One of a business owner’s greatest challenges is to attract, motivate, and keep key employees. As owners near the finish line (the exit from their businesses), often tired and distracted by the end of the race, they often assume that it is no longer desirable to keep and motivate key employees. Keeping key employees is not only desirable, however, it is necessary if the business is to be sold—and sold at the highest possible price.
A basic premise of key employee incentive planning is to keep the key employee as a long-term, contributing member of the company. Consequently, incentive plans incorporate relatively long vesting schedules and provide benefits that are relatively moderate in the early years but become substantial as the years pass (usually after the employee has participated in a plan for at least five years). Incentive planning is discussed in the book The Completely Revised How To Run Your Business So You Can Leave It In Style.
Planning techniques that work well in long timeframes, however, are not as effective and, indeed, may be counterproductive in the short timeframes of owners who are actively selling their businesses. Plans designed for short timeframes must provide a substantial benefit in a short period of time, provided the business is sold. Keep in mind that this “short period of time” must be long enough to keep the key employee productive during and beyond the sale. Additionally, while the benefit should be rich if the business is sold, it must be affordable to the company if the business is not sold. Owners who wish to successfully balance their needs again the desires of their key employees must tread these fine lines.
This article focuses on short-term incentive plans. If you desire more information about long-term incentive plans please read Chapter Four of The Completely Revised How To Run Your Business So You Can Leave It In Style or refer to the page of this White paper for a quick synopsis.
Business owners considering a sale to a third party must take every reasonable step to ensure that their key employees remain at their posts even as the owners prepare to leave theirs. Not only are the key employees’ efforts to maintain cash flow critical to maximizing the business’s eventual sale price, these key employees may need to shoulder extra duties as the owner’s attention wanes or is diverted.
Finally, given that few sales to third parties are all-cash sales, owners are usually exposed to post-sale financial risk. If the business does not continue to perform after closing, the owner may not be entitled to receive the earn-out portion of the sale price, or the buyer may default on the owner’s carry-back (promissory note) for the balance of the purchase price. This is one reason why it is not uncommon for owners to offer key employees a share of the “spoils” when the business is sold.
In our experience, selling owners typically have three objectives with respect to their key employees:
- To motivate them to increase the company’s cash flow:
- To keep them on board before, during, and after the transition; and
- To reward them when the business is sold, (provided that the award is not so great and so immediate that there is no incentive to continue working with the new owner).
Using a sound and thoughtful incentive- based plan for key employees, owners can achieve these objectives. A sound and thoughtful plan includes the following attributes:
- It provides a substantial benefit in the eyes of each key employee. This means that only a small number of participants can be included in an incentive compensation plan or the benefit is diluted. For example, an owner who may wish to include eight or ten key employees in an incentive plan that offers 25 percent of the company’s profits or equity will find the effect of this plan severely muted. Because the number of participating employees is so great not one stands to benefit significantly.
As long as we’re on the subject of “significant,” remember that key employees will want a “significant” slice of the future value that they help to create. If the company is to be sold in the near future, management will want its “share” of the “windfall” to be received when the new owner pays fair market value (rather than the current value) for the company.
- The plan must be perceived as a “win-win” for both company and key employee.
- The plan must “handcuff” the key employees now, during the actual sale process, and through any earn-out period that may be imposed by the buyer.
Of course, the ideal time to begin key employee incentive planning is well before a business transfer occurs. However, even those owners already dancing in the arms of a would-be buyer would do well to begin the planning process. As the old saying goes, “The best time to plant a tree is seventy-five years ago. The second best time is today.” So, today, let’s look at the fictional case of John Ewing, owner of Ewing Lubricants, Inc.
We weren’t 60 seconds into our meeting when it became clear that, while John Ewing may have not formally launched the process of selling his company, he had mentally checked out months ago. Ewing Lubricants was being maintained by the efforts of its three key employees, all of whom were well aware of—and increasingly nervous about—John’s desire to sell the business. In fact, it was John’s relationship with these employees that brought him into my office. In a sound effort to retain these employees during an eventual sale process, John had “sort of unofficially, informally promised” them a “piece of the pie” upon a successful sale. In addition, his “promise” reflected his desire that they benefit should he sell the business for his asking price.
John’s problem is typical. As he thinks about how to exit business, he must give equal thought to discouraging his key employees from doing the same. Key employees are never so “key” as they are when the owner begins exiting the business. There are several reasons for this.
- Owners often lack motivation—“the fire in the belly”—to enhance the success of the business on a daily basis. They are either tired of slugging it out in the trenches every day, or they have grown bored with the daily activities of the business. In order to keep the business successful and on track, they must have a properly motivated, strong management team in place. John Ewing was acutely aware of the need to motivate his key employees. Somebody had to propel the company forward and it was all John could do to go to work each morning.
