Use Equity Incentive Plans to Boost Exit Value

/in , /by Al Statz

Closely-held business owners often use equity and equity-like programs to attract and retain key employees and incentivize them to boost profits and build enterprise value. These plans provide value to the employees through current profit sharing and/or future equity appreciation. I am a strong proponent of utilizing these types of incentive plans as part of an exit strategy. Let’s break this down.

Why profit sharing for key contributors?

  1. Sharing company profits with key employees incentivizes them to work harder and smarter, think more holistically about the business and be more productive.
  2. For the company, profit sharing shifts compensation from a fixed to a variable expense and aligns the employee’s short-term interests with its own.
  3. The company can track, calculate and compensate employees on the performance of the whole company or a business unit (e.g. regional office) when appropriate.

Often, profit sharing is all that is needed to attract and retain top talent. However, by itself, profit sharing isn’t an incentive to create value for company shareholders.

Why equity appreciation incentives for key contributors?

  1. Equity plans encourage longer-term thinking and behaviors that increase enterprise value.
  2. Allows employee to defer compensation into the future, assuming there is an exit strategy.
  3. Creates incentive to stay, if the company increases in value.
  4. Allows the company to conserve cash needed for growth (vs immediate compensation).
  5. Rewards employee for betting on a new or unproven company, if applicable.
  6. Helps company compete for talent, both with private “tech” companies that grant stock options, and with public companies that promise more opportunities for career advancement but rarely offer equity appreciation incentives except to the very top executives.

Equity Incentive Plan Options

These plans include “Qualified” Incentive Stock Options and Non-Qualified Stock Option plans. Qualified means the plan qualifies for favorable tax treatment by the IRS.

Stock Appreciation Rights (“SAR”) plans grant a right to employees to receive compensation if and when the company is sold, based on the increase in value over some base value (strike price). The employee pays ordinary income tax on the gain when realized. The rights typically vest over some period and are subject to continued employment. SARs do not pay dividends and holders receive no voting rights. It is common (but not required) to have both a profit-sharing plan and a SAR plan.

Phantom Stock plans are similar to a SAR plan. One key difference is that phantom stock plans usually pay dividends on the vested portion (like actual shares), which effectively adds a profit sharing component.

I’m barely scratching the surface of this subject. If you are considering creating an equity incentive plan for key employees, it is critical to work with an attorney that specializes in this area. Jonathan Rubens, a partner in the San Francisco-based law firm of Moscone Emblidge & Rubens LLP, is one of the best. Read Jon’s article: Equity Incentive Compensation and Succession Planning Part I: Stock Options and other Structures for the Closely-Held Business

When your ultimate goal is to sell the company, you have to think about how potential buyers will view the plan(s). It is exceedingly difficult to take benefits away from key employees and keep them happy. The buyer will likely have to continue a profit-sharing plan or replace it with some other form of compensation. This just means that your plan has to produce the desired effect – an incremental boost in sales, earnings and net cash flow. You have to get this right!

Al Statz is President and founder of Exit Strategies Group, a leading California-based M&A advisory, valuation and exit planning firm with decades of experience. For further information or to discuss your exit plans, confidentially, contact Al Statz at 707-781-8580.