yours will also be subject to his liabilities, which would include a property settlement pursuant to his divorce proceedings. So, think twice before “rewarding’ your key person with stock. And what if you want to sell your company or borrow funds to grow it, your new shareholder might have to sign every document involved with the transaction. Always check with your attorney, CPA, financial advisor, and business consultant before offering to transfer an interest in your company to anyone.

Strategies to Consider

Before considering any strategies, focus on what you are trying to accomplish and what would be of value to the employee. For most key employees, the right strategy will result in more total compensation, often on a tax-efficient basis, and recognition and appreciation for their contribution to the company. More importantly, determine how any strategy you are considering would add value to your company such as through improvement of the bottom line, and commitment to a shared vision for the company. The right strategy can have a positive impact on recruiting and maximizing retention of key people. If you plan to sell the company, a well-functioning management team can add significant value to a potential buyer, but only if the buyer is assured that those key people will remain after the acquisition. It will also deter a key person from leaving your company and taking customers, other valued employees, trade secrets, intellectual property, and other aspects that are critical for maintaining the value of your business. Here are a few strategies to consider:

Non-Qualified Deferred Compensation: This strategy is an excellent way to promote loyalty of key people while improving company performance, if properly designed. The plan must include a financial reward for the employee only if meaningful and realistic objectives for company performance are met. And, the rewards for the employee must be meaningful enough to provide an incentive for him to perform. Vesting and payment schedules, along with forfeiture provisions are needed to protect the company, long after the company changes hands. A forfeiture clause along with other necessary documents, such as an employment agreement with a non-compete clause, can deter an employee from leaving and setting up a competing business with his deferred compensation funds. This provision is usually included in other key person incentive plans as well. When designing a non-qualified deferred compensation plan, be sure the provisions are in compliance with the recently enacted Pension Protection Act. This plan, like all plans, must be properly communicated with the employee to be effective.

Phantom Stock: This strategy gives the employee the right to a bonus that is based on performance of “phantom” rather than real shares of the corporation over a specified period of time. The amount of the bonus is usually the difference between the fair market value of the shares of common stock at the date of the grant and the fair market value at a later specified date. The right to receive the bonus is usually subject to certain conditions such as continued employment and can be paid in cash, stock, or a combination of the two.

Typically a phantom stock bonus pool is created, such as a stated percentage of the growth of the grantor’s stock during the specified time. That pool of stock can be allocated to the qualifying participants based on their respective compensation. If your company sells during that specified time, the participants will participate in the proceeds from the sale.

Stock Appreciation Rights: While similar to phantom stock, with stock appreciation rights (SARs), the employee is only entitled to receive appreciation on a stated percentage of the stock appreciation rights units that are valued against the corporation’s stock, but not the entire principal value of the stock. As with phantom stock, the employee does not own stock and has no shareholder rights. The same as with Phantom Stock, when he leaves the company, he receives payment in a lump sum or in a series of payments over a stated period of years, depending on the plan design. Each SAR unit granted to the employee increases by the same percentage as the increase in value of the stock.

Funding Strategies

One very important consideration is how to fund these benefits. Life insurance is the most common, and the most cost and tax-efficient funding vehicle. It offers cash value build-up to fund the promised benefits, cash in the event of death of the key person, and it is protected from creditors. Disability buy-out insurance, not to be confused with disability income insurance, can provide a lump sum cash benefit in the event the employee is unable to work.

How You Benefit When You Implement These Strategies

Your ultimate goal is to maintain and grow company value. There are several strategies, including the three mentioned above, that might be right for your company to retain key employees. If a key employee leaves and takes your customers, or other company assets, with him to a competitor or to start his own enterprise, you lose. Stop and ask yourself, how long it would take to replace or win back those customers. Be honest with yourself. It could take several years. Once you rebuild a diversified customer list, it could be too late to take advantage of the current unprecedented market cycle in mergers and acquisitions. You now have an opportunity to walk away with top dollar. This market will not last forever. So when your key employee says “give me your stock and nobody gets hurt”, take his threat seriously if his departure could have a negative impact on company value. If he is a valued employee, and if his departure could seriously affect company value, take steps now to implement a plan that satisfies his needs and yours while maintaining and growing company value.

 

Joan M. Ridley is president of Business Wealth Solutions, a Dallas-based advisory firm that consults with business owners about how to successfully grow and leave their business. Visit our website at www.bwsllc.net. Call us today at 214.692.9192 for a complimentary meeting to learn how we can help you get where you want to go.

Copyright 2007 Joan M. Ridley