Non-Stock Deferred Compensation Plans for Rewarding Key Employees
Non-stock deferred compensation plans seem to be getting increasingly popular among privately-held businesses as a method of rewarding those who are making major contributions to the growth of the enterprise.
These type plans are often incorrectly assumed to be real “stock,” since they’re sometimes called “phantom stock” or “stock appreciation rights.” However, they have no bearing on ownership, and have no voting rights.
Regardless of what they might be called, they present a very attractive alternative to awarding “real” stock, especially for privately held businesses. While they are sometimes awarded to those who already own traditional shares of stock in the company, they are most often issued to those who are not shareholders.
The best way to describe them is through an example. Therefore, let’s assume that Acme Company has 4 owners:
- Individual A owns 25% of the company’s stock-
- Individual B owns 25% of the company’s stock
- Individual C owns 25% of the company’s stock
- Individual D owns 25% of the company’s stock AND is active in the business day-to-day
Individual D is active in the business, while A, B, and C are not. In addition to Individual D, there are two other employees who play crucial roles in growing the business over the long term through their day-to-day contributions — Individual E, and Individual F.
In an effort to reward Individuals D, E, and F for their active roles in growing the business, let’s assume that the four shareholders agree that these three people should receive a long-term incentive for their performance. In addition to rewarding them for growing the company, it should be noted that these types of plans also tend to keep key employees from leaving (especially going to a competitor, or starting a business of their own).
In this example, Shareholders A, B, and C agree to share 30% of the growth in the VALUE of the business (not sales, but true value) with Individuals D, E, and F. Here’s how it would work………First, the shareholders would agree on the value of the business on the date that the three employees begin the deferred compensation plan. Usually a formula is used to determine the value of the business, since that same formula can then be applied at a later date to determine the actual dollar growth in the value of the business. Value is often calculated using a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). Multiples vary depending on the industry and other factors, but a multiple of 3 or 4 is common.
Let’s say that the value of the business, as calculated on 12/31/14, is $1 million. And, let’s assume that Individual D is awarded a stake of 15%, Individual E receives 10%, and Individual F gets 5% (for a total of 30%).
If the business is sold for $4 million in 2017, here’s what would happen:
- Individual D would get 15% of the difference between $1 mill & $4 mill (.15 X $3 mill =$450K)
- Individual E would get 10% of the difference between $1 mill & $4 mill (.10 x $3 mill = $300K)
- Individual F would get 5% of the difference between $1 mill & $4 mill (.05 x $3 mill = $150K)
A total of $900,000 would be paid to the three individuals who are enrolled in the plan, generally at the time the deal is closed. Tax laws are always changing, but typically the distributions made to individuals under these agreements would be treated as ordinary income. The remaining $3.1 million ($4 million, less $900 thousand) would then be distributed to the 4 owners, as shown below:
- Individual A gets $775K (25% of the stock)
- Individual B gets $775K (25% of the stock)
- Individual C gets $775K (25% of the stock)
- Individual D gets $775K (25% of the stock)
Note that in the example above, Individual D would receive $775K for his ownership share in the company, as well as $450K for his deferred compensation award. The difference is that $775K would be subject to capital gains tax, whereas $450K would be treated as ordinary income. NOTE: DO NOT SET-UP A DEFERRED COMPENSATION PLAN WITHOUT THE
HELP OF YOUR ATTORNEY AND TAX ADVISOR!
It’s extremely important to emphasize that there are countless ways to structure non-stock deferred compensation agreements. The plan needs to be customized to deliver the kinds of objectives you want to achieve, and the type of behavior you want to reward. The purpose of these plans is to reward key players almost as if they were shareholders, yet no shares ever change hands. The absence of this type of incentive plan can lead to the departure of a key player, either to join a competitor, or to start a new business that will compete head-on.
The percentage set aside for deferred compensation plans can vary substantially. It’s also important to remember that, if the company in the example decided to do so, they could reward another 10% at a later date, either to one of the three individuals who already received them, or to a new key player who joins the company. Of course, the value of those would be calculated using the formula at the time those new awards were granted (for example, the new starting point might be $2 million rather than $1million).
Generally, these awards are granted on a particular date, but are vested over a period of time. For example, the 10% granted to Individual E would normally be vested as follows: 2% at the end of year 1, 4% at the end of year 2, 6% at the end of year 3, 8% at the end of year 4, and 10% at the end of year 5. If the company is sold before the five-year vesting period, many companies will immediately vest them at 100%.
One other aspect to consider is the departure of a key employee who is part of this plan. In that event, the company calculates the value of the employee’s award on the date that he or she leaves (based on the pre-established formula), and pays-out the funds over some period of time, perhaps 36 months, at a reasonable interest rate that has been established in the initial agreement.
This is only an example used to demonstrate the major features of non-stock deferred compensation plans for key employees. When you select the attorney who is going to help you create this plan, be sure it is someone who is very well versed in establishing such programs, and that your attorney and tax advisor are BOTH working together to create the plan.