- Buyers buy cash flow—and they pay top dollar for cash flow that they expect to increase after they buy the company. Think like a buyer. Owners cannot allow cash flow to stagnate simply because they are planning their escapes. Once again, it falls to the key employees to drive cash flow upward.
- Key management is as vital to a new owner as it is to exiting owners for its role in maintaining and increasing cash flow. Sophisticated buyers, in particular, will pay far more for a business if key management will stay with the company after it is transitioned. In fact, a potential buyer may have little or no interest in acquiring a business, at any price, without assurance that the key employees will continue under new ownership.
- Key management provides an owner with an alternative exit strategy. If a sale to a third party fails or is unworkable for some reason, the management team may be willing to purchase the business.
Although John may have checked-out emotionally, he was still a quick study. He readily understood that the long-term key employee incentive plan he had previously implemented needed modification to include not only the elements of regular incentive plans (long-term vesting and increasing benefits), but two additional attributes.
First, John recognized that a condensed timeframe was crucial to employees. Owners and their employees need a plan that lasts no longer than two to four years from its inception to its total pay out. It is during this period that the business will be marketed, sold, and the key employees will be employed for one to two years by the new owner/new company.
Second, John needed to assure his key employees that, even though the ownership of the company would change, their benefits would not be affected. While the incentive plans was created to provide substantial benefits to his three key employees, (assuming they stayed long term) the incentive plan also created substantial problems if he sold the business in the near term. Ewing was on the horns of a dilemma.
To fully appreciate his situation, (one shared by many owners) we need to first understand what the company had done to handcuff management to the business.
Ewing Lubricants had two plans. The first was a non-qualified deferred compensation plan designed to provide two of his three key employees with as much as $750,000 cash upon full vesting (about 10 years). The second was a stock purchase plan for the operations manager. That plan allowed the manager to acquire ten percent ownership using a low value over a number of years.
John’s dilemma then was:
- If, at the time of sale, the vesting under each plan was accelerated, the key employees would receive the windfall John intended to provide, but the windfall would be so great that the employees might take it and run (exit the business) along with John. That would spell disaster for John’s chances of successfully selling the business. He knew that, without the assurance of management remaining when he departed, no buyer would want to purchase his business.
- If, at the time of sale, vesting was not accelerated and the key employees lost their assurance of a “windfall,” they (being almost as strong-willed and independent as John!) might pack their bags and leave-with the same deal-killing results as if they had received the enhanced benefit!What to do? Before answering that, let’s examine one other situation.
That is the owner who has not created written incentive or “golden handcuff” plans for key employees, but who is nevertheless concerned about key employees leaving when the business is sold. When employees contemplate their employer selling out to a larger and, (in their minds at least) less employee-friendly company, they are naturally apprehensive. Although acquiring companies typically provide their own stock option plans, or similar benefits to key employees, the risk that the acquiring company’s stock will not retain its value undermines the employees’ sense of security. The only thing employees fear more than the unknown is the “loss of the known:” their job security, their roles within the company and their existing benefits. Over time, they come to trust the direction and mission of your/their business. Will what they know evaporate only to be replaced by promises made by an unknown and more remote owner? A common response to these uncertainties is for key employees to seek alternate employment. Rather than lose key employees at the very time the company needs them most, smart selling owners provide a formal plan to handcuff and motivate management. This plan is also helpful if (for some reason) the sale is not completed; the owner will still have this company and its key management team intact.
That brings us to how owners who have not created incentive plans for key employees find themselves facing the same dilemma as did John. If a selling owner provides no incentives, management has little motivation, in today’s labor market, to remain employed by a company they did not choose. They will leave. This certainty dictates what you must do for your key employees if you are to leave your business in style. On the other hand (or horn), if the prudent owner promises key employees a “share of the windfall” upon a sale, they will certainly accept but may leave shortly after you do.
If you wish to avoid teetering between these horns (and already have an existing plan) consider adding a “conversion feature.” If you have no such plan, consider creating a short- term bonus plan. This short-term bonus plan must provide the key employees with a reason to continue with the new company. That reason is a promise: a promise that comes, not from the new organization but, from the existing owner – you. And that promise is: cash. We call these plans “stay bonus plans.”
Part of John Ewing’s exit plan involved installing a stay bonus plan for his key employees. To determine the proper amount of a stay bonus, look at either the unvested benefits of any existing key employee benefit program or at the percentage of the anticipated purchase price that the owner wishes to give to his key employees.
Ewing had already “informally” promised his three key managers a total of 20 percent of the anticipated sale price. Using that as our basis, we began to design a plan. (If you do not have an existing plan, the method to create a stay- bonus is still the same.)