By Jeff Henkelman
As a business owner, you understand the challenges that competitors in your industry can bring every day. But competition on price, features, or your service offerings aside, one thing competitors may be doing is looking to poach your key employees, especially if you’re employing some of the best and brightest in your field. These desirable employees can include your sales force, production team, or key managers.
Losing vital players from your team can be detrimental to your organization, especially at a time of economic uncertainty in the markets. How can you ensure your top people want to stay with you?
Motivating factors may be different for each employee, but in many cases part of the solution revolves around compensation.
Something for a business owner to consider is whether you want to share more of your profits or even some ownership and future growth with your key employees.
You have several options to consider that will achieve the objectives for both the organization and the employees. Ultimately, the basic premise is to allow some or all of your employees to share in the rewards and risks of the business.
We’ll talk about three typical structures in a bit more detail.
Profit sharing plans
A periodic bonus tied to employee performance may be sufficient to achieve the objectives of both the employee and the enterprise. If the employee hits certain targets, they get a cash bonus taxable to them as employment income and deductible to the business.
If you go with a bonus tied to targets, it’s important to make sure the targets are well defined so both you and the employee understand them. And ensure that those targets are aligned with motivating the employee to do what’s good for the whole business as opposed to simply enticing them to do what’s in their own best interests.
Employee share ownership plans
For employees you are confident would make good owners, an employee share ownership plan (ESOP) can be an attractive and effective tool for both motivating and retaining employees.
An ESOP allows employees to acquire an ownership interest in the company. The plan can take a variety of forms – equity shares, share options, stock appreciation rights or a combination of these – but the basic idea is that some or all of the employees share in the risks and rewards of owning the company.
An ESOP allows you to set the terms on the shares available to the key employees, including the timing, number, and percentage of shares you want to make available to them and the price they will pay for the shares.
You will need to consider what happens if an employee passes away, quits, is fired, becomes disabled, etc. The terms covering most of these issues will be found in the ESOP agreement along with the unanimous shareholder agreement.
Your key employees will benefit from an ESOP because it will provide them with a direct link to the benefits of being an owner, including sharing in the annual profits through growth in the equity of the business as well as in the increase in the share value.
If the plan is set up correctly, the employees will not be taxed until they actually dispose of the shares they receive under the plan.
There are also other plans that do not involve direct ownership but do allow key employees to effectively benefit from the growth of the business. These are often known as phantom stock option plans.
Another way to include employees in the ownership of the business is to execute a freeze of your business. This procedure is tax-free for you as the owner: you lock the value of your common growth shares into fixed-value preferred shares (they will not grow in value).
You can then issue new common growth shares for $1 per share in any percentage you want to yourself as the principal owner, as well as to your key employees. At this stage, the new common shareholders (including the employees) are participating only in the future growth of the company.
Be aware that some of the benefit of share ownership that comes from feeling like an owner by investing in a business may be muted if the employees do not invest a meaningful amount of their own funds for the shares. You, as the owner, must balance this issue knowing many key employees may not have access to capital to invest. You need to ask yourself if it is more important to retain the employee or for them to pay fair value for their shares.
For many, the answer lies somewhere in between. If you’re concerned a key employee may not feel like an owner because they haven’t actually paid for any of their shares, you can always have them invest a smaller percentage in the enterprise so they have skin in the game.
As with an ESOP, a significant benefit of the freeze option is that the employee now gets immediate ownership and will be able to see the fruits of their labour – not only in the annual profits of the business, but also in the appreciation in the value of their shares.
One of the keys to ensuring a successful implementation of a freeze is to have a clear dialogue with the key employees so they understand what they are getting as a result of the freeze. You also need to make sure you have a robust unanimous shareholder agreement in place before the execution of the freeze: all new shareholders must agree to it before being allowed to acquire shares of the business. Essentially, you dictate the terms of the agreement that will govern all new shareholders.
Before venturing down the path of employee profit-sharing, it’s important to do your research and ensure all parties understand the proposed plan and how it will affect them directly. You also need to ensure you’re attracting and retaining the right people; some employees may be motivated only by money and may not make great owners. For other employees, the idea of being an owner may drive them to act like one, as they can now directly see the benefit of their efforts in the bottom line of the enterprise.
First published in the December 2020 edition of The Business Advisor